Travis Scher is a bitcoin and blockchain investor at Digital Currency Group, and a former attorney working on M&A and corporate finance transactions.
In this opinion piece, Scher gives his personal view of the lately popular ICOs and appcoins, and offers a warning for potential investors.
Initial coin offerings (ICOs) and appcoins are a hot topic in the blockchain community these days.
Forward-thinking investors have thrown their support behind the movement, thought leaders have proclaimed that ICOs are turning the traditional venture capital model on its head, and bitcoin industry veterans have launched hedge funds to invest in blockchain tokens.
I expect this discussion and activity to gain momentum in 2017, but I remain skeptical.
As the most active investor in blockchain startups, we at Digital Currency Group are uniquely positioned to capitalize on the growth of ICOs. So, over the course of 2016, I've taken a close look at what is actually happening in the market.
I've had conversations with dozens of entrepreneurs who have either considered or actually raised money via token sale, and I’ve spoken with many of the leading investors in these projects.
And, while I’m excited about blockchain’s long-term potential to enable new models for both financing and operating organizations, I believe that ICOs and appcoins are, broadly speaking, not an attractive investment nor are they likely to become one in the near-term.
For the uninitiated, an ICO is a crowdsale of cryptographically secured blockchain tokens to fund the development and operation of one of three types of blockchain projects:
- A platform-layer blockchain (such as ethereum or Lisk)
- An organization that operates on a blockchain (known as a decentralized autonomous organization ('DAO'), or a centrally organized distributed entity ('CODE')
- A decentralized application ('dapp') that runs on a platform-layer blockchain.
A token that fuels a dapp is sometimes referred to as an appcoin, while tokens that fuel DAOs and platform-layer blockchains are simply known as tokens or cryptocurrency.
In a typical ICO, new tokens are issued in a crowdsale in exchange for bitcoin or ether, and then, if sufficient demand exists, digital currency exchanges will make a market so they can be traded.
This new fundraising approach, while still in its infancy, is being hailed as a way to decentralize and disintermediate venture capital, creating new sources of funding for entrepreneurs and new investment opportunities for individuals.
Some blockchain entrepreneurs have been able to raise larger sums of money (with much less effort) via an ICO than would have been available to them in the venture capital market. Moreover, the broad distribution of a token can incentivize early investors to become advocates for, users of, or developers on a blockchain platform. Not surprisingly, more companies we are speaking with are considering a token sale to fund their businesses.
These are exciting developments, and ICOs and decentralized organizations may very well transform industries long-term.
However, in the midst of all this excitement, I believe it is important to be clear about what reality looks like today. And in my diligence, I’ve repeatedly encountered four issues that make investing in new tokens – at least for now – very unappealing compared to traditional VC investing:
- Regulatory uncertainty
- High valuations/over-capitalization
- Lack of controls
- Lack of business use cases.
I’ll touch on each in order.
Firstly, the creators of these new tokens seem to broadly underestimate the regulatory risks associated with ICOs.
They often pay lip service to regulatory compliance, and unanimously proclaim that they are "speaking with lawyers" and will "make sure" their offering is compliant. But the reality is that most don’t seem to be taking the legal risks seriously.
Few of the entrepreneurs launching ICOs actually understand the Howey Test, which is used to determine if a transaction is a “security” subject to the SEC’s registration requirements. As an example, many falsely believe that incorporating outside of the US will place them outside of the scope of US law enforcement. And few have convincing answers as to why a new token, rather than bitcoin or ether, is necessary for their project to operate (and thus why their token is not merely crypto-equity).
The folks I've spoken with have been broadly dismissive of and naive about these risks. But unregistered ICOs may very well be deemed broadly illegal. I appreciate the ethos of asking for forgiveness rather than permission, but that does not mean investors should stick their heads in the sand.
While the limits of unregistered ICOs have not yet been defined, financial regulators tend to expand their jurisdiction where they can, and the scammy and opaque nature of some of the projects is likely to draw their attention. Having recently released the rules governing unregistered equity crowdfunding, they will likely be quick to clamp down on structures that they believe violate these rules.
