ICOs must add VC-like selection, else it’s a crowd-suicide
By Fabio Ciucci Founder, CEO at Anfy srl,
I decided to write my humble ICO opinions after the 10th contact asking me: “Will ICOs replace IPOs?”, “Should I invest in ICO? In what ICO?”, “How can I get funded with an ICO?”, etc. (Update: after I posted this article, I am getting many more ICO questions, not less! I had to guess it). Please note, I am not an ICOs (Initial Coin Offering) expert. But I dealt for 20 years with “classic” Venture Capital (VC) / Private Equity (PE) / Mergers and Acquisitions (M&A) guys, those that ICOs are supposed to replace along with Goldman Sachs, JPMorgan, and all the investment banks at once.
Investment bankers and VC fund managers are expensive. Some can be biased or do errors. They’re humans, guess what. One of the blockchain ideas is to cut out middlemen, intermediaries. This can work where the value is known and certain. For example, Alice sends to Bob $500, and Bob sends to Alice a $500 worth cell phone. Middlemen can be cut out: to buy at $500 and resell at $550 is no service to either Alice or Bob. But the value of an ICO token is unknown and uncertain: to estimate the value of a startup or project (really, its future value) is nearly impossible. It would require parapsychology extrasensory perception, such as clairvoyance and precognition.
VC guys have no paranormal sixth sense superpowers, in fact, they pick several dead horses, not all unicorns. Yet, perhaps just due to experience, statistically the VC and PE guys pick (mostly, reject) at least a little better than the average crowd. Most people wrongly think that since VCs have funded startups like Google and Facebook, then every VC fund returns 1000% profits. Really, the same VC funds that invested one dollar in a “Google”, also invested 99 dollars in other startups that mostly failed or kept up barely flat. The recent average VCs funds return is 5% profit per year, less than investing in an S&P 500 index fund. The top quartile VC funds return is 20% per year.
Several VCs lose money, most experts can’t-do more than 5% per year. Leaving the “crowd” alone to pick ICO projects without any expert’s advice, should return a little less than experts, average 0% or loss. Of course, some ICOs may end up in profit, as well as there is one winner at the lottery, but consider the probabilities: it’s always someone else. ICO picking, to be often profitable, should “replace” the classic VC experts with cheaper ones, that must guide the crowd investors. Not “fully remove”. Else, too many ICOs ending up in loss will be funded, instead of the profitable ICOs.
I checked Bitcoin in 2011 when priced $1, and traded some on Mt.Gox, then on BTC-e. I didn’t expect BTC to reach $5000, so I sold at $1, shame on me. Later, Mt.Gox bankrupted due to a hack, and BTC-e owners were arrested for money laundering, including for the funds stolen to Mt.Gox. A small crypto crime world. I helped a few online merchants to accept BTCs and Litecoin, but none had relevant cryptocurrency sales because they sold legal goods: it’s quicker to use Paypal for that. BTC made volume only in the TOR Dark Net markets, for illegal drugs and gambling.
Recently the bitcoin transactions became so slow, that you must pay high “fees”, up to few dollars, or it will take days or even fail. Everyone can see that centralized Paypal or VISA systems are faster, cheaper, and consume less electricity. To make bitcoin useful outside the illegal and anarchic rings, and given its rising price, BTC was “forked” into a few upgraded versions. Many alternatives exist, but no one replaced BTC for value or usage. The news was talking about the original and faulty bitcoin only, so BTC only was acquired or traded by new investors, at least until the ICOs.
More people purchased bitcoins to keep as a long-term investment, making the price rise. Higher price news, in turn, convinced more people to buy, in an obvious bubble loop: “let me buy before it’s too late”. No mass selling happened for a long time, so it’s all ok. This BTC-only loop could have continued unchanged for years, but a shortcut to richness was created: the ICO, Initial Coin Offer. For the first time, bitcoin holders are convinced to invest their BTCs in something else, believed to grow in value faster than BTCs. You need BTCs to buy ICO tokens, so more people acquired BTCs for the first time, making the BTC value grow too: 400% in few months.
