According to public announcements, approximately $790 million has been raised by Bitcoin-related companies over the past three years (and really in earnest since the San Jose conference two years ago).

Where did that funding go? And how did that impact the price of cryptocurrencies?

Below I attempt to break down the numbers to answer both of the questions.

The tl;dr is that there are multiple unseen cost centers that have likely absorbed capital that would have otherwise been more productively deployed elsewhere. Some of these costs were related to compliance — which many startups assumed would not exist or could be ignored. Others included denial of service (DOS) and ransomeware which no one besides Bruce Schneier could have predicted or thought of years ago.

In addition, consumer behavior — or as Buck Turgidson would label “the human element” — is not behaving based on the initial assumptions of many entrepreneurs, enthusiasts and VCs. Whereas 18-24 months ago cryptocurrency-based payment processors proclaimed that consumers would flock to Bitcoin and other altcoins as a payment rail, this has not occurred (yet). Stagnant tokens left in cold storage therefore impacts multiple verticals, especially those relying on large aggregates of transaction fees to fund growth as they scale up.

Mining

Investing in mining and hashing is effectively taking out a short position on fiat and long on a cryptocurrency, in this case usually USD for BTC. It is a foreign exchange play as it enables investors to turn fiat into magic internet money without typically needing to abide by foreign exchange regulations or institutional registration requirements. For instance, a venture capital firm is typically not permitted or allowed to use LP funds on the open market to purchase forex, or in this case cryptocurrencies — but by funding a mining company they effectively fall within a “loophole” (or at least that is how some pitch it).

What does this look like?

Listed on the continually updated – though slightly inaccurate – CoinDesk Venture Investment spreadsheet are the following capital raises specific to mining:

Spondoolies Tech: $10.5 million

Avalon Clones: $3 million (likely clones of the Avalon chip)

Bitfury: $40 million (in two public rounds)

Hashplex: $0.4 million

KnC miner: $29 million (in two public rounds; note that KnC however had a pre-tax loss of $4.4 million last year)

Peernova (raised $19 million, however they are no longer in the Bitcoin mining space and didn’t raise the Series A round based on mining products)

Not included are funding from:

21inc: according to Nathaniel Popper it has raised $121 million over at least three rounds (perhaps more) and is now building Tom Sawyer botnet hashing chips — consumers are expected to collectively absorb the operating costs such as electrical and administrative costs thereby painting the proverbial white fence; consumers socialize the costs and 21inc privatizes the gains

Bitmain: is the largest independent manufacturer, has taken no VC money to date (fully financed via private sources)

CoinTerra: bankrupt, previously raised $2.2 million

Hashfast: bankrupt, owed creditors over $40 million, “acquired” by a Venezuelan politico

Alidyan: part of CoinLab, now bankrupt, spent $4 million building hashing machines

Butterfly Labs: sued by FTC for failure to deliver product to customers, collected between $20 million to $50 million in pre-orders, currently sending some refunds

Avalon: successfully pre-sold the first commercially available ASICs (see interview with Yifu Guo from Motherboard); Guo is no longer involved with Avalon and the company is now called Canaan Creative

ASICMINER: “Friedcat” is the Chinese businessman who created an immersion mining facility in Hong Kong and custom ASIC chip, allowing those with bitcoin to exchange bitcoins for ASICMINER shares; despite allegations, it is still unclear if he absconded with the funds of a new project called AMHash

Gridseed (recently merged to become SFARDS): built both SHA256 and scrypt hashing equipment; in late July 2014 they purportedly owned 20 billion dogecoins (via mining) and as recently as April 2015 still supposedly controlled 60% of the hashrate for dogecoin (the management team led by Li Feng was allegedly under pressure by investors to somehow reverse the bear market)

ZeusMiner: shifted from building SHA256 ASICs to scrypt (dogecoin, litecoin, etc.)

Genesis Mining, Mega Big Power, RockMiner and a variety of small actors in the manufacturing/proprietary farm/pool business

DiscusFish, consistently one of the largest pools, may or may not produce some of their own hardware

A smorgasbord of cloudhashing scams that didn’t actually have the actual hardware (e.g., GAW mining)

So of the ~$790 million so far:

$82.9 million is comprised by known mining manufacturers

plus $121 million from 21inc (but misclassified as “Universal” in the spreadsheet)

but cannot include the $19 million from Peernova (this is misreported on the spreadsheet and again, they are no longer in that specific vertical)

This comes to: $203.9 million, or about 25% of the publicly known funding has gone directly into converting one currency (fiat) into another (bitcoins, litecoins, etc.). How much of the capital has been fully deployed to date is unclear.

