Early-stage financing in blockchain projects. Data sourced from a variety of third parties: Crunchbase (Equity funding), Messari (IEOs), ICOdata.io (ICOs)
Blockchain and crypto businesses raised a total of $4.5Bn across all financing types in 2019 (one major outlier — Bitfinex’s $1Bn token issuance), ~70% less than was raised in 2018. The main cause of this fall was a drop in crypto-asset led fundraising.
According to Messari and ICOdata, only 309 crypto-asset sales took place, raising $1.8bn (~80% less than in 2018). It is unclear which investors were partaking in these funding activities; however, we are to believe that the majority are still retail investors.
Meanwhile, equity funding grew in importance. In 2019 it accounted for 678 funding rounds, raising a total of $2.7Bn, with participation from 997 accredited investors — according to CrunchBase.
Traditional venture capital is now the dominant source of finance for early and growth-stage crypto businesses, accounting for >70% of early-stage funding across all financing types when one removes Bitfinex’s $1Bn crypto-asset sale from the data.
Please note that ICO/IEO funding data is often unreliable. We have chosen sources that we believe offer an indication of the industry’s investment trends, but not a perfect picture. Therefore, please exercise caution when citing the statistics quoted above.
Appetite for crypto-asset fundraising wanes
The Initial Exchange Offering (IEO) model came into full effect in 2019 reigniting investors’ interest in early-stage crypto-networks. IEOs are very similar to Initial Coin Offerings (ICOs) in the sense that they are both tokenised forms of crowdfunding.
In contrast to an ICO where the project’s team co-ordinate the offering, IEOs are co-ordinated by a crypto-asset exchange, which sells the project’s tokens directly to its users. The added benefits of an IEO for users are 1) near-instant liquidity (through a guaranteed listing on the host exchange) and 2) greater due diligence (undertaken by the host exchange).
Despite this, IEOs still do not address many of the institutional investors’ greatest concerns, namely:
1. Regulatory uncertainty: The SEC’s considers many of the ‘pre-utility’ crypto-assets as unregistered securities, regardless of whether they are issued via an IEO or ICO.
2. High mortality rates: like the ICO model, IEOs, for the most part, rarely account for follow-on financing, which has resulted in many projects simply running out of cash. Some teams try to compensate for this by raising large lump sums of money in a single sitting, hoping by the time the money runs out, they’ll be self-sustaining.
3. No rights: most crypto-assets do not offer investors any of the rights that shareholders are traditionally afforded, such as liquidation preference, control or dividends.
Venture capitalists are finding new ways to ‘get in’ on crypto through equity investment
Many venture capitalists are finding ways to overcome the concerns outlined above and make traditional equity investments into cryptocurrency businesses, entitling them to greater protections and regulatory assurance.
Crypto-related projects that raise equity finance are typically companies building application layer products with no direct link to a particular crypto-network. These projects tend to operate a traditional business model while offering access to decentralised ecosystems. Classic examples include wallets, exchanges and custodians. In these cases, it always made sense to seek equity.
The mechanics of crypto-networks and their native crypto-assets, however, are fundamentally different since crypto-networks are not companies. Value accrual is opaque and requires thorough investigation on a project-by-project basis.
That said, entrepreneurs and their early backers are finding novel ways to get more exposure to lower layer, value-accruing, crypto-protocols, without necessarily holding or investing in crypto-assets.
At Saxon Advisors, we have observed three new types of deal emerge:
1.What we call “Red Hat 2.0” Businesses — contributors to the open source-code and dedicated ecosystem development partners for specific crypto-networks.
2. “Generalised Mining” Businesses — workers for decentralised crypto-networks (similar to miners in Bitcoin).
3. Equity-to-Token Convertible — popular among service protocols (running on pre-existing public blockchains) that do not rely on needing a token to offer real utility for customers.
1. “Red Hat 2.0” Businesses
Crypto-assets are typically issued by a foundation incorporated in a crypto-friendly jurisdiction. These entities are complex to invest in and, as non-profit organisations, do not offer shareholders a direct means to generate financial returns.
However, most cryptocurrency projects, in addition to establishing a foundation, will also create an operating company in their native country. The sole purpose of the operating entity is to contribute to the open-source code, develop products and establish commercial partnerships that increase the utility of the foundation’s crypto network, very similar to the role of Red Hat in the early days of Linux.
In return for this service, the operating company receives periodic, predetermined grants from the foundation (denominated in the network’s native crypto-asset), which are booked as revenue.
As the network grows and decentralises, the overall role and influence of the founding team’s operating company may diminish and welcome competition from alternative software distros. Nevertheless, as demand increases for the network’s native crypto-asset, in theory, the value of the periodic grants rises, increasing the company’s operating revenue.
Contingent on well-thought-out crypto-economics, by investing in the equity of the operating company, investors benefit from increased revenue denominated in the crypto-asset as well as exposure to the crypto-assets held on the firm’s balance sheet.
A good example of this is Divi and its operating entity Divi Labs, which is developing an innovative mobile banking app that lets anyone run a masternode with their savings to earn rewards on the Divi network.
2. “Generalised Mining” Businesses
‘Generalised mining’ is a term used to describe participation in a crypto-network, beyond the purchasing tokens, for a reward.
