The Hidden Costs of Initial Coin Offerings

In recent years, much has been written about how the Blockchain is poised to transform traditional industries such as banking, real estate, and healthcare. More recently, it has gained attention as a way to finance new ventures, through what is known as an Initial Coin Offering (ICO). Less noticed, though, is ICOs appear almost antithetical to the standard approach to financing a risky venture.

In fact, ICOs have upended the conventional pattern of staged experimentation and fundraising. Blockchain startups raised over $5 billion in 2017 through ICOs and over $12 billion through the first three quarters of 2018. The average amount of capital raised by a Blockchain project through an ICO in 2017 was $13 million; through the third quarter of 2018 it was $25 million. These ICOs are nearly always held when a project is at an immature stage of development akin to a seed stage startup — when it is testing hypotheses around its consumer value proposition and forming a founding team.

Blockbuster capital raises will always occur in unusual situations (e.g., EOS raising over $4 billion in their ICO and Telegram raising nearly $2 billion in a private financing), but if the average amount of capital raised by a Blockchain project is 10-20x that of a normal startup at an equivalent stage of development, while the failure rate remains roughly similar to staged financing startups, then either investors are foolishly leaping into a dangerous bubble or there are more profound differences in early stage financing at play.

3 Defenses of Large ICOs

Some observers have pointed out that blockchain projects may have an inherent incentive and strategic reason to be more aggressive in raising capital earlier in the experimentation process. Those benefits fall into three categories:

To jumpstart network effects that provide a first-mover advantage:

Many of the projects being built using blockchain technology are “protocols” that govern the interactions between users in a decentralized autonomous network. In this framing, the native tokens issued through the ICO are the means through which users transact between a decentralized network of participants without the need for any central organization or platform.

Just as with other such platforms or marketplaces that connect users, the value of the decentralized network is a function of the users who choose to transact using the given protocol. By making the tokens issued through the ICO widely available and liquid (and by using the cash raised to finance further development of activity on the network), projects can rapidly channel developer attention towards their protocols. For example, Sia is a decentralized storage platform on the blockchain, leveraging underutilized hard drive capacity around the world. The more hosts offer up their storage capacity, the more users will be attracted. The more users that come online to store files, the more hosts will be attracted. If the users and the hosts are both owners of the Sia tokens, which appreciate with greater usage of the network, they have an even greater incentive to see the network grow. This so-called “token network effect” creates a positive feedback loop, making it more valuable to be transacting using a given protocol when many others are also transacting through it.

To generate publicity that allows them to solicit broad feedback on their beta product

The publicity around the upcoming launch of an ICO that plans to raise several tens or even hundreds of million dollars is a related way to drive developer interest and engagement. This focused attention from developers has the added benefit of crowdsourcing feedback on the beta version of the project. When the decentralized exchange protocol 0x raised $24 million in their ICO in the middle of 2017, a few months after releasing an early-stage version of the software, it created an enormous amount of developer attention. By completing its ICO shortly after going live with its over-the-counter (OTC) platform for exchange tokens, developers and investors were attracted to testing out the protocol. Today, 0x is widely considered one of the leading decentralized exchange protocols with numerous other applications built on top of its platform.

To create a decentralized governance structure that is inherently beneficial to the nature of the project

Blockchain projects that can achieve a fully decentralized architecture and governance are inherently more valuable because they are more resistant to attacks and collusion. As Ethereum founder Vitalik Buterin notes, “Once you adopt a richer economic model…decentralization becomes more important.” But achieving decentralization requires a meaningful investment in capital in order to attract a distributed network of users and network managers that maintain the decentralized ledgers (or nodes). A larger injection of upfront capital is more likely to create the incentives for autonomous agents to participate in the creation of the blockchain network, thereby making the network that much more valuable.

The Downside to Large ICOs

In some cases, these benefits are real. However, there are very real potential downsides to a large, public fundraising through an ICO. To understand the downsides and why they’re important, though, it helps to understand why staged venture-capital financing has been so successful in the first place.

One of the fundamental elements of commercializing new ventures is the high failure rate they face. Failures are not necessarily due to bad execution; it is just that most new ideas fail, a few become incredibly successful and it is virtually impossible to know which outcome it will be without undertaking the hard work to develop and commercialize an idea. Indeed, over 60% of startups backed by venture capitalists fail and evidence points to the most successful VCs having bigger “hits” as opposed to fewer failures.

A solution to this challenge is multi-stage financing, which allows entrepreneurs and investors to learn about the ultimate viability of an idea through a sequence of investments over time. Multi-stage financing is usually seen as benefiting the investors: It allows them to commit only a fraction of the money upfront, preserving the option to abandon the investment if the idea does not pan out, but allowing them to reinvest if things continue to go well.

