The tech and investment worlds are abuzz over blockchain and cryptocurrencies. According to CoinDesk, venture capital funding allocated to the space has steadily increased since 2013, and in 2017, the number of global crypto-focused funds exploded from less than 40 to over 200 by year-end. Based on TrueBridge’s due diligence into the blockchain space, including ongoing conversations with venture capital managers, entrepreneurs, and tech experts, below is a primer on the basics of the blockchain and why it matters.
What are the blockchain and cryptocurrencies?
Blockchain technology utilizes a shared, decentralized database (“ledger”) that is owned in part by each member of a peer-to-peer network rather than by a single entity (e.g., a bank or local DMV), as in the case of traditional, centralized databases. The ledger serves as a registry of transactions, which is split into records (“blocks”) of who participated in a transaction, the price, and other details. Ownership and verification of these blocks are enforced and secured by encryption from members of the blockchain. Members compete to encode transactions; when a solution is found, the block is added to the record of all prior transactions (the “chain”), which is then implemented across the network.
Cryptocurrencies leverage blockchain technology to offer a transaction medium (a “currency” or “token”) to track and reward the computational work that is required to maintain a blockchain network. For a blockchain network to remain current and usable, its members must validate the records comprising the blockchain in a computationally intensive process (“mining”). Cryptocurrencies exist primarily as an incentive for members of a blockchain to maintain the network. Theoretically, a cryptocurrency will rise in value as transaction volume increases and as the blockchain network becomes more socially and economically valuable.
Why does it matter? What are the drawbacks and risks?
Fundamentally, some VCs see a potential for the blockchain to be the organizing mechanism and economic model for the next-generation Internet, but there are also drawbacks and risks to the current system.
Potential Opportunity
- Blockchain and cryptocurrencies may cut out the “middle man” in traditional transactions and create less expensive and safer community-owned and governed business practices.
- Blockchain and cryptocurrencies may create a new asset class uncorrelated with commodities, equity markets, etc. and without the risk of intervention by a central authority.
- Top talent is moving from leading Internet companies to start compelling blockchain-focused projects.
- The size, complexity, and “velocity of change” of crypto markets is strong.
- Corporations such as Citigroup, Google, and Microsoft are investing strategically in blockchain technology.
Potential Risks
- Outside of investing/speculation, blockchain’s utilization in the real world is currently limited. It will likely remain so until the infrastructure and regulatory foundations are in place to ensure effective transfers of blockchain records and cryptoassets.
- Blockchain technology needs to be faster and more secure to gain the trust of the broader public and drive mass adoption.
- Substantial time and effort will be required to shift to a decentralized data model.
Where does venture capital come into play? What’s next?
Venture capitalists have been investing in blockchain startups and related areas for years. However, over the past 12 months, fundraising methods have shifted with the advent and widespread adoption of Initial Coin Offerings (ICOs).
ICOs provide a means for startups to raise capital by issuing cryptocurrency to their investors, rather than follow a traditional cash-for-equity arrangement. As the value of the startup entices new members to join its blockchain network, the utility (and thus value) of the tokens distributed to investors theoretically should also increase. More than 80% of blockchain venture funding was raised through ICOs in the second half of 20171. That trend has continued into 2018, which saw a high-dollar ICO by Block.one which could be larger than nearly all of the world’s IPOs to date.
Because the terms of ICO funding are favorable to entrepreneurs, some view ICOs as a potential threat to the traditional VC model in the long term. Nevertheless, some VCs have found opportunity by investing directly in ICOs via SAFT arrangements (“Simple Agreement for Future Tokens”), which sell tokens directly to VCs in a pre-sale.
Other major blockchain or crypto-focused areas where VCs are investing include:
- Cryptocurrency exchanges or mining companies
- Payment/remittance companies
- Private blockchains
- Industry-specific applications of the blockchain
Overall, traditional equity investments in the seed space appear to be maturing. Total seed/angel equity transactions last year amounted to 50% of total deals, down from 57% in 2016 and 72% in 20151. Yet the increasing use of ICOs has created a surge in seed-stage companies not represented by this equity financing data.
This surge of new companies may be evidence that the blockchain is following the path of other emerging technologies, from concept creation to market crowding. The next phase, consolidation within a subgroup of early-success companies, may come swiftly as few seed/angel-funded companies went on to receive follow-on funding last year.
Regardless, how these trends play out – and how pieces of the blockchain are built, refined, and standardized going forward – will determine how venture capitalists approach investing in the sector in the future.
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