Can this full amount impact the market price of specific cryptocurrencies? We will try to answer that question later below.

Startup life

There are multiple budgetary components to any startup that are not unique to Bitcoinland.

For instance, irrespective of locale, the cost of living for an employee can typically be broken down into:

Housing/Rent

Utilities (electricity, gas, internet access)

Phone

Food and clothing

Auto/house/health insurance

Discretionary income (entertainment, luxury items, vacations, investments, etc.)

We will come back to these later.

For an entrepreneur in Bitcoinland, in addition to the labor costs above, some of the company-specific costs include:

Domain name: a large Bitcoin API company is rumored to have spent $350,000 on a five character dotcom domain; for perspective Roger Ver rents out (domain squats?) Bitcoin.com for roughly $120,000 a year (in 2012 the highest valued domain fetched $2.45 million)

Legal fees: some of these are delayed via equity swap deals with law firms, e.g., independent lawyers as well as firms such as Perkins Coie may provide some legal assistance for X% of equity via convertible note; similarly regulatory consultants such as Promontory have done pro bono work to assess the lay of the land for the whole space likely with the goal of converting promising clients into retainers and so forth

Office rent/lease/mortgage: co-working spaces are increasingly common for many seed stage companies in order to stay lean and limit the burn rate

Utilities and internet access: particularly important for mining farms/pools

Attending events: flying to conferences and meetups (which are incidentally, probably one of the few legal, profitable areas for Bitcoin right now; Mediabistro pivoted to focus on this space)

Event sponsorships: food and speaker honorariums; e.g., Chain.com was a lead sponsor for the O’Reilly Media Bticoin & Blockchain event, BitPay sponsored the ill-fated, one-and-done Bitbowl (Platinum sponsorship at the NYC InsideBitcoin event was $13,000 and $12,500 for Singapore)

Marketing and advertising: user acquisition, lead generation, brand awareness, e.g., Gyft, eGifter, and BitQuick.co purchase many of the ad slots on reddit, various “rebittance” companies purchase ad slots on Facebook, itBit is everywhere on Twitter, ChangeTip attempted to capitalize off of the Nepal earthquake and curates sock puppet spam (BashCo, a reddit moderator now works for ChangeTip)

Front-end design: can reach $75,000 to $100,000 and there are now companies such as Humint and Bitsapphire catering to cryptocurrency-related startups

Advisory fees to banks: American Banker recently explored the rumors that banks such as SVB charge its clients (such as Coinbase) a monthly “advisory fee” (payola?) which could range $20,000 – $60,000 per month

Lobbying special interest groups: a number of Bitcoin-related startups donate to non-profit organizations which in turn pays the salaries for staff at Coin Center, Chamber of Digital Commerce, The Bitcoin Foundation and others in order to influence policy making

Board of Directors and Advisors: Larry Summers (Xapo, 21inc), Arthur Levitt (BitPay, Mirror), Sheila Blair (itBit), Gene Sperling (Ripple Labs), and several other VIPs; while some of these relationships are in exchange for equity (0.5%-2%) others may be in the form of cash ($5,000-$10,000 per month) — either way, not free

Company outings and vacations: ChangeTip flew out to Argentina, another well-heeled group went to Malta, while others have had traditional typical perks (e.g., company lunches and dinners)

Money transmitter licenses: in addition to maintaining a compliance team that regularly submits SARs, it currently costs about $2-4 million to obtain the necessary MSB licenses to operate in all states within the US (recommend readers chat with Faisal Khan and Juan Llanos for more info)

Insuring virtual currencies that a company may hold in custody: Xapo, Coinbase, BitGo, Gemini and others now advertise that the holdings (of some kind) are insured by third parties (and purportedly even the FDIC in the case of itBit)

