Bart Stephens has found himself in high demand lately. After four years of investing in cryptocurrency and preaching its gospel, his venture-capital peers are finally listening.
During a recent briefing at a storied Silicon Valley venture-capital firm, the young analysts in the room nodded along to his words in excitement, Stephens says. But not everyone was sold. In the middle of his presentation, a gray-haired senior partner stood up, yelled “PONZI SCHEME!” and stormed out. “Most generalist venture capitalists do not believe in this sector,” Stephens says.
If investing is driven primarily by greed and fear, few subjects elicit either more greed or more fear among venture capitalists these days than cryptocurrencies. Some big-name venture investors, including Andreessen Horowitz and Sequoia Capital, are plunging deeper into the arena, excited by the prospect of big returns, and perhaps, changing the nature of venture investing.
Crypto-evangelists believe their “initial coin offerings,” or ICOs, employing a new way to fund startups, could upend the $500 billion, 50-year-old institution of venture capital itself. In most ICOs, entrepreneurs sell “digital tokens” related to a service they plan to build using blockchain technology; in some cases, they sell options to buy the tokens. If the service is successful, the value of the tokens will presumably rise, and its creators will have funded their companies without ceding any of their ownership stakes to venture capitalists. Tim Draper, founder of venture firm Draper Associates, is forcefully bullish on the trend. “I think it’s a bigger deal than the internet. I think it’s a bigger deal than any of the industrial revolutions. It’s an opportunity and a new technology that we can all use to transform society,” he declared at the Web Summit technology conference this week.
This year cryptocurrency startups and projects have used ICOs to raise $3.2 billion, according to ICO tracker Coinschedule. In some months this summer, ICO funding eclipsed that of traditional venture startups. In the second and third quarters, 90% of venture funding for blockchain-related startups came through ICOs, according to a report by Silicon Valley Bank. “It is already significantly changing the venture landscape,” says Greg Gilman, a partner at venture firm and incubator Science Inc.
Others are reluctant, seeing cryptocurrency as a bubble, a fraud, or worse. “People are raising obscene amounts of money for companies that are not yet at the stage where they are good stewards of that much money or would know how to deploy it,” says Mark Suster, a managing director at Upfront Ventures. “It’s being done with a get-rich-quick mentality, and it never ends well.” Even some longtime cheerleaders for the sector lament today’s hyped-up gold rush mentality. “You know how you feel when that band that you saw in a 20-seat club and fell in love with plays Madison Square Garden?” asks Fred Wilson, a partner at Union Square Ventures, who was an early believer in cryptocurrency. Still, Union Square’s partners believe the hype will fade and the tech will persist. “That’s what we all experienced with the internet from 1990 to 2000,” he says.
The debate is playing out between firms, but---as Stephens’ recent incident dramatizes---also within firms, largely between younger partners and their older colleagues. Venture capitalists make their living taking big risks, but when it comes to cryptocurrencies, most are proceeding cautiously. They’re reading books by bitcoin gurus, opening digital wallets on Coinbase, and dabbling in crypto speculation. They’ve assigned research projects to analysts and hired evangelists to give presentations. Several have purchased mining rigs for the office. But they’re not yet allocating any of their investors’ cash.
General Catalyst's partners recently heard a deep dive on blockchain technology, outlining the opportunities and risks. The firm is still deciding on its stance, says managing director Hemant Taneja. General Catalyst has ruled out buying bitcoin and ether directly, even though owning those currencies has generated the best returns so far, because that’s not a proper use of the firm’s funds, he says.
Hyped tech trends come and go with the wind in Silicon Valley, but this one is more complicated, more arcane, more legally dubious, and more glorified. Blockchain, the technology that powers digital currencies like bitcoin and ether, and its growing ecosystem of related software and startups, has been called a revolution, with growth opportunities comparable to those of the early consumer internet. And as with the early dot-com days, crypto-world is packed with fraudsters and zealots.
When firms are willing to invest, the novelty of the field poses legal, administrative, and appearance challenges. Firms can, as they have for decades, write checks to software companies that enable digital currency. That includes well-funded digital-wallet startups like Blockchain and Coinbase---the metaphorical pickaxes in the gold rush. But for the last three years, currency speculation---buying bitcoin or other tokens directly---has been more lucrative. The price of ether has increased almost 30-fold in the last year, for example. Few of the firms that have put fund money into tokens will admit it publicly, either for fear or angering their investors or fear of being hacked.
Most venture firms aren’t permitted by their investment agreements to speculate on digital currency. Doing so also potentially exposes a firm to additional regulation and disclosure, because venture firms typically don't have to register with the SEC as long as 80 percent of their holdings are in private-company equities. Some lawyers interpret this to mean funds shouldn't buy tokens. Some firms have obtained permission from their investors, or helped their investors make their own direct investments.
