The Innate Sins of ICO
Updated: Aug 19, 2018
I have a friend. He doesn't want to disclose his name. Let's call him Steve. Steve is the founder of a SAAS company whose headquarters is in Shanghai with business in both China and the US. Last year, he started exploring opportunities in the blockchain space and finally decided to have his company launch its own token project last month. In the first 2 weeks, he received tremendous interest from token funds and individual investors, most of whom were in China. However, rather than feeling encouraged by the high level of interest, he felt worried.
Steve told me that he is not alone. Many project founders share his anxiety. Nowadays, especially in China, early-stage investors in the crypto space will ask for a big discount compared to the ICO price or even demand a free quota if they provide sources instead of money. Compared with his experience with traditional VCs, Steve told me many crypto investors are simply on the prowl for the quick buck. They want the projects to get listed on an exchange as soon as possible so they can get access to the liquidity that will allow them to exit. After registering on an exchange, the lock-up period is usually 3-6 months and could even be as short as none. Once the lock-up period is up, most investors will sell all of their tokens or at least a good part of them to at least generate a return. Since the investor obtained a big discount, even if the trading price is low, they can still secure their profit.
Steve's concern is that it is impossible to deliver a disruptive product as promised in several months. The problem is that even without an eligible product, they first need to rush to get their token listed on exchanges under pressure from the investors. That costs money. One big source of cash flow at many exchanges comes from the listing fee. According to a token broker who asked not to have his identity disclosed, he has heard of listing fees as high as 5 million dollars and usually it is a mix of Bitcoin/Ethereum and the project token.
To top it off, in order to attract retail investors, a token project needs to put a lot of money into PR. Without a product being quickly available, PR becomes the critical part. And since the investor will unload his or her tokens soon after the listing, the project will need to spend a substantial amount of money to support the price and provide liquidity to the market.
In conclusion, before they can do any real work, Steve will spend a lot of money on the listing fee, PR and support for the market and the investor will get their profit by selling the token.
For Steve, he sees these investments more as a kind of debt with a stronger pressure to make the token successful on the market rather than deliver a product. According to him, the relationship with the investor is quite different from that with a traditional VC who will, in comparison, cares much more about the long-term strategy. Steve feels the investor is merely looking for opportunities to make money with the token developer, which, can certainly be a lot easier. Even though he is aware of all the possible risks, Steve is still pushing ahead with the project. He thinks it would be foolish to miss the blockchain wave and he has to deal with the reality of the present situation.
In the early days, the ICO model was considered a new way to stimulate innovation. It can tap into a bigger market while retail investors can also get the chance to invest in early-stage projects. Plus, many ideas which might not be able to attract funding from traditional VCs can now raise a lot of money through ICOs. Steve's story might not depict the whole picture of ICO market. However, if Steve's story is typical, that means the ICO model is evolving into a money game instead of a tool for innovation, at least in China. There are still investors and entrepreneurs out there who sincerely want to innovate and disrupt the world. Unfortunately, they may have to deal with the noise and the quick buck mentality. With all these questions in mind, I interviewed Jeffrey Wernick, an early adopter of Bitcoin since 2009. Mr. Wernick is also an early investor of Uber and Airbnb and an advisor to various blockchain projects including Qtum. Here is what he shared with me.
BIANCA: You mentioned ICO was pretty corrupted. Tell us why you think so.
JEFFREY: I think ICO is corrupted by design. There are rules for investment that everybody should follow independent of the form of investment. Almost all ICOs are pretty illiquid. And it's not like they have a business: they have a hope; something they're hoping to do. So for somebody to write a white paper and become a millionaire, I have a problem with them, some who has an expectation that by writing a paper they deserve that type of compensation. I don't think this good incentive alignment, and I don't think there's adequate skin in the game.
The design of the ICO got perverted in the sense that once the market got hot, people started expecting like 10x returns. Ultimately, we have a lot of investors in this space who are not in it because they care about the company or the project they invest into. They want to make a quick 10x.
For me, corporate governance is very important. If the ICO ecosystem was more like, "here's my white paper. This is the smart contract of my deliverables." Every time I delivered what I promised to deliver I got tokens as based on performance. That would be more acceptable. If it's embedded in smart contracts. There was a governance structure embedded in smart contracts that had the founders accountable if there were requirements for ongoing information disclosures. Then I would say, okay, I'm giving money to people who respect my money.
BIANCA: Still, many argue that because of ICO, ordinary people now get the chance to participate in these early projects. And for teams who could not fund their projects from VCs, now they get a chance to survive. Do you agree that may stimulate the innovation in a way?
JEFFREY: I like the fact that through crypto, a lot of young people who would have never gotten rich quickly have gotten rich quickly. But so far they're getting rich without any innovation. There hasn't been any real innovation yet. I would have liked them to earn their money beyond just the production of the white paper. The issue is not whether you fund the business. The issue is how much money you give them for the white paper. I would be happy to fund the business if they said I don't deserve a lot of money yet I got to earn it first.
BIANCA: What kind of role is the token fund playing?
JEFFREY: Most investors are agnostic to what they're investing in. They just want their money to be productive. Most people giving money to token funds don't understand tokens. What they do is they now see a fund.
What they're selling them is "I can get you extraordinary returns you can't get somebody else." In order for them to keep the money in, they have to produce the extraordinary returns. They have to structure the deals, so they get extraordinary returns. All these incentives that reinforce each other. One is they get big discounts. Some projects have come to me when they want me to advise them. One of the questions I ask is I want to know the deals the funds got. If I don't like the deals the funds got, I won't advise them. So some of them have told me that they've had some of the funds get 90 percent discounts. Some they've given to principles in the funds free tokens.
If I have a 90 percent discount, basically I'm buying 10 percent that of the public price. I could sell 30 percent of the tokens I get, walk away with a 200 percent return, and still keep 70 percent of the tokens with basically no cost basis and already a profit. At that point, I really don't care because it's all gravy to me. Because I've made money through foreseeing the listing. What I need to do is to monetize it as quickly as possible.
BIANCA: So who is going to pay for this, since these investors are getting a big discount?
JEFFREY: Almost every ICO was below its ICO price. That means the last one in has lost money. The retail investors have lost a lot of money. A lot of funds said they made extraordinary returns. In a bear market, it could all be one of two ways: the shorting projects, and maybe disclosing it to the people whose money they manage. They're certainly not disclosing it to the community that's relying upon them. When they sell projects, you know their basis is so low that even with prices this low, they still have profit. What they've done is they've basically bastardized the retail market by promoting too many shady projects. So the market is no longer believing the hype. That's why it's why I say this is not a bear market. This is a market that I think is getting smarter about pricing the value of projects.
Perhaps as Jeffrey conceived, the market will slowly correct itself and mature, and perhaps we will have more innovative models. In the end, what we hope to see is not to make it easier for the people to get rich, but to lower the threshold of innovative inventions and let the resources be distributed to the people who are most contributors, so that the human footsteps can go faster together. it is good.