Acquiring and maintaining an inventory of cryptocurrencies: many wallets and exchanges need to maintain some kind of ‘hot wallet’ so that customers can quickly transfer their virtual assets. For instance six days ago the hot wallet at Bitfinex was compromised and a hacker stole 1,459 bitcoins, earlier this year Bitstamp’s hot wallet was hacked and lost 19,000 bitcoins, Coinfloor stated two weeks ago it holds 5,081 bitcoins on behalf of customers and as of this writing Bitreserve states it has $1,716,030 obligations to its customers. In addition many exchanges run prop desks to trade liquidity with partners (e.g., most VC-funded exchanges have an OTC team that handles large block trades)

Customer service and bug bounties: reimbursing customer for problems with R values/RNGs. For instance, in December 2014, Blockchain.info used untested code in a production environment that cost customers at least 267 bitcoins (and again on May 26, 2015). In April 2015, reddit user vytah fixed a BitGo integer overflow error that cost a customer 85 bitcoins

Denial of service (DOS) vandalism and extortion: commonly happens with mining pools (competing pools threaten to do a denial of service unless a certain amount of bitcoins is paid) — in March 2015 at least five different pools were targeted; also happens with media sites such as when Josh Garza (from Paycoin/GAW mining) allegedly attacked Coinfire to prevent stories regarding scams/fraud from surfacing

Ransomeware: as noted last month while this type of malware has existed for several years, CryptoLocker itself stole nearly 42,000 bitcoins in the fall of 2013, thus signaling to market participants that this successful method of attack could be copied. According to Dell, during a six month time frame last year, “CryptoWall infected more than 625,000 computers worldwide, including 250,000 in the United States. During that time, the gang that operated CryptoWall raked in about $1 million in ransom payments.” Currently hackers are targeting smaller and more marginal actors. For instance, two months ago the network for Swedesboro-Woolwich School District in New Jersey was held hostage for a 500 bitcoin ransom. And the Tewksbury Police Department system in Massachusetts recently became just one of many public organizations that has paid similar ransoms in bitcoin.

It is still unclear how much of these variables will ultimately absorb the budgets of each startup. Not everyone is targeted with ransomeware, some startups eschew conferences and others are uninterested in building consumer facing products. Similarly, some early employees are content with living in a SOHO or communal setting, thus reducing a rent component for someone.

At some point as the industry matures, as companies are acquired or even go bankrupt, we will likely have a better picture of percentages for each of these categories. It could be the case that as Bitcoin-related custodians and depository institutions grow and merge, they will continue to absorb the costs borne by the traditional financial industry.

Ignoring the cryptocurrency-related challenges (such as securing hot wallets), perhaps several of these entities named above will end up needing to acquire the same licenses and charters as their peers (banks) do and thus could materially impact their balance sheet and growth targets. Thus it will be worth revisiting these shifting characteristics again at the end of the year if not sooner.

Converting salaries into bitcoins

Another bullet point that is of interest to this conversation yet falls in the cracks between employer labor costs and employee discretionary income are: those individuals who convert part, or all of their salaries into bitcoins.

Most, if not all, Bitcoin-related organizations now offer some method to convert fiat-based salaries into cryptocurrencies. Bitwage is a startup that provides a conversion service to do so. Prior to this service (which BitPay also does), some organizations like The Bitcoin Foundation, at one point (perhaps it still does) offered to pay salaries based on a 30-day rolling average of bitcoin-to-fiat.

Another tangential example: one VC-funded Bitcoin company that raised more than $20 million late last summer bought a tranche of bitcoins (then valued at around $1.5 million) to lay aside for employee benefits. Their employee deal is to hand over some options in future bitcoins so they wanted the bitcoins locked in to handle the employee liability.

In another instance, it is also worth noting that the $30.5 million Blockchain.info round (the largest Series A so far) that was announced in October 2014, was a mixture of bitcoin and USD (primarily USD).

What is the impact on the price of cryptocurrencies if all the employees at these startups converted their salaries into cryptocurrencies?

This has not been analyzed due largely to a lack of public information yet but it bears mentioning that it is likely that most, if not all, employees cannot fully convert their entire salary into cryptocurrencies because, for example, their land lord or utility company likely does not accept it for payment. Perhaps this will change in the future, until then however: rent, utilities, phone service, food and insurance are probably still largely paid for with fiat.