The 2017 ICO funding boom so far: $103M April, $232M May, $462M June, $574M July. Modern ICOs started in 2016 with Ethereum, a new blockchain not only supporting a transfer of value like bitcoin, but also running contracts (programs): a distributed computer. Its first project, the DAO (Decentralized Autonomous Organization), raised a record $150 million, showing the potential of convincing many bitcoin holders to invest in such offers. But the DAO was quickly hacked, $50 million was stolen. This caused a “fork”, splitting the Ethereum in two rival networks. The Ethereum and DAO embarrassing fiascos cooled down investors, but only for a while.
Rebranded as ICOs, using a draft Ethereum standard called ERC-20, more IPO-like “token” (shares) issuing events was organized for blockchain-based projects of all kinds. People from anywhere, with any background, some with no real business or plans, can now try to raise up to $100M of real dollars within days. Other CrowdFunding (CF)platforms like Kickstarter exist since years, allowing anyone anywhere to be funded by anyone else, but most projects there raise very little, not millions, and must pass several checks to be listed. The incredible ICO news is that many projects, made of people almost all under 30 with no prior business experience, succeeded in raising millions by just writing a “white paper“, a document with an idea that looks cool to many bitcoin holders, nothing more. Yes: no need of beta versions or users, no need of a team to do the project. All you need is an idea, better if not detailed enough to be assessed by experts. And promotion by influencers. I expect a movie about ICOs soon.
Some ICO project seems legit and properly prepared: Tezos and Filecoin raised $232M and $205M respectively, after working at these projects since 2014. But most ICOs look like last minute (fake?) projects. ICOs all are trying to “disrupt whatever”, by bringing “whatever on blockchain“, so excuses to setup an ICO are endless. Who holds bitcoin believes in blockchain in the first place, but wants updates from the old bitcoin. The ICO marketing should convince the BTC holders about a believable new decentralized dream, better and profitable. But the tokens of most ICOs are made available in exchanges for sale after a just few days from the funding. A so quick listing is just for speculation, bad for real long term projects. Who setups or funds a startup in seed stage (just an idea, no users), knowing it can be sold 3 days later, will be tempted to do quick sell (dump) profits: who cares if projects will work ever? A startup should be funded (ICO), then do the project, add users: only after this, be traded again.
The main goal of ICOs is to convince bitcoin holders to exchange bitcoin for the ICO’s newly created tokens, with the promise of a higher value at the end, plus some service over (mostly Ethereum) blockchain. Example ICO projects: Bancor ($153M) “offers liquidity of digital currencies outside of exchanges”. EOS ($185M) “cuts off transaction fees from blockchain”. FileCoin “provides decentralized file storage on blockchain”. That’s all projects adding features to blockchain, possibly released as open source. Calling these events “ICO” can be misleading: unlike in IPOs, normally the tokens you get from an ICO do not include equity (shares) of any company owned by the people setting up the ICO. Same as bitcoin: it’s not shares of a “Bitcoin inc.”, it’s tokens that you hope will become more (rather than less) popular, exchanged, valued.
To me, ICOs seem “donations” for the research and development of better free blockchain systems, rather than investments in companies that may produce profits ever. Tokens do not normally include equity (shareholding) in the company of the ICO founders anyway. The hope seems that most people will exchange their BTCs for the new blockchain tokens, abandoning the old BTC blockchain. This is in part happening with Ethereum, but there can be only 3 to 5 new blockchains really “replacing BTC”, not 1000. All the other 995 new blockchains will end up with little market cap, and token sales will be a loss from the BTCs paid at ICO. In general, the top 3 or max 5 platforms get the 80% of each market, waking up the antitrust guys. There can’t be 1000 Google’s or 1000 Facebooks, or 1000 profitable ICOs. I wonder how much of these ICOs business plans was understood by those who acquired bitcoin or ethereum for the first time in their life, just to join ICOs, advised by others who heard from others etc. How many investors have read the white paper at all? In some, there is no detailed commitment to spend the raised money in the project, and/or the investors must accept that the ICO founders can abandon the project as they please, and that’s it!
