The Token Sale

Token sales are a new mechanism for blockchain based companies & projects to raise funds from their communities and early adopters. Similarly to the traditional method of incentivising early employees in companies through stock options, cryptographic tokens allow to incentivise early adopters of the protocol. This effectively solves the strategic chicken and egg problem of needing adoption to grow network value, but also needing value in the network to grow adoption. Fred Ehrsam gives a comprehensive overview of what these tokens are, how they are issued and what incentives they bring in his 2 brilliant blog posts: Value of the Token Model & Blockchain Tokens and the Dawn of the Decentralised Business Model.

Not only does it allow companies to bypass the hassle of raising from Venture Capitalists, it brings higher valuations, community incentives and significantly faster fundraising time periods. In November 2016, Golem raised $8.6m in 29 minutes. In January 2017, Melonport raised $3m in 10min. In April 2017, Cosmos raised $17m in 30min and Gnosis raised a round at a $300m valuation in less than 10min. The list goes on… Most of these rounds were raised on the back of White-papers. When comparing this to the usual 1–3 months VC fundraising periods, a problem for traditional VCs starts to crystallise: they might lose their usual exclusivity with early stage companies.

There are of course a few problems with some of these decentralised projects:

There are naturally some Ponzi Schemes, Pump and Dumps and other scams

Regulation is bound to swoop into the ICO universe as tokens issued for fundraising means are likely to be considered a security.

A considerable amount of money is raised before even launching the projects, protocols or products.

The token sale is currently not a sustainable model: companies have to raise all their funding in one round, and have little opportunity for follow on funding. In the future, this might be solved by stepped token sales, holding larger reserves (which might signal negatively) or some sort of ‘token vesting’.

Quite a few tokens are not fundamentally linked to the product. They are used as a pure fundraising mechanism, but do not have any intrinsic connection to the network. This undermines the incentives of contributors and early adopters and removes any correlation between the success of the network/protocol and the price of the token. This might be one of the fundamentally most important overlooked aspects in many of today’s token sales, and as Nick Tomaino explains it might very well be viewed as the stone age in the not so distant future.

Blockchain assets should only be used for fundraising if they are a product feature in the first place

Token functionality: At the application layer especially, finding a ‘work’ function that doesn’t exist solely just to collect fees, but rather solves a real problem will prove crucial to the long term viability of a token and its value. I suspect this may lead to more firms with stronger technical due diligence.

Thankfully a lot of great research is outsourced to Reddit & Slack channels (e.g. CoinFund), research groups (e.g. Smith and Crown) and ratings agencies (e.g. ICO Rating)

The VC mismatch

The traditional VC investment is an equity investment. We take a minority share of equity in the centralised value-holding company. We invest in an illiquid asset. We take a board seat. We get protective rights. We get voting rights. We look for traction around user adoption, revenues and positive customer referrals. We look for network effects that lead to ‘unfair’ advantages and higher margins.

In contrast, the token model, by definition, is not an equity investment. There is no central entity that will accumulate value. Tokens are liquid and can be traded on exchanges. Large investors do not necessarily get board seats. No protective rights. No voting rights. Projects are often pre-product & pre-traction. By nature, decentralised projects tend to democratise industries which removes unfair advantages and potential for higher margins. Some of these differences are positive. Nonetheless, they will still require significant re-adjustment from the investors’ side!

Another fundamental problem for VCs is that they currently cannot invest in tokens due to their fund mandates — tokens are not a security and many regulatory bodies are still investigating them. They can be bought semi-anonymously by anyone, are paid for in Bitcoin or Ethereum and there’s currently no proper AML or KYC compliance for token sales.

Interestingly, it is currently easier for less traditional and rigid investment structures to invest into tokens; could this lead to the rise of venture-focused family office funds, SPVs run by VCs and business angels?