Recall that each startup also has its own cost structure, some attempt to position themselves as a “just” a software company while others try to compete in the compliance-heavy and saturated exchange/wallet market place. Thus the types of costs each company has is not uniform. What this also means is that some portion of the VC funds that have gone into these companies is likely, ultimately kept in fiat and not converted into cryptocurrencies.

But, there is still more to look at.

The on-going Bitcoin crowdsale

Approximately every 10 minutes the Bitcoin network generates 25 bitcoins. Miners (collectively in the form of mining pools) compete with one another over winning these tokens. They do this by coordinating with hashing farms which consume large quantities of capital (primarily electricity) to rearrange a few attributes with the goal of finding a target value below a certain threshold.

In a sense, Bitcoin mining is an on-going auction, or crowdsale, to convert one currency for another. And miners continually bid up to an equilibrium threshold in which the marginal costs of creating a bitcoin equals the market value of a bitcoin (i.e., in the long run it costs a bitcoin to create a bitcoin).

In theory, over the past two years roughly 2,625,000 bitcoins were created. In practice the actual amount is about 10% larger due to the fact that blocks are not being created at 10 minute intervals but much quicker, as fast as 7 minutes during October 2013 (as of this writing it is roughly every 8-10 minutes; see Appendix B). Thus, whereas block reward halvings were expected to take place once every four years, this has accelerated by several months.

The first halvening occurred in late November 2012 and the next one is expected to occur at the end of July or early August 2016.

How does this impact the fiat-denominated price of bitcoin?

If the average weighted fiat value of bitcoin over the past 24 months has been $400 then based on the theoretical growth in money supply approximately $1 billion in bitcoins have been auctioned off to mining pools over the past two years. Yet because the supply has increased 10% faster than the actual number is probably closer to $1.1 billion.

What does this mean?

This means that the capital spent on mining — primarily a wealth transfer to utility and manufacturing companies — still far outpaces VC investments, especially once mining-related investments are accounted for. Altogether, once publicly announced mining investments are removed this amounts to $590 million, not $790 million.

Or in other words, since mining pools, farms and hashing participants ultimately have to sell their $1.1 billion in block rewards to pay for land, labor, taxes, equipment and electricity there is a continuous sell-side pressure on bitcoin that even all of the publicly announced VC financing cannot fully absorb even if it were allowed to. But that does not mean it has not been dampened. And it is also known that some of the farms and pools have attempted to hold onto large bitcoin holdings with the expectation that these will appreciate or due to the inability to find reliable OTC partners to liquidate them without slippage.

Based on known figures above, in percentage terms, the acquisition of block rewards via VC mining investment represents about 18.5% of the $1.1 billion rewarded to miners.

While we may not know the exact numbers that venture backed firms, their employers and their investors have spent acquiring tokens, it is likely that the amount is non-negligible and perhaps even has much as several hundred million if not more.

For instance, Tim Draper publicly bought around 32,000 bitcoins last year (from the DPR/Silk Road auction, not freshly mined coins). While it is unclear where these bitcoins will go, Boost VC (run by his son Adam Draper) is investing an additional 300 bitcoins in each startup that completes demo day (there were 24 startups in the most recent tribe, 21 of which are Bitcoin-related). Entities like Seedcoin (renamed Coinsilium) have also tried funding startups this way. This type of fiat conversion into bitcoin could absorb some of the sell-side pressure that comes from seizures, payment processors, miners, ransomeware and scammers liquidating their holdings (see Flow of funds).

There is some added historical precedence to this. For instance, and as copiously noted in Nathaniel Popper’s new book, between January through March 2013, at least a dozen or so high-net-worth individuals such as Wences Casares, executives at Pantera and the Winklevoss twins collectively bought tens of millions of dollars worth of bitcoin. The demand of which resulted in a rapid increase in market prices. On the other hand, a few years from now when we have more data, there may not be a direct causality between outside investment and what effect that had on the price of cryptocurrencies.

Yet, with $1.1 billion in mining rewards virtually popping onto the scene, why is the community still relying on venture capital funding at all? This native pool of virtual capital created in the past two years alone surely is capable of funding internal improvements and enhancements to the ecosystem?

To be even handed, it is also about having access to the capital (irrespective as to whether it is virtual or fiat-based).. In practice an individual with an idea is unable to approach miners and ask for capital — many of the pools and farms are not set up or positioned to act as investors and many prefer to remain unknown. Thus in practice it is probably easier to raise from dedicated firms that advertise the fact that they fund startups (like incubators and accelerators).