USA and UK declared that ICO tokens should be regulated like IPO securities, and China banned ICOs completely, asking money to be given back. This ban, much like bitcoin bans the years before, was considered by blockchain enthusiasts as the evidence that bitcoin and ICOs are “disrupting outdated governments and unreasonably expensive financial institutions”. Some bank fees are questionable, but many ICOs are plain frauds, is frauds better than fees? Even where ICOs are honest, they can simply fail. It will take years to know the results, why to hurry buying into all the ICOs now, rather than wait a first verified mid term success? The governments and banks expect ICOs to be a big loss for investors, they do not fear to be disrupted by ICOs. Regulators simply do not want to be blamed, later, for permitting ICO losses today. If ICOs are deemed as illegal, and strong warnings are given, no one who lost money can complain later with regulators. Many use bitcoin for illegal gambling anyway, be it Poker or ICOs, no problem. But be sure to setup in Zug, Gibraltar or Singapore.
A real issue with VCs, is that the 80% of their money goes in Silicon Valley (Paypal Mafia), London and few other places only. Since most people live elsewhere, the only hope to get funding is trying to relocate, not to be smarter. Really, this geographical injustice should be solved already by the many CrowdFunding (CF) platforms, that since years give equal access to investors to anyone, anywhere in the world. If you live in let’s say Bulgaria or Argentina, you can get funded in both reward-based and equity CF platforms, but projects in Kickstarter and others hardly could reach $5M maximum funded across years, and the average is below $10,000. This is laughable compared to the several $100M+ ICOs across just months. But for how long ICOs will raise that much? Will ICOs end up raising max $5M too? Let’s compare ICOs with VC: the SoftBank Vision Fund alone is $93 billion and invested $4.4B into WeWork in August. This and many other VCs will continue investing that much in the next year, for sure.
ICOs are too basic if providing only the technology to issue shares (tokens). This is like letting people go to vote without access to information about what they will vote for. Democracy requires access to the independent press. In IPO case, expert advice, what VCs and investment banks do, of course for high fees and with some mistakes. Yet, if after centuries of free market, every country ended up with a similar securities and IPO regulation, there should be some valid reason. If who holds large amounts of money, no matter how smart, is paying the fees of VC, PE and M&A staff, rather than research and pick themselves, there should be some valid reason. ICOs can “disrupt” (compete and win over) IPOs and VCs only if adding (keeping) what’s useful in VC and investment banks: independent reviews and rejections. The equity CF platforms are already doing a good job by trying not to list scam or too risky projects, and by double checking claims in marketing material. This is long-term increases investors confidence in the CF platform, needed for organic growth. But they fail to raise high amounts, probably because not many of the projects funded by the crowd have shown large profits later. In fact, so many crowdfunded projects ended up bankrupted or flat sales after some time.
Except in few ICOs backed by VCs or by known people (I don’t mean Paris Hilton or sport stars), investors are left alone with the marketing claims of the ICO founder. I don’t see a reason why, on long-term, ICOs should raise more than the $5M max of the other CF platforms. Bitcoin holders had nothing better to do with their bitcoins, unlike who holds cash. ICOs raised max $200M because many bitcoin holders were convinced to exchange their BTCs for ICO tokens in a crazy hurry. ICOs, in turn, raised the BTC value, which in turn raised ICOs value, while the news amplified this growth, bringing new investors and raises in a loop. Unlike the quiet CF platforms that had modest funding records, and where almost no one became rich even after being crowdfunded.