Certainly if these blockchain projects turn out to create tremendous value without unreasonable risk to unsophisticated investors, the laws should adapt. But anybody who follows financial regulations knows that these laws usually do not evolve as they should.
Thus, investors in these tokens should understand that they could lose most or all of their investment in these projects with the swipe of a regulator's pen.
Secondly, the implied "valuations" that these DAOs are raising at are, in my view, unjustified, and the amounts being raised in these token sales are alarming. Founders with ideas that would struggle to raise a $500,000 seed round from experienced venture capital funds are raising millions in token sales.
Some may view this as a good thing, with entrepreneurs able to cut out the elitist VC gatekeepers and get voluntarily funded by perfectly sovereign individuals who understand the entrepreneur's vision. I view it as a sign that the market is out of whack.
The only buyers in these token sales seem to be overly enthusiastic early bitcoin and ether holders who feel like they are playing with house money, and have no basis for determining the value of these projects or how much money they will need.
This situation may stabilize over time, but, at the current moment, this is not a market I would want to participate in. Even the most promising projects are likely to be massively overvalued and overcapitalized.
Lack of controls
Thirdly, I've been shocked by the lack of controls governing how the decentralized organizations issuing new tokens can use the proceeds of ICOs, and how revenues and/or profits associated with the projects are to be shared with token holders.
In many cases, it is totally unclear what rights the token holders have.
Promoters of these token sales probably have no legal fiduciary duties to use the proceeds of an ICO for the benefit of token holders, and they rarely lay out in advance how such proceeds will be used. Several of the companies I've spoken with are sitting on millions of dollars raised via ICO that they unilaterally control.
In most cases, nobody is really monitoring the use of funds, which might be held in fiat currency in a private bank account or in cryptocurrency in a multi-sig wallets. Fraud and scams are inevitable. And even the promoters with the best of intentions will be swayed by their self-interest and distorted incentives.
Some take solace in the notion that investors rights are "coded" into the project , but in practice the original promoters generally have the power to single-handedly alter or fork the code for their own benefit.
Corporate forms have weaknesses, but they have evolved over hundreds of years in conjunction with markets and common law to balance stakeholder incentives and manage agency problems.
I accept that DAOs can implement workable governance structures in theory, but it remains to be seen if they can do so in practice. A DAO is a smart contract, but is it an actual, binding legal contract between the parties, with sufficient investors protections? I think the answer today is no.
No business case
Fourthly, and perhaps most fundamentally, I have not yet come across a blockchain-based dapp that is providing a solution to a real problem on a significant scale. Is the market really demanding a decentralized Uber or more ways to gamble?
Dapps can theoretically provide lower costs, enhanced privacy, and greater security by cutting out middlemen. But privacy and security won’t drive mass adoption.
In my view, to really go mainstream, these dapps must provide meaningfully lower costs without compromising user experience – and providing a first-rate user experience will be extremely challenging without a normal organization consisting of responsible employees. Wikipedia has demonstrated that this is possible, but adding the blockchain adds another layer of complexity that must be tackled.
Even the rare dapps that have put forth a plausibly compelling value proposition have been marred by an overly complicated set of rules that may be inherent to the project’s decentralized nature.
This is not to say that a wildly successful dapp will never materialize. And failure, learning, and iteration will all come before success. But the current reality is that no dapp has resonated with real consumers, and many of the attributes that make blockchains fundamentally revolutionary also make it much harder for them to achieve mass adoption.
In spite of all the risks mentioned above, I might seriously consider a token sale if I were a blockchain entrepreneur today – ICOs are an easy way to raise money, and the broad distribution of one's token can create powerful momentum for your product.
Furthermore, I believe that open-source blockchain protocols may be transformative over the long-term, and am excited to witness and contribute to this development.
However, none of this will happen if the issues of regulation, valuation, and controls are not addressed, or if blockchain entrepreneurs fail to use these new protocols to solve actual problems in a user-friendly way. The reality is that these coin issuances are tremendously flawed today, and investors interested in ICOs and appcoins should proceed with caution.