A year ago at the May 2014 Amsterdam conference, Robert Sams elaborated on this issue:

There is a different reason for why we maybe should be concerned about the appreciation of the exchange rate because whenever you have an economy where the expected return on the medium of exchange is greater than the expected return of the underlying economy you get this scenario, kind of like what you have in Bitcoin. Where there is underinvestment in the actual trade in goods and services. For example, I don’t know exactly how much of bitcoin is being held as “savings” in cold storage wallets but the number is probably around $5 billion or more, many multiples greater than the amount of venture capital investment that has gone into the Bitcoin space.

Wouldn’t it be a lot better if we had an economy, where instead of people hoarding the bitcoin, were buying bitshares and bitbonds. The savings were actually in investments that went into the economy to fund startups, to pay programmers, to build really cool stuff, instead of just sitting on coin. I think one of the reasons why that organic endogenous growth and investment in the community isn’t there is because of this deflationary nature of bitcoin. And instead what we get is our investment coming from the traditional analogue economy, of venture capitalists. It’s like an economy where the investment is coming from some external country where Silicon Valley becomes like the Bitcoin equivalent of People’s Bank of China. And I would much prefer to see more organic investment within the cryptocurrency space. And I think the deflationary nature of bitcoin does discourage that.

It is likely the case that VC funding, and therefore LP funding, is currently propping up both the ecosystem and maybe even the price due to the fact that consumer demand, via transactions remains muted.

How do we know this?

The majority of bitcoins, 96% to be precise, stored in Xapo are inert and that a similar amount is likely left inactive in Coinbase (both of whom store investor and venture partner funds as well). We also know this is the case indirectly via payment processing figures such as BitPay (as shown below), which have effectively plateaued.

In short, because of a dearth of transactional demand, the internet commodity is reliant on speculative demand to fulfill any movement in market prices. Perhaps this will change in the future with projects such as BitX, Coins.ph and Alliance Commerce which have been gaining genuine traction.

What, as Sams suggests, would it look like to actually fund internal improvements or other projects with this virtual currency instead of relying on the People’s Bank of China, Silicon Valley or other outside entities? Where, as economist might say, is the circular flow of income?

Crowdfunding altcoins and altchains



What about non-VC funded startups in this overall space? What are some examples of people attempting to put to work the virtual capital without relying on exogenous sources?

In early January I looked at a number of the “initial coin offering” (ICO/ITO) that have occurred over the previous 18 months. The list included:

Since then, there has been at least one other large token sale, through Factom. Over the past two months it has received 2,278 bitcoins.

Altogether this amounts to 66,566 bitcoins raised by 14 projects in about 21 months.

This may sound like a lot, and perhaps it is relative to the illiquid altcoins it represents (such as Mastercoin which has been rebranded as Omni), but for perspective the Bitcoin network generates roughly 3,600 bitcoins per day — an on-going token sale that continually absorbs more real-world capital and resources than most of these projects collectively do.

Yet despite this level of external funding, participants still prefer to store and hold and not actually spend due to a variety of reasons including low time preferences and the expectation that token value will increase. Perhaps that will change in the future.

Furthermore, it bears mentioning that crowdsales such as those above, are not circular. Costs nearly always end up being paid for by selling the received currency (bitcoin mostly) for fiat. In practice it is less of a circle and usually just an added step: bitcoin wallet -> altcoin crowdsale -> convert to fiat -> pay real-life costs.

While a number of these projects are still less than a year old, where are the scorecards for other cryptocurrency-only projects? For example, in 2012, administrators at Bitcoin Talk raised nearly 7,000 bitcoins to build a new forum. What about other projects that are paid for directly with other cryptocurrencies such as those on Lighthouse?

Open questions about the circular flow of LP funding

[Note: the image above is a variation of my previous illustration on the movement and source of funds within Bitcoinland]

There are a number of popular predictions percolating on the tubes including Bitcoin investments which are on pace to reach $1 billion by the end of the year.

Perhaps that will take place, however at some point these companies will need to generate some kind of actual non-sock puppet traction and returns to justify their 4x, 5x, even 6x valuations. If not, then VC funding could decline as they did with cleantech.

How would a decline impact services?

