When I first wrote Mastering the VC Game, Satoshi Nakamoto had just issued his seminal Bitcoin white paper. At the time, no one could have imagined the transformative impact the invention of Bitcoin and the blockchain would have on the venture capital industry.
With the invention of Ethereum and a Turing-complete platform that allowed for smart contracts, startups could suddenly raise money ahead of delivering products from a crowd of investors, not just a universe of a few hundred venture capitalists. Last summer, I wrote about the impact Initial Coin Offerings (ICOs) were having on the venture capital industry. This summer, I am amazed at how quickly the science of token-based fundraising has evolved and the hybrid of VC, crowdfunding and crypto token economics best practices that have emerged.
Last summer, one of my portfolio companies, Enigma, completed a $45 million ICO with only three employees and a (very well-written) white paper. Like many companies at the time, they had only raised a total of $1 million in a prior seed round and had yet to deliver any software to the market. At the time, they were not alone — startups raised more capital in ICOs than in venture capital rounds last summer. As of this writing, over $10 billion has been raised in ICOs since their invention in 2016. The money seemed to come so easily that aggressive entrepreneurs seized the moment.
Those days are gone. As William Mougayar correctly observes, “the only token that matters is the one being actually used.” The SEC has stepped in with some strong, cautious guidance and both professional and retail investors, although still enthusiastic about blockchain and crypto, are showing a bit more caution.
Today, a new playbook is emerging for startups who wish to follow best practices in fundraising in a post blockchain world. To understand the contrast to the pre-blockchain, you first have to understand what the best practices playbook looked like previously:
Financing Playbook, Pre-Blockchain
- Seed round: $1–2m. Raise from a mix of smart, value-added angels or seed funds. Pre product-market fit. Build the team and deliver an MVP in order to run some experiments to test the customer value proposition. Run a few go to market experiments and perhaps a business model / pricing experiment. Hit some important value-creating milestones, such as early customer revenue or at least engagement.
- Series A: $5–10m. Raise from a professional, series A firm. Complete the product, round out the team with some commercial executives (first salesperson, first marketer) and get to product-market fit. Begin developing a repeatable, scalable business model. Stand up a growth team.
- Series B: $10–30m. Raise from a professional, series B / growth stage firm. Execute on your repeatable, scalable business model. Expand beyond the initial product to deliver multiple products in adjacent areas. Expand internationally. Build a senior executive team that includes a head of finance and a head of customer service / operations.
- Series C: $30–60m. Raise from a professional, pre-IPO firm with a good, credible brand to assist in the IPO process. Work towards a profitable, scalable business model. Execute well across multiple products, multiple channels, multiple geographies. Complete some M&A to expand your product footprint. Build a strong, independent board and prepare for IPO.
In a post-blockchain world, the playbook has changed dramatically from the pre-blockchain world and also has evolved from the go-go days of last summer. Today, the market has become more discriminating, forcing companies to be more deliberate and professional. Here’s what the best practices playbook looks like now:
Financing Playbook, Post-Blockchain
- Seed round. $1–2m. Raise from value-added angels and professional seed funds, particularly those with strong reputations and credibility in the crypto community. Include in the seed round terms a token conversion option, allowing equity holders to convert into tokens at their election (following a vesting schedule) if the company’s business model is more focused on token value creation (utility, security) than equity value creation (revenue model, cash flow). This option tends to be anchored on a pro rata ownership share of the equity. In other words, if an investor were to own 10% of the fully diluted shares, they would have an equity conversion option on 10% of the tokens that are held by the company in treasury post-ICO. Build the team and articulate a product roadmap in the form of a technical white paper. Focus on writing code and building out a testnet (i.e., public beta). Ideally, leverage existing platforms (e.g., Ethereum, Cardano, NEO) to minimize the amount of new code required. Link your vision to a secular trend in the space and enlist thought leaders to publicly endorse you on Twitter, Reddit, Medium and at conferences.
