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August 28, 2017

The Summer of Initial Coin Offerings

Note: my blog has moved to www.seeingbothsides.com. Also, check out www.jeffbussgang.com to see my new book, Entering StartUpLand, which ships on October 10th.

Goldman Sachs and CB Insights recently reported that startups have raised over $1 billion in Initial Coin Offerings (ICOs) this summer — more than the total amount of venture capital raised during the same period.

At Flybridge, we are wading into this uncharted territory as a result of one of our portfolio companies, Enigma, staging an ICO in the coming weeks.

Many investors in the ecosystem that we respect have shared their thoughts on the power of the blockchain and cryptocurrencies to disrupt many industries (and we share those views) but few have discussed the downstream ramifications to our business. Hence, the purpose of this post.

I won’t attempt to provide all the contextual background regarding the blockchain, cryptocurrencies and why they represent such a profound innovation in our world.

Others do a good job of that. Instead I will make a few observations about how an investor might think about the impact of ICOs / token launches on the venture capital industry, in particular, and some of the downstream ramifications that need to wrestled with.

Need for growth capital.

A company that can successfully raise money in an ICO may never need venture capital again. Most of those companies will still require seed capital to assemble their team and fund a year or two of initial development and experiments.

Perhaps, when things settle down a bit more, those companies will even raise series A capital from traditional institutional sources to expand the product features, beef up the operations team more fully and make progress in finding initial product-market fit.

Early stage entrepreneurs will also still likely value experienced advice on company-building from seasoned venture capitalists. But once entrepreneurs have their initial team and product in place, a few smart advisors around the table and the social proof required to attract great talent, why would they raise additional dilutive equity capital if they can raise non-dilutive capital through the sale of tokens?

Put aside the frauds and hucksters — time and transparency will cause them to shake out — and obviously not every business model is a fit for an ICO. But many are. Good teams creating something of real value around which they can build a community now can tap another source of scale capital available to them.

I wonder, for example, if our portfolio company, Codecademy, would have avoided its latest financing round and instead created “CodeCoin” in order to incent contributors to software development lesson plans and a marketplace for coding content? In these early times, some startups may be hesitant to pursue this path because of the uncertainty and perceived risk.

But once the regulatory and systems infrastructure for ICOs is in place and the friction is reduced, it will become a more common means of raising growth financing, representing a disruptive force for later stage investors. In short, token sales allow early stage companies to skip the series B round and beyond.

Shift of value from equity holders to token holders.

When a company that has raised venture capital creates a token and raises capital in an ICO, there is a real risk that value is being shifted from the equity holders to the token holders.

In fact, that is somewhat the point — a community is created and value begins to accrue to the participants in that community. The hope is that the early stage investors select companies that have a business model that takes advantage of the growth in the community and the ecosystem around it.

The ICO generates excitement and valuable incentives to contribute to the ecosystem which accelerates its growth and, as the ecosystem grows, the company has a cash flow formula that allows value to accrue to the equity holders of the corporation not just the tokens. But that balancing act is a tricky one and not guaranteed, particularly because business models and cash flow formulas are often hazy in the earliest stages.

Further, not only does substantial value accrue to the community but control and governance over the underlying technology and protocol accrues to the community and token holders as well.

As Sarah Tavel pointed out in a recent tweetstorm, for a company trying to stay nimble and have the flexibility to run a lot of rapid experiments, the very existence and power of the community may reduce degrees of freedom during the search for product-market fit.

We typically advise our portfolio companies to avoid taking on strategic investors at an early stage for this very reason. Entrepreneurs who embark on ICOs may similarly want to be careful before empowering their community of supporters too early.

Fuzzy Governance.

In a world where startups can raise over $1 billion in proceeds in token offerings and avoid later stage financings, how should we think about the investor’s role in the governance of the corporation and the community?

Governance of the corporation is a bit easier—Delaware Law has long-practiced guiding principals for things like fiduciary duties such as duty of care and duty of loyalty—but what are the governance requirements and obligations with respect to the token economy and the related community?

Albert Wenger wrote a terrific blog post on this topic where he points out that the governance over the ICO proceeds requires new thinking in order to avoid self-dealing. There may be additional governance issues that need to be thought through with respect to the selling of tokens that companies retain in treasury (often 25% of the ICO proceeds).

Who sets the policy for token sales—management or the board of directors? What happens if the company has raised money in the form of a convertible note and has not yet formed a board of directors? What are the ramifications and conflicts of interest that may exist, particularly if executives and employees have tokens as incentives or have bought tokens (or have friends and family who have bought tokens) in private transactions?

Should early investors be allowed to participate in token sales and pre-sales and how should they treat their investors in those transactions? Our guidance at this nascent stage is to follow the mantra that sunlight is the most effective of disinfectants.

Transparency and open communication is key to establish trust—both between entrepreneurs and investors as well as between entrepreneurs and the community.

Seeking Liquidity.

Another consideration investors need to think through in this brave new world of ICOs is the impact on liquidity. If a portfolio company can raise money in an ICO and retain tokens that then rise in value, it dramatically reduces the company’s incentive to seek an exit.

If the management team and employees receive tokens as part of their compensation plan and those tokens are highly liquid — as they should be after an ICO thanks to the meteoric rise of exchanges and crypto hedge funds — then the value of their compensation may be more through token value than equity value.

How does that impact the management team’s incentive to create equity value and liquidity for the equity holders? Should investors be negotiating with management teams post-ICO to exchange some or all of their equity for tokens to generate liquidity?

Are investors and management as aligned as they are in a company that does not raise money in an ICO or do token sales create more opportunities for misalignment—which gets back to the issue of governance. Our advice on this point is for investors and entrepreneurs to try to talk through as many of the anticipated issues as possible before they come to pass.

In other words, determine precisely before the initial seed round how to ensure as much alignment as possible. The standard seed tools that investors are familiar with, like SAFEs and convertible notes, need to be modified to anticipate token sales (e.g., SAFT agreements and perhaps even SAFTE agreements).

If early stage investors can develop more options for achieving full or partial liquidity in a private company, all the better.

The territory we are all entering is exciting and revealing of the extraordinary potential that cryptocurrencies and the blockchain represent for the economy—yet it is also fraught with complex issues. And there’s much more ground that I haven’t even covered, such as:

  • VC funds buying cryptocurrencies: how is that different from VC funds buying yen or euros, which our LPs probably would not want us to do, or speculating in Bitcoin or Ether directly? Are VCs going to be competing with crypto hedge funds?
  • VCs investing in cryptocurrency hedge funds: would our LPs want us to invest in early stage hedge funds? Does it matter if it makes money? What is the liquidity path for an investment in the equity of a hedge fund?
  • VCs need different structures in their standard convertible notes or SAFE notes in the context of a company being able to avoid follow-on equity financings and thus being able to avoid conversion.

We and our peers are wrestling with all these issues alongside our entrepreneurs and, clearly, one group that is going to benefit are the lawyers who are in the middle of it all!

This article originally appeared on Medium. Thanks to Deanna Rampton fromStartup Grind for her help in editing.

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