Why is the crowd not good at picking investments? The main portfolio construction rule is to diversify: invest in all of USA, Europe, Asia (geographic and currency diversification), and in stocks, bonds, real estate, commodities (asset classes diversification). Even the Tezos ICO diversified: after raising $232M, they sold bitcoins to buy stocks, bonds, and gold, avoiding the loss hitting everyone else with the recent bitcoin drop. VCs invest in a bit of everything too: consumer startups, business to business startups, various themes and technologies. It’s simply safer statistically. Unfortunately, most people don’t do diversification: they invest in what they “like” or “know”. Most CF funded projects in Kickstarter and Indiegogo, but also in equity CF platforms, are video games or consumer gadgets, what most people like or know. Further, they don’t really fund people anywhere, a lot of the funding comes from people who already know the founder or living in the same area. Too many CF funded projects fail to end up profitable, because competing in the same few crowded fields that most people like or know. Instead, other projects, liked or known by less people and so not funded, would enjoy lower competition and higher probabilities to end up profitable. ICO investors can try to diversify by betting a bit in every ICO, but the percentage of fail + fraud ICOs seems higher than in the stock market. ICOs must be rejected and picked: simply buying few dollars of all the ICOs will probably still sum up to a loss.
The “wisdom of the crowd” works for things like voting the funniest video, or the cutest puppy photo to share. But fails for picking the best project to invest into. To guess the future value of a startup project is generally more difficult than to fly a plane. No one wants the crowd to drive your flight in place of a pilot. A pilot drives better. A minority of experienced experts, like VCs or investment bankers, will statistically pick better startups than the crowd, much like a pilot will fly better than the crowd. Next ICO: crew-less planes controlled by the crowd over blockchain, rather than by a pilot.
ICOs suffer the crowd’s lack of diversification like the other CF platforms, plus the “blockchain mono-mania”. ICOs are almost only “whatever over blockchain” business models. The blockchain is not optimal in all the cases. But why to remind in the ICO X whitepaper, to investors (blockchain fanatics), that X over blockchain was already tested by others and didn’t work well? Someone can write about X in forums, but no independent reviews about the ICO claims will end up in the ICO site or whitepaper. No ICO regulator or rating agency will double check and be cited.
Let’s put aside the blockchain for a moment, and look at how the VC model is being “disrupted” in centralized ways. First, let’s describe the VC model. The VC guy, a “General Partner” (GP), setups a VC fund, then starts begging for money every “Limited Partner” (LP) for a year or two. That’s pension funds (the main source of VC money), family offices (the accountants of rich people worth $100M+) and so on. After hundreds of rejections, the VCs raised let’s say $100M to invest, across 10 years, the duration of the fund. Now, the GP can revenge, rejecting thousands of startups in the following years, to finally only invest in a dozen. VCs main job is to avoid rejections from LPs, and to reject most (but not all) the startups, a little better than randomly.
The VC will bill the 2% of the total fund each year: over $100M, it’s $2M/year in fees, no matter if all the startups will fail. In 10 years, the total is 20% fees, in our example $20M out of the $100M. No only: in the lucky case that after 10 years the startups IPOs and exits returned more than the invested, the VCs will keep the 20% of profits, too. This fees model is called 2 and 20, used also for Private Equity and Hedge Funds: take the 2% per year of all the assets, no matter what, and 20% of profits, if any. Not so risky, at least for those VCs that do not invest own money in the startups. The VC guys, unlike the average crowd, are experienced: they know that most startups fail!
The VCs don’t beg for money the average crowd, they beg only rich people and pension funds, most of whom are at least less naive than the average crowd, so they know of being not good at (and/or haven’t timed for) creating a portfolio of startups with high probability of success. These LPs prefer paying 20% per VC fund in fees and just reject dozens of VCs and PEs guys, rather than save VC fees, but hire more staff to check and reject thousands of startups, still with same fail rates. Accurate research takes time, and time is money: hiring in-house VC-like staff to reject startups may end up costing 20% or more anyway. Ever tried to read and reject 1000 business plans a year?
The crowd’s money is already invested in VC via pension (retirement) funds, just the crowd does not know. Most of the VC money comes from pension funds, in turn raised from average and “poor” workers. Only a small part of the VC money comes from ultra-wealthy individuals. The 1% of richest guys do not conspire to keep the best VC deals for themselves only. Pension funds invest in bonds, index funds, VC and PE: all what is expected to grow in value, yet with the lowest risk. If future Bitcoin or ICO systems will bring stable profits with low risk, pension funds will crypto invest the crowd’s money. No need of ICOs to “democratize” VCs: pension funds done it already.