What is often less appreciated is that this methodology is equally valuable for entrepreneurs. For the entrepreneur, the earliest money invested into a venture, which is raised when uncertainty is highest, is the most expensive. By raising only a small amount of money initially and de-risking the venture through a series of structured experiments, entrepreneurs who succeed raise subsequent capital at higher prices and are able to retain a higher share of the venture they have built — never mind avoid wasting years of their lives fruitlessly pursuing bad ideas.

This approach to structured experimentation from the entrepreneur’s perspective, popularized by Eric Ries’ The Lean Startup with concrete steps for how to de-risk the venture in the most capital efficient way, has been widely embraced as the gold standard for how to approach the commercialization of radical new ideas. From Boston to Beijing to Bangalore, entrepreneurs and investors rattle off the importance of designing focused experiments to test hypotheses in a capital-efficient fashion in order to achieve product-market fit. Moreover, as the cost of experimentation has fallen in software (due to the cloud, open source tools, reusable code components and global distribution platforms), hardware (due to rapid prototyping, 3D printing, improved design and modeling software) and biotech (due to technological advances in gene sequencing and editing) and across-the board increases in computational power, modeling tools and big data techniques, so has there been a massive explosion of experimentation in a broad range of industries.

How ICOs Constrain

ICOs substantially limit the benefits associated with such staged experimentation, for three reasons:

Architecture

One of the benefits of blockchain technology is that it is immune to centralized parties making changes of their own accord. But this also implies that the software protocol at the time of the ICO needs to embed — as much as the project’s creators can — the set of rules that will govern the protocol forever.

It is hard for the project’s creators to fully anticipate the technological and incentive issues that will arise from a given protocol, and being able to learn from the way in which users engage can have a consequential effect on the ultimate usability and quality of the platform. An ICO “bakes in” the protocol early in the life of the project and makes it hard to adjust architecture to enhance performance and capabilities.

Governance

ICOs cede control of decision making to the community. In the early stages of a venture, centralization can be very powerful as it allows for speed, focus and collaborative effort towards one direction. Centralized decisions can be valuable when testing a particular idea and deciding when to abandon, pivot or double down on the effort. Once the project has an ICO, governance becomes decentralized, slowing down decision-making and reducing flexibility.

Value

While some entrepreneurs believe that selling tokens is different from selling equity in that it is “non-dilutive” — they don’t give up stock in the company — there remains substantial risk that the protocol will not succeed. When you’re raising money, there is no free lunch. As the markets become more sophisticated, the price at which the ICO happens will reflect this risk and the price of the token will appreciate as the risk is mitigated over time. Selling tokens early therefore has implications for the amount of value that is captured by the entrepreneur who creates the protocol — potentially leaving substantial “value on the table” for raising capital when the risk is so high. This dynamic is no different from the dilution cost faced by an entrepreneur raising a substantial money at the earliest stages as opposed to raising a small amount of this expensive capita, de-risking, and raising further funding once the odds of success have improved. For example, Ethereum’s original crowdsale in the summer of 2014 raised $18 million. Today, Ethereum’s market capitalization is $24 billion.

In addition to these constraints on experimentation, there is a another cost to ICOs:

Exposing Strategic Roadmap to Competition

Many early stage ventures start off in “stealth mode” to prevent their idea from being widely accessible and among the reasons firms have taken advantage of the abundance of growth capital to remain private much longer (e.g., Uber, Airbnb, WeWork) is that it allows them to only selectively disclose confidential information that can be important for strategic reasons to not be available to competitors. An ICO exposes a startups strategic roadmap and, in many cases, actual software code to the public, allowing competitors to learn and adopt elements of it into their own protocols.

In summary, while there are particular benefits of ‘going public’ early through an ICO, there are also a number of potential costs. Entrepreneurs, investors, and managers need to understand the full implications and risks of having a large ICO early and seek ways to mitigate unintended consequences while taking advantage of the inherent benefits. For example:

Complete a few rounds of more traditional staged equity financings in advance of an ICO.
Wait to expose the actual software code and detailed design as long as possible.
Use a subset of your community to enhance feedback and speed up experimental cycle time (e.g., private briefings of product road maps).
Begin with a more centralized governance structure (e.g., NEO choosing to launch with seven consensus nodes, growing to over 1000 over time) and then migrate the governance structure to a more decentralized one over time.
Consider the ICO more conceptually equivalent to the firm’s “IPO” — executed at the moment in time when the idea has become mature and is ready to be widely held and governed in a more decentralized manner.

Disclosure: One of the authors, Ramana Nanda, is a board director at Dunya Labs, a blockchain startup. The other, Jeffrey Bussgang, is an investor in and board member of numerous blockchain startups as part of his role as a general partner at Flybridge Capital Partners.