There’s a growing sentiment within the investor community that Silicon Valley isn’t what it used to be, and that they’re missing the future while searching for the next Facebook or Uber. While Bitcoin has been fluttering around the fringes of the investment community for a few years now, 2016 and 2017 have seen cryptocurrency projects leap into the spotlight, with a corresponding increase in attention from VCs. At the CryptoFinancing 2017 conference in London I engaged several investors with this question: What does a VC look for in an ICO?
Long Term Value of the Token
VCs are not day traders. They’re looking for an exit at some point, but they’re not looking to pump and dump. These are men and women long accustomed to following US and EU laws against insider trading and stock manipulation, and thus are not prone to behaving maliciously like certain bad actors have in the current crypto space.
They want to look at the fundamental usage case for the token being offered, and see that it has the potential to grow in value by being useful to the token users and achieving widespread adoption. This criteria can be difficult to evaluate due to the blockchain industry being in its nascent stages, and thus requires a twin dose of vision and confidence in your ability to see where the market is heading.
Having said that, in many ways it’s not unfamiliar territory for a VC. To paraphrase a quote from Dr. John Clippinger, “It used to be you’d ask a startup how they planned on being profitable and giving you an ROI. With an ICO, you have to ask them why people will want to use their token.” This is the defining question any startup doing an ICO must be able to answer well.
Trustworthiness and Competency of the Project Team
Almost every ICO that’s happening right now and in the near future offers little, if any, protection for the investor or legal recourse in the event of fraud or incompetence. This can be scary ground for any investor, especially when the investor is a VC looking to put large sums of money into a project.
An additional factor is that an ICO does not give an investor neither equity in the company, nor any kind of control. So an investor may see the team, they invested in, make several fatal errors with no leverage to influence them in any way.
This makes trust in the team a major factor in the VC’s decision to buy into a token generation event. (TGE is the new acronym some companies are using to distance themselves from being called a security). There’s several factors that go into determining your trust level in a team.
What is the background of the founders? Have they been part of previous successful projects, were these blockchain or not? What is their reputation within the industry? Do they clearly communicate who they are, what their experience is, and what the benefits of buying their token are? There are other questions an investor could ask, and they vary from person to person depending on the level of risk they’re comfortable with.
Post-ICO Business Plan
You’ve probably heard this line before, “Company X had an amazing idea, but they just didn’t execute it well.” This is the sad ending for a lot of startups, and VCs are wise to be very careful when researching projects to invest in in the mostly unregulated space of the cryptocurrency and blockchain industry.
I touched upon this topic earlier in the article, regarding the long term value of the token, but the way a project generates long term value is having a solid post-ICO business plan that will take the idea and turn it into a functional product that generates self-sustaining revenue and motivates the value of their token to go up over time.
Does the ICO have a good dev team? Do they have a competent marketing and PR team? Do they have project managers who can keep the machine moving forward so that they hit their milestones? If they don’t have any of these in place, do they have a viable plan for outsourcing?
Having a couple of brilliant project founders and a pile of money in no way guarantees success. If the founders of a project don’t understand the fundamentals of running a business, the future of that project is very bleak.
What are Some of the Challenges Investors Face?
The accelerated timeline is one of the biggest. In the traditional fundraising model of tech VC in Silicon Valley an investor often has months to get to know a project team, bring them in for meetings, and then make a decision.
While there are “lightning in a bottle” kind of projects that instantly cause a VC to scramble for their checkbook, it’s more common for an investor to have more time to carefully research a project before committing funds. The blockchain space is evolving very rapidly, and the timelines for performing due diligence have been compressed. This leads to situations where a VC has to make a decision using incomplete information, which is never ideal.
Risk assessment can be challenging in an industry where a project can literally take the money and run once their ICO is done. What VCs look for here is to make sure that the project founders lock themselves out of taking too big share of the project through conditions in the smart contract, and also to make sure that the project isn’t trying to raise far more capital than they need to execute the business plan. If a project needs $5 million to move forward, but wants to raise $25 million, this is a very troubling sign that they might not be acting with good intentions.
Is it a visionary project on the bleeding edge of innovation, or is it a solution in search of a problem? This is another tough one. Blockchain and cryptocurrencies are fundamentally transformative technologies that are very reminiscent of the dawn of the great dot.com boom of the 1990s.
Now, as it was then, there are a lot of tech startups with visions of a future that assume that everyone thinks like they do. As a result, there are many projects that at best have a niche usage case, and at worst solve a problem that no one thinks is really a problem. Essentially, these projects have no real business justification for launching a new token, because it’s unlikely to increase in value or have much liquidity.
How Does a VC or Other Investor Sort Through the Large Number of Projects to Find the Good Ones?
There are dozens of ICOs lined up just in the next two months, which involve a huge amount of information to sort through. Compounding this, most of the “old school” authorities in the crypto-investing market space are running their own existing projects, or are investors themselves, so many of the projects coming up are run by relatively new players, who haven’t established concrete reputations yet.
The new move for VCs in the crypto-investing space is to diversify their crypto holdings and entrust their investments to professional fund managers. It’s always been standard practice for a VC to place reasonable bets on a large number of projects, rather than putting all of their capital into one startup that might fail, so it’s a logical move.
When there are short timelines for performing due diligence combined with what can be a frustrating lack of reliable forecasting, it really does make sense to let a fund manager, who does have industry knowledge and a great track record, do the work for the investors.