- SAFT or SAFE-T or SAFTE. $3–6m with a pre-defined “launch valuation rate” (i.e., crypto valuation cap at which the dollars convert to tokens) as well as a discount. The labels the different lawyers might use are somewhat fungible, but this investment agreement is typically in the form of an option to purchase future tokens or equity with professional investors that are a mix of traditional VCs and crypto funds. This agreement looks very much like an offering document nowadays (due to recent SEC guidance), with many provisions that you might find in an IPO boilerplate, but is explicitly not a registered security but rather a carefully-worded agreement to purchase a non-registered investment security. Entrepreneurs attempt to raise enough from smart money (and ideally good brands to assist in the ICO) to go beyond the technical team and add a community executive and investor relations / business development. Issue the testnet and perhaps even release an initial component of code on the mainnet (aka the live blockchain) — not the entire product roadmap, but enough to get a community of developers something to play with and get excited about. Build out your community infrastructure (Telegram, Slack, Reddit, Twitter) and have your community manager recruit and engage with two types of members: developers (most important) and investors (secondary but still critical). Expand and publicly publish the multi-year product roadmap and vision. Prepare for ICO.
- ICO. $20–200m. The range is wide, but most top-tier ICOs are aiming for a crypto market cap of $100–300 million which would place them in the range of 50–150 top tokens (as of this writing, #50 is trading over $300 million and #150 is trading at $70 million according to CoinMarketCap). Thus, if they are selling 50% of the tokens, they might be raising $50–100 million. At this stage, a decision needs to be made as to whether the project meets the Howey Test, and is thus aiming to be a utility token, or should be a registered security. More and more blockchain projects are leaning towards the full offering and registration requirements consistent with a security token offering (known as an STO) due to the SEC’s recent guidance. The team needs to be a more fully formed team — not quite as mature as the IPO team (e.g., no CFO required) but ready to handle developer recruitment and support, have a point of view on the business model, a full treasury and finance function (what will you do with all that money? how will you maintain security? what are your treasury policies? how much tax do we pay on the ICO proceeds and when is that tax due?) and a fledgling legal function to assist with compliance. And a real product needs to be delivered or very close to being delivered, where customers and developers can actually evaluate the quality of the code (it is all open source, after all).
These points of evolution are a good thing. They are causing startups to slow down, be more professional and responsible, and deliver real code that has some real utility — not just a well-written white paper and an active Twitter account. Some companies may skip the SAFT step and still go right from a seed round to an ICO (e.g., our portfolio company NEX is in the midst of doing that), but it takes a pretty special team to deliver a large enough number of milestones in that rapid a fashion. Most companies are going to take 2–4 years to be fully prepared to journey from inception to ICO/STO. Considering the median age of an IPO company over the last fifteen years is eleven (our company, MongoDB, just completed it in ten and it seemed breakneck!), this time compression is still an amazing development for the future of innovation.
Many open questions remain and there is much more work for entrepreneurs and investors alike to sort through. One of the trickiest, for example, is incentive compensation. We have had decades of experience with stock option grants to employees, complete with vesting schedules, acceleration provisions and various exercise price processes and mechanisms. What is the right incentive compensation structure for token-based startups? Is there going to be a vesting schedule and, if so, for how long? What are the tax implications? If the token is a registered security, how will the issuance of securities as employee compensation be handled?
It is an exciting time for both entrepreneurs and investors in the post blockchain world. I suspect that the next year will bring similarly rapid and unanticipated developments and evolution!
Great article, thank you for the information! Is it possible or common for an investor to hold both tokens and equity of the same company? That is, instead of converting the seed equity into tokens, can the investor purchase pro-rata share of tokens (at discount) and still own the equity? Is there situations under which owning both is better than converting to tokens?
That is rare but it can happen. Usually the company decides that they will be equity-focused in their valuation creation goals or token-focused but, yes, investors can hedge if it’s unclear which direction things are heading.