Naturally, to participate in this ecosystem, VCs will have to become stakeholders in networks and communities via token ownership. In our conversations with more traditional firms, we regularly observed an insistence on taking only an equity stake (and zero token exposure) on the legal entity implementing the network, to allow them to impose corporate governance. To us, this appears counterintuitive to the spirit of the network we are attempting to build and the decentralization movement. This stance signals to us a firm who is applying the same dated ways of thinking about business and value creation to a new paradigm. Tokens are creating new organization structures — we’re quite literally observing the formation of global crypto-economic communities, where both users of the network and its creators have real skin-in-the-game, and a shared set of goals and beliefs. This dynamic creates a fundamentally different alignment of incentives than those achieved through traditional venture rounds, and allows direct participation by early supporters of the project, much more in line with what decentralized projects aim to accomplish. My hope is this will provide a path towards services and networks governed directly by their own users.

The Way Forward

The ball is in the VC’s court to find solutions to these problems and adapt to them.

There have been a lot of investments into blockchain related companies, but very few funds have been able to participate in token sales so far. USV, continuing its first mover tradition, already plays in the token market.

In fact they have been documenting their thesis around investing at the protocol layer for a while: Joel Monegro’s ‘Fat Protocol’ blog is one of the best illustrations of the new value capture dynamic, and Albert Wenger’s writings about Protocol Innovation thoughtfully demonstrate the radical innovation of incentives through cryptographic tokens.

Other investors that have taken leaps forward include Blockchain Capital, which has in fact raised its own ICO and now has $10m to invest in the space. Polychain Capital and Metastable Capital — that arguably resemble hedge funds rather than VC funds — are building credible and innovative alternatives to invest directly into the tokens at the initial token sale and on exchanges.

At a Seed level, I expect we’ll see many firms begin to participate via the token-equivalent of a convertible note. As the community starts to self-regulate towards demanding alpha or beta software being released before a public token sale, this will create an opportunity for early stage firms to invest in these projects in their infancy in a private funding round. As the market matures, however, I expect we’ll also see VCs participate in token sales directly. The accessibility and lower transaction costs to raise capital via token sales will be a great equalizer, and will force VCs to quantify and demonstrate the added value they can bring to the network, should they wish to receive a discount over public participants.

Numerous original approaches are likely to spring up, but outlined below are two ways forward for traditional VC funds to start investing in this decentralised future:

Direct Token Investments

If funds can get approval from their LPs to invest in this new asset class, investing directly into tokens at ICO through a pre-allocation of the sale (with a potential discount) makes a lot of sense. Not only is it the most exciting solution that keeps VC investors at the forefront of technological innovation, but it will also allow them to prove their competitive edge over any other VC investor.

Direct token investments will hopefully bring more rigour to ICOs: having institutional investors signal their interest based on technical analyses will most likely be instrumental in the future. Such investments would create a hybrid crowdfunded/VC investment trend, where the VC does the bulk of the research and due diligence.

It’s not a traditional equity investment, but it has a very real potential for VC styled returns when looking at the growth in value of the total token market cap: In just 2 years, the total cryptotoken market cap has increased tenfold from $3.9B to $39B.

Total Market Cap of Cryptotokens has 10x in 2 Years

Direct token investments will also bring a new breed of more technical investors to the table. These funds will need to dive into the architecture and code of the project, be comfortable with autonomous governance models, understand white papers, accept and assume security issues with token ownership and have trading skills to sell a liquid asset at a right time. Small details, such as having to ‘centrally’ cold store tokens in offline wallets, have most likely not been thought through fully: do we store the wallet in the office, in a safe at home, or (ironically) in a safe deposit box at a bank?

A couple interesting difficulties with this model:

Regulatory : There currently is no regulatory involvement in the token space — We’re still in the Wild West of blockchain fundraising. Any funds that are lost due to fraudulent initiatives will never be recovered. Going forward, as tokens are a fundraising mechanism, they will most likely be classified as a security by regulators, which amplifies the importance of making the token a product feature instead of a pure fundraising mechanism. So far, only two jurisdictions have classifieds tokens as assets instead of securities: Singapore and Switzerland. This has led to Zug (Switzerland) becoming known as the Crypto Valley and attracting numerous companies looking towards their token sale.

