Making Sense of ICOs: The $100M Seed Investment

For the most parts, ICOs sound and look like the modern day gold rush. An ICO or an Initial Coin Offering is the imperfect blend of an IPO (Initial Public Offering) and Crowd Funding. Although it’s been in existence for the last 4-5 years, it started gaining colossal popularity in 2017. For instance, just last year companies like Tezos raised $232M, Filecoin raised $257M, Bancor raised $153M, and EOS raised $185M, to name a few.

At first I thought ICOs were used by startups to bypass the rigorous and regulated capital-raising process required by venture capitalists or banks. Which may still largely be the case for most ICO teams – but there is definitely more layers to ICOs than just fund raising (Which I shall cover in subsequent posts).

But these ICOs, which are in the 100s of millions of dollars, seem absolutely ridiculous for projects that are essentially seed stage investments. Imagine if Uber raised their entire $9 billion investment without even signing up 1 driver? I’d probably think that was impossible. It makes me wonder if ICOs are just the aftermath of several people kicking themselves for not getting in on the ground floor of blockbuster crypto coins like Bitcoin and Ethereum.

Are the markets completely irrational?

I certainly hope not.

While ICOs might potentially be the craziest fund raising instrument ever, a closer look reveals that the idea is to pre-sell tokens of a blockchain project that will magically become functional units of currency at a later date or when the ICO funding’s goal is met. In this case, investors in the operation are usually motivated to buy the tokens in the hopes that the plan is successful, which means that the token value is higher now than what they purchased it for before the project began.

While upfront capital is (an) important (signal), the ICO has another powerful effect: it gets the tokens into the hands of investors who believe in your blockchain project and are therefore, incentivised to help the network grow. Early investors will not only help spread the word, they are also more likely to use the protocol. This helps create network effects!

(Shout out to Professor Roberto Serrano, circa Econ 111, Brown University for endless lectures on network effects)

More on network effects!

If this model has the potential to create huge network effects, each individual is more likely to buy and hold (i.e. Hodl – since I am now part of the crypto space) as many tokens as possible. At a system level each individual investor will behave according to what he/she believes the majority will behave. This ‘winner-takes-it-all’ mentality distorts the incentive structure of ICOs allowing companies to raise several millions of dollars in just a matter of seconds.

Not that I am complaining about this particular conundrum but if large groups of people behave like the textbook examples of Game Theory 101, don’t ICOs have the potential to inflate project valuation exponentially?

Yes they do!

(I looked it up – it’s a huge problem with several uncapped ICOs coming into the play)

At this point, I put my thinking cap on and wonder if ICO teams should just limit the amount of tokens any one person can buy? Because while the ‘buy and hold as many tokens as you can’ is great for the individual investor, it is actually detrimental for the network as a whole. After all, isn’t blockchain all about decentralising the Internet, and hence decentralising (and democratising) the funding aspect of it too?

OK never mind – upon further research I found out that an investor’s real identity isn’t tied to their crypto addresses (I mean it’s a pseudonym, usually in the form of a series of letters and numbers), even if we go ahead with my brilliant plan and limit token purchase per buyer, essentially one person can create as many addresses as they want and still get their heart’s desired amount of tokens.

Conclusion: the network effect and human psychology have led to ridiculous amounts of money being raised at absurd valuations for seed stage projects!

But Hey! Maybe the reason why blockchain companies raise such large upfront investments is because there are no series B or C rounds for blockchain protocols, at least there haven’t been any yet (Please correct me if I am wrong here!)

In traditional fund raising rounds, early stage venture capitalists invest knowing they will be diluted as a company grows and raises additional capital. This is contradictory to one of the core values of crypto economics. The number of tokens for all major crypto protocols is fixed. And ICO teams do not (or rather should not) issue more tokens to fuel growth (Again, correct me if I am wrong)

Perhaps ICO fundraising targets are extremely high because they have enormous capital needs and know they will not get another chance to raise capital. Blockchain software development, and the required marketing and sales effort will definitely cost a pretty penny (or bitcoin).

Also ICOs are structured with several layers of pre-sale before the actual crowd sale of tokens. Investors in the pre-sale stage typically receive significant discounts and it usually translates to higher savings if they participate earlier.

These ICO structures are designed to leverage human psychology in raising a huge amount of capital at the shortest time period possible. Since tokens, unlike restricted stock in a startup, are liquid, investors are willing to invest more in a pre-sale or ICO: They know they can offload their tokens to the market, which all perpetuates these ridiculous investment numbers.

ICOs are an incredible new way of raising money, and I am always for more innovative and inclusive ways of building a company. But there is more to an ICO than just publishing a white paper and slapping on a pretty website – you need to make sure it works and makes sense for your business model (I’ll try to demystify them as we go along). The rules of the ICO game are still being written; so make sure you do your homework before you put all your bitcoins in one basket.

 

 

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