For instance, it is unlikely that more than a handful of non-VC funded companies or individuals are actually paying for API access at platforms such as Chain.com, Gem or BlockCypher (not to pick on them, just an example). Perhaps this will change in the future.

Yet by looking at the customer list at API companies we notice two things: 1) these customers are similarly VC-funded startups, 2) most of these services have no real traction yet either and are themselves reliant on VC-funded customers.

If and when VC funding dries up this could have a knock-on effect on both of these as the solvency of other virtual currency startups is heavily reliant on a VC-subsidized customer base and the price of bitcoin itself (if it does not dramatically rise by several orders of magnitude then the forex play does not pan out).

Or in other words, what economists would want to see is a circular flow of income yet what we see occurring is a circular flow of VC funding (or rather LP funding).

If VC funding withdrew it could not only impact the hashrate (as VC funded miners are turned off) it also could impact the fees to miners. Why? Because VC funded companies are more likely to send higher fees because they can dig into what amounts to VC subsidies which currently masks some of the dysfunction in the fee system.

In addition, recall that nearly half of BitPay’s volume last year were miners selling block rewards and other people buying IT services (which could be GPU-based mining gear). If this extends to the rest of the active, non-cold storage Bitcoin economy as a whole, then the miners collectively account for a large portion of the supply and perhaps even the demand of bitcoins (due to keeping tokens on their books as long-term bets on the appreciation of the token). People in general are excited about the forthcoming halving because it decreases supply and therefore sell-side pressure, but if the mining industry shrinks, its ripples then impact those dependent on its sales such as non-diversified payment processors.

Conclusions

Perhaps as the bullish narrative states, increased consumer demand is around the corner and the trends above will drastically change.

In the meantime some startups in this space are still typically trying to evolve along the lines of an early stage social media app: build an MVP, raise a seed, acquire users, rapidly introduce new features, manage a rational head count and steady burn rate for 12 months before raising the next round all while trying to allegedly build Wall Street 2.0.

While the “move fast and break things” mantra may work for certain sectors of the economy, it probably does not work as effectively with finance. And contrary to the wisdom from some venture capitalists in this space, nearly all the verticals in the Bitcoin-space are attempting to recreate a financial product or service of some kind that is based on the success of the currency being widely adopted/transacted/used. Forex plays.

What does that mean?

Last November I made a trip to Singapore and heard a Los Angeles-based VC claim that “Bitcoin and Hashcash reinvented economics” and that we could ignore the world of finance and economic gurus.

Perhaps she is right. But probably not.

Trying to reinvent hospitals without talking to doctors or nurses would be short sighted just as building a car without talking to mechanics and engineers would likely be asking for problems.

Bitcoinland is filled with hundreds of very bright computer scientists and entrepreneurs who are being funded by well-intentioned capitalists with a mandate to take risks and attempt to disrupt incumbents everywhere. For instance, who would have guessed three or four years ago that conditions in mainland China, when coupled with guanxi in exchange for sweet land and energy deals, would incentivize a cottage industry of pools and farms to set up shop and pump out more than half the network hashrate?

However, while this topic is beyond the scope of this article, Bitcoin itself does not natively replicate the plethora of financial services or instruments that the real world currently provides; and its current internal monetary system incentivizes users not to actually spend magic internet beans as they would actual currency but rather store them indefinitely.

Instead it has come down to limited partners — pension funds, insurance companies and high-net worth individuals — whom are directly trying to build a new financial ecosystem yet who, as shown in the flow chart above, indirectly end up owning a lot of this economic dead weight in the form of frozen virtual beans. These tokens, like gold before them, do not provide dividends or interest, they cannot be natively relent without introducing a new trusted third party and thus are unable to generate additional wealth.

Again, trends can always change, perhaps linear growth will indeed catalyze into exponential curves. Perhaps rumors of “major deals” between Bitcoin companies and large banks will eventually germinate and DCG or the Argentinian community buys Necker Island with a few satoshis next year. Yet so far, about the only two exponential phenomenon we can empirically observe thus far is the usage of the terms “exponential” and “network effect” at conferences and in media. Just three more to go and we can finally get a bingo.

[Acknowledgments: thanks to Pascal Bouvier, Ben Doernberg, Dave Hudson, AL, Jake Smith and Fabio Federici for their feedback]

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