Some experts, neither VCs or consultants, called “Angels”, actually invest their own money in startups as a job. It makes sense: people who can reject startups better than the average crowd, up to be in profit each year, may simply invest their own money, rather than risk the money of others in exchange of a fixed fee. A new VC alternative is to “copy” the investments of expert “Angels” for free. For example in Angel List (AL), where multiple experts agree to invest in a specific startup. Platforms like AL offer “syndicates”, where Angels invest together in a pool, that also “not expert” individuals (the crowd) and LPs (who got big money) can join too. The Chinese firm CSC gave $400M to AL syndicates, in place of a VC firm, saving the VC fees, and still getting experts to pick startups (no blockchain required, AL is centralized).
The crowd and LPs copying the investment of groups of experts for free (or in exchange of small incentives), seems the best VC-killer trend so far. This can be a CF-killer too, because less risky for the average crowd than picking what they “like” or “know”, rarely what “will succeed”. In the future the crowd, as well as LPs, may be increased following (copying) the new investments of groups of experts who picked the most profitable private equity deals in the past. The wisdom of the crowd is to see that following the few experts that win profits, will bring more profits to the crowd.
Returning to the blockchain, the FileCoin ICO ($205M) was raised on CoinList, a partnership with Angel List. And some ICOs was backed by VCs in private pre-sales. I have no idea how the ICOs will evolve: VCs and Angel syndicates, together with Ponzi schemers, gamblers, anarchists and Paris Hilton? But what’s sure is that the crowd, if not advised by groups of independent experts, can only get financial losses at the end, whether centralized or decentralized. ICOs must add VC-like selection systems, else it’s a crowd-suicide. In the meantime, ICOs backed by VCs or super Angels, like Bancor or Filecoin, are probably less risky than some others, but again: I am not an ICO expert.
Currently, the crowd can only obey to “influencers”, people who simply got many “followers” for various reasons, rarely for being able to pick good investments. These influencers are not regulated, so they can accept money from ICOs for “marketing” such ICOs. They’re exactly like financial advisors with a conflict of interest (not fiduciary), that promote who bribed them more, rather than what seems best for the investors.
How to automatically figure out who are the best independent startups rejection experts, on blockchain? The ICO investment decisions could be tracked for the whole crowd until the system can identify those who made the best picks. But to be statistically significant, it would require many years of picking history, and ICO crowds require experts right now. Better than nothing, there are self-appointed ICO rating agencies, giving hype score (media and social interest, this can be mined with bots), fraud-risk-score (I am skeptic, easy to uncover the silly scams, not the well-forged ones), and investment potential (this takes time, it can’t be done for free, the same problem of VCs). Too many ICO-rating and pre-IPO services are popping up: most will not reach volume and fail. A single standard is needed, not many fragmented ICO portals.
After years, when the picking success story on blockchain can be enough to automatically identify the real experts, then scam startups will try to bribe them, to be unfairly picked. It would take time for the failures to show and downgrade the corrupt experts, and then new experts can be bribed again. Rejection experts should receive fees from the crowd that is copying their picks also to make less worth to accept bribes.
But again, the variable fees of some top experts, automatically calculated on blockchain, could end up even higher than the VCs and bankers fees. It’s easier to continue to hire experts like now, for a certain and fixed fee. Someone may think: “We replace humans with Artificial Intelligence!”. But AI can’t evaluate business plans, and will not be able to do so for perhaps 100 years more. Please read my AI articles “AI (Deep Learning) explained simply”, and “Will AI kill us all after taking our jobs?” for more about the AI hype. ICO platforms should replicate something like the “angel syndicates”, where a minority of experts is identified, and copied by the larger crowd, in exchange of a reasonable reward. Perhaps a similar blockchain system already exists? Else, the same good old VCs, PEs and bankers will simply continue to find the most profitable deals, and rightfully continue to get mandates to handle the big money.