Everybody is talking about ICOs. Of course, they are coming hard and fast and raising a ton of money in very little time.
ICOs are great!
This is great for entrepreneurs: they can raise money much easier and quicker to develop their projects. After all, banks don’t lend money to startups and raising money from angel investors is time consuming, difficult and expensive.
This is also great for investors, especially those who cannot afford to write 50 thousand dollar checks and/or don’t live in Silicon Valley. It is hard to invest in startups: you must have the right connections to get in and, because the minimum amounts good startups expect from their angel investors are quite high, you have to have a lot of money to create a sensible portfolio of 15 startups or more. With ICOs, investors can create a portfolio of projects by investing little money (as little as one dollar, maybe less) in a very easy way: just send some ether or bitcoin to the projects address.
Or is it?
The risk of too much money, too soon
I have worked in venture capital and startup accelerators for six years now. And I believe ICOs are very exciting and truly disrupting. Startups don’t have to depend on the whims of VCs, angel investors or accelerators anymore. The tables are turning. We have seen this already happening to a certain degree with crowdfunding sites like Kickstarter. Especially for hardware startups. And we have seen several crowdfunding projects turning out to be outright scams or just complete failures. And this is going to happen with the ICOs, for sure.
Not all ICOs are scams or bad projects to invest in. There are some projects that are only possible because they can raise funds through ICOs and that might, in the future, really change the world. Would Ethereum be in the place where it is, were it not for its ICO (or pre-sale) in 2014? Millionaires have been made. After all, you were able to buy ether at around 30 dollar cents and now the ether price is at 236 dollars (that’s a 786x return on investment in less than 3 years!).
But we know from observation that too much money, too early in the lifetime of a startup increases the probability of it to fail dramatically! Founders and employees get greedy, start arguing, people stop working because they have gotten rich, the startup turns into a magnet of scammy consultants and overpriced contractors.
Adding tokens where there should be none
And, finally, we see startups creating tokens that have no need to exist just because they want to be able to do an ICO. It’s a bit like lots of startups last year which put the word blockchain on their pitch deck just to ride on the hype, but worse. As long as you can offer a token to be pre-sold, it almost doesn’t matter what you do. Just ICO the sh*t out of it!
Does the startup’s system need to be censorship resistant? Then use blockchain. If it doesn’t, then don’t. Use a regular database instead. If you like, add blockchain inspired techniques to it: assymetric cryptography, hashing, blocks, block linking, distributed ledgers and so on. No problems with that. Just don’t call it a blockchain and don’t create a token for it.
Risks versus opportunities
The opportunity for the entrepreneurs are clear and very enticing, tempting, even. But there are a lot of risks involved.
- I already talked about the risk of the startup failing because of “too much money, too soon” above
- the startup could be selling something that might be interpreted as a security and its founders might go to jail for that
- after the ICO, somebody could steal their funds in cryptocurrency
- failing to meet the expectations of all the small investors and feeling the burden of seeing their savings going to the trash because of the founders’ own shortcomings
- startups have no idea of who has invested in them. And what if a big portion of their shiny, newly minted tokens is held by unscrupulous “investors” who might come after the founders if things don’t go as expected?
For founders, risk number 2 and number one are the main ones, I believe. Number 3 would be high on my list and number 4, to be honest, is more fiction, at this point in time.
For investors, the two main risks are obvious:
- the typical startup risk, but amplified: if regular startups have less than 10% chance of succeeding, ICOs promise to be way riskier, still
- investing in outright scams
Incentives, checks and balances
In a usual startup investment, a few things happen which are not necessary for ICOs to happen. These things are important to improve the odds of success and have been optimized over decades of experience and billions of dollars of investment. Of course, as with any radical innovation, what served us well in the past might not be adequate anymore. But I will argue that the following points are still very relevant
Investors spent a lot of time and energy examining each investment opportunity before investing in them. This is a strong incentive for founders to really do as they preach. They know that a shiny powerpoint slide won’t hold up to the type of scrutiny an investor exerts if it is not backed by fact.
Startups have to show progress and concrete achievements before being able to raise capital, in most cases. It is highly improbable that they will raise a substantial amount of money just on an idea alone. Not after the dot.com bubble experience almost twenty years ago.
Investors also analyse the track record of the team behind the startup as a major risk factor.
Investment in rounds or tranches
Investors don’t just pour dozens of millions of dollars in a 3-month-old startup. They will invest in several rounds, starting with a small investment of thousands of dollars, then going to hundreds of thousands of dollars, to millions of dollars and, only then, to tens of millions of dollars.
The entrepreneurs first must prove that they are able to deploy smaller amounts of capital wisely and effectively, before being able to deploy larger amounts of capital. This builds track record.
Skin in the game
Investors and founders both are shareholders in the company. They share both profits and risks. Not always equally, it is true. Entrepreneurs give a stake in their company, an ownership percentage in their business to investors. This makes the money they are raising much more expensive to the founders, which should lead to a more balanced disbursement of it. But this also makes the investors much more involved with the startup. If some things go wrong, they don’t have only money to lose.
If someone (or a firm) invests 100 thousand dollars or more in a startup, if that startup fails, the pain is 100 thousand dollars strong. If someone invests 10 dollars in a company and this money disappears, how much pain is there?
Not much. This is great, because if a startup fails, the loss, for many of its investors, won’t be a great problem. But this is bad too, because the investor has very little incentive to do a thorough analysis of the investment opportunity. If you earn 25 dollars an hour, how much time will you investing going over the details of a 10 dollar investment?
This is an initial collection of thoughts on ICOs I’ve been pondering for some time, now. More is to come, as this subject is both fascinating and very encompassing.