: There currently is no regulatory involvement in the token space — We’re still in the Wild West of blockchain fundraising. Any funds that are lost due to fraudulent initiatives will never be recovered. Going forward, as tokens are a fundraising mechanism, they will most likely be classified as a security by regulators, which amplifies the importance of making the token a product feature instead of a pure fundraising mechanism. So far, only two jurisdictions have classifieds tokens as assets instead of securities: Singapore and Switzerland. This has led to Zug (Switzerland) becoming known as the Crypto Valley and attracting numerous companies looking towards their token sale. Investor lock up : Short term trading strategies are a core part of public equity markets. However, given the small scale of these token sales, the lack of investor lock up periods will bring significant threats to the stability of the network. Any large early buyer can be a market maker.

: Short term trading strategies are a core part of public equity markets. However, given the small scale of these token sales, the lack of investor lock up periods will bring significant threats to the stability of the network. Any large early buyer can be a market maker. Founder vesting : In a traditional VC investment, the founders have a 3–4 year vesting period, making them earn their share through continuous contributions. Without vesting, a token sale is a potential tool to scam investors. There have been a couple such cases in the past, and I’m afraid that a lot more will follow. We are now just starting to see the very first token sales that are including vesting periods (albeit much shorter): e.g. Aragon just announced that the founders will have vesting in their token sale. These vesting terms will hopefully be hard coded into the token sale!

: In a traditional VC investment, the founders have a 3–4 year vesting period, making them earn their share through continuous contributions. Without vesting, a token sale is a potential tool to scam investors. There have been a couple such cases in the past, and I’m afraid that a lot more will follow. We are now just starting to see the very first token sales that are including vesting periods (albeit much shorter): e.g. Aragon just announced that the founders will have vesting in their token sale. These vesting terms will hopefully be hard coded into the token sale! FOMO driven: Some of the recent token sales are not driven by rational value analysis. Given the sudden rise to power of the new model, and the rapid multiples early adopters have seen, FOMO has become a considerable driving force for investors. As tokens are openly traded in a liquid market, there is an unfortunate risk of a premature crash that would heavily hurt the ecosystem. When Gnosis recently launched their token sale, even the founders were surprised by the demand to the extent that their well intentioned dutch auction ended up failing, leading to the question of how much money was left on the table?

A New Paradigm: Applying the exact same tactics to creating defensibility in these systems simply won’t work. Web 3.0 companies won’t create value through propriety software, but rather open networks and communities built around these networks.

Issuance models: Our main reservation with the standard model used today, is it leaves little room to raise additional growth stage capital, which may prove to be detrimental for many projects. I applaud teams willing to experiment with alternative structures, and firms should keep an eye on how these evolve. While it will take time, I believe things will trend towards issuance models that more closely resemble traditional venture rounds or new variations such as ‘Continuous Token Models’ (Simon de la Rouviere has been doing some fascinating research here), where new tokens are minted and dispensed for services rendered befitting to the network. Aragon is a recent example of the latter.

Traditional Equity Investments

While one of the core problems highlighted earlier is the mismatch between traditional equity investments and the lack of central value aggregation in decentralised networks, there are ways around this. VCs can invest into the teams that developed a protocol, with the idea that, despite consciously breaking down network effect defensibility, those teams will be best positioned to sell services for the protocol users, create apps on top of their protocol, design a slick UI or offer support to larger users. An interesting case is well illustrated by Brad Burnham in USVs post about their investment in OB1 (for profit company created by the founders of the OpenBazaar protocol), and how they intend to make money. Interestingly, when looking at recent blockchain investments, it could even be argued that certain equity investments into projects are just buying an ‘option’ to invest at the token pre-sale with a discounted price.