Then there's the security risk of buying cryptocurrencies, where theft is irreversible and hacking is common. Unlike equity investments, where stock certificates are held by escrow companies, venture investors must take direct custody of any tokens they buy. “That asset looks like a string of characters that might be 25 to 40 characters long,” says Science Inc.’s Gilman. “If that disappears, that’s a scary possibility." Union Square's Wilson expects "institutional-grade custodians" for crypto assets will emerge to offset the risk.
Instead, some venture firms have backed hedge funds that invest in cryptocurrencies. Polychain Capital, a blockchain-focused hedge fund, counts venture funds Andreessen Horowitz, Sequoia, Union Square, Founders Fund and Bessemer Venture Partners among its backers.1 MetaStable Capital, another hedge fund, has raised capital from the same crew, according to Fortune. Bain Capital Ventures has backed Digital Currency Group, an investment firm structured as a corporation.
These strategies are complicated and can create tension with the fund’s investors, some of whom may balk at paying fees to VCs who then are paying fees to hedge-fund managers. To avoid this, some venture firms are investing directly in the firm that runs the hedge fund, instead of, or in addition to the fund, which charges the fee. Union Square took this tack with Polychain. “Everyone is changing the lane they work in in order to do this,” says Salil Deshpande, a managing director at Bain Capital Ventures. “The lanes are there for a reason, but you also change lanes sometimes, and everyone is figuring out how to do that.” Matt Huang, a partner at Sequoia, compares his firm’s investments in Polychain and MetaStable to Sequoia’s investment in startup accelerator Y Combinator. “There’s nothing they can invest in that we can’t, but they are 100% focused on this asset class,” he says.
Venture investors are also backing companies ahead of planned ICOs. Sequoia, Andreessen Horowitz, Union Square, and others invested $52 million into Protocol Labs, the company behind data-storage network Filecoin ahead of its ICO. The company went on to raise $257 million in the year’s largest ICO. If successful, Filecoin will allow people to buy and sell data storage using a blockchain.
Bain Capital Ventures and Andreessen Horowitz recently backed Basecoin, a “pre-ICO” startup that aims to tie the value of its tokens to traditional currency to lend it stability. The firms’ investments will give them coins when they’re created in Basecoin’s forthcoming ICO. And last month Orchid Labs, which is building a protocol to allow people to access the internet without censorship or surveillance, raised $4.7 million from nine venture funds.
Beyond hedge funds and pre-ICO deals, some firms are launching their own ICOs. In September, Science Inc. held an ICO, raising nearly $12 million as of press time. That money will help fund the firm’s incubator of blockchain-focused startups, many of which will hope to hold their own ICOs. Investors in the Science tokens will also get tokens from the startups in the incubator, Gilman says. Blockchain Capital also held an ICO in May as an experiment in managing a “liquid venture fund,” Stephens says. The firm raised $10 million in six hours.
The new forms of dealmaking raise questions that investors, lawyers, and regulators don’t have clear answers to yet: What happens if a company that has raised capital through an ICO wants to raise traditional venture funding? What happens if a company backed by an ICO is acquired, folds or the project fails? What happens if a company raises millions in token sales and its founders disappear? Many investors are wary to talk publicly about their activities in the sector because securities law around cryptocurrency is still evolving and regulators have yet to clarify their views.
And even the biggest crypto-heads aren’t sure how disruptive the revolution will be to their own industry. “There’s a big role for traditional investors in this ecosystem,” says Sequoia’s Huang. He adds, “In the early days of a project you have all the same challenges of an early stage company---hiring, strategy, marketing, or design.” Deshpande says, “ICOs might be a nice tactic, but they're not going to replace traditional fundraising and the work of vetting teams, ideas and markets that goes into a financing.” Jim Breyer, whose firm, Breyer Capital, has backed several so-called “pickaxe” companies building blockchain-based technology, said at a recent conference, “I watch, I try to learn, but I’m not in the camp of thinking it will change everything overnight.”
That could be self-preservation talking. Or maybe these VCs are just being realistic. Most of the up-and-comers riding the cryptocurrency hype haven’t experienced the euphoria and pain of the tech industry’s last big revolution. When the dot-com bubble burst, they were in grade school. Blockchain Capital recently surveyed 91 cryptocurrency hedge-fund managers. The average age was 26.
1 CORRECTION, Nov. 9, 2:42 PM: Sequoia Capital is an investor in Polychain Capital. An earlier version of this article omitted Sequoia from the list of Polychain's investors.