Crypto-networks are decentralised systems that derive their value from network effects (similar to Uber — its only valuable because taxi drivers use it). All network businesses or protocols need to onboard supply-siders if they are to attract demand-siders and vice versa.
Supply-siders in crypto-networks, however, encompass a variety of market participants. They typically come in three forms: developers (those who develop and maintain the source code of the service protocol or build applications on top of them), the stakeholders (those who partake in governance-related tasks through voting), and resource providers (those who are providing the resources that ultimately serve to benefit the demand siders e.g. taxi drivers if we’re to use the Uber example).
Crypto-networks bootstrap their growth by incentivising ‘supply-siders’ through the issuance of token rewards. In bitcoins case, only the miners (resource providers) are programmatically rewarded financially with newly issued bitcoins. Newer protocols are a little different. In an effort to be more sustainable, these protocols are being designed to distribute freshly minted crypto-assets to all value-adding supply-siders.
The types of businesses that engage in generalised mining can be grouped into the following categories: digital asset investment funds (who want to help lift projects off of the ground), data centre operators (looking to diversify their income or utilise unspent resource), dedicated generalised mining businesses and, occasionally, the founding team’s operating entity.
Generalised mining businesses are appealing to investors due to their positive feedback loops, whereby those with a substantive share of the coin supply or said resources (hash power in bitcoin’s case) entrench their position over time. Moats develop and obstruct new entrants as block rewards paid to generalised miners diminish over time, increasing the cost of profitable participation.
Projects like BitFury, a bitcoin mining technology firm, which raised $80m series C equity financing in 2018, offer a good case study.
3. Equity-to-Token Convertible
Today, it is possible to develop and deploy a decentralised protocol without having to reinvent the wheel. Smart contract platforms like Ethereum grant entrepreneurs the ability to leverage its decentralised computing infrastructure, mitigating the need to onboard and incentivise IT infrastructure providers.
This enables companies to develop and deploy service-orientated ‘service protocols’, offering customers new services that leverage unique properties made possible by the underlying blockchain’s ‘trust machine’.
Centralised decision-making enables fast, iterative development cycles, which are widely regarded as the most effective way to achieve product-market fit. While this is a great way to get a service protocol off the ground, the corporate structure (in its current, centralised format) is likely to fail in the long-run, due to two factors:
1. Single point of failure (centralised governance) — from a governance standpoint, the founding team’s organisation takes full responsibility for the design of the protocol, with the power to make changes to the source code if they please. This poses a significant attack vector, which can lead to horrific consequences if, for example, the smart contracts running on the protocol are managing large sums of money.
2. Forking risk — Since the company behind the service protocol is for-profit, they theoretically have the power to modify the genetic makeup of these protocols to extract rent-seeking fees to please the operating entity’s equity shareholders. Because all the software code is open-source by design, hard-coding rent-seeking fees into the system will inevitably encourage disgruntled developers to fork the system and remove fees, for the betterment of the users. This is what makes crypto exciting and incredibly innovative. The ability to fork an application’s source code is a fightback against monopolies whom, in the centralised world, employ value extracting tactics once they gain traction and move up the adoption S-curve.
Therefore, to ensure long-term project sustainability, these post-product-market-fit protocols must become more community-orientated, which can only be achieved by better aligning the needs of the beneficiaries (traditionally shareholders) and the users. We are seeing this being done through the issuance of a governance token. The governance token, which also serves as both currency and capital in the system, empowers the community of users and offers them financial incentives (tokens) to take on corporate-level responsibilities, eliminating value-extracting shareholders from the equation.
This may imply, however, that the value which had accrued to the equity of the original operating entity, to transfer to the issued token — as the token holders will attain the power to govern the service protocol as well as capture value/cash flows. We are seeing institutional investors, who are shareholders in these types of organisations, agree on a pre-specified % allocation of the crypto-assets at a future date as a means to mitigate potential capital losses by holding equity. We’ll revisit the governance token topic in future posts.
Although this is yet to play out in practice fully, projects like Compound
Finance, a decentralised lending and borrowing protocol residing on Ethereum’s smart contract platform that raised $25M in series A financing in November 2019, offer a live case study.
The last few years have shown us that institutional investors are still wary of investing capital into pre-utility token sales due to perceived market risk. While IEOs are a step in the right direction, further work is necessary to institutionalise the token-led fundraising process (to be explored in future posts).
For now, traditional venture capital makes the most sense for early-stage crypto-founders to bootstrap development and validate their problem/solution hypothesis.
Weak participation in crypto-asset led fundraising, however, should not be mistaken as a dismissal of crypto as an investable asset class. Due to regulatory uncertainties and structural complexities, we witness institutional investors overcome obstacles by investing in novel equity deals that implicitly give exposure to certain crypto-networks and crypto-assets.
Therefore, investors must take extra care in due diligence and continue to pay attention to underlying crypto-networks. Most importantly, they must thoroughly asses projects’ crypto-economic design to ensure that incentives align across a network of supply and demand siders, and that the value flows in the system result in the crypto-asset accruing value. If you’d like to learn more about how Saxon Advisors help investors to overcome these obstacles please visit our website, or feel free to get in touch with me directly.