The path to liquidity for tech companies used to follow a very simple model. Raise money privately, build up sales and earnings, then go public with a splashy IPO. This worked well until the big Y2K tech bubble, during which many companies went public at huge valuations but with no earnings and not much revenue. By going public, these companies offered liquidity for investors, and profits for venture capitalists, but that liquidity gave investors the opportunity to bail when the bubble burst. This ended in a lot of sad entrepreneurs left holding founders shares of a now public, micro-cap company with limited prospects.
The result of this was a change in the way companies raised money from investors. Instead of going public, where management is (heaven forbid!) held accountable and expected to produce revenues and earnings, many companies have opted to stay private. By doing so, venture capitalists, aka the self-proclaimed smartest people on earth, could invest large sums of money at ever increasing valuations. A great new model for the VCs, managements could focus on building for the future, no matter how far off it is, while investors got rich…on paper at least.
The problem with the ever-increasing private company model is that darn liquidity issue. When valuations keep going up, eventually someone will want to take their money off the table. Especially when the bloom is off the rose and things start to look a little dicey. For example, do you think any Theranos investors would have like to have sold their shares at a $4.5B when they realized the product didn’t actually work? Or, how about trimming some Uber at $70B when the CEO and board turn their treatment of women into a public fiasco for the company?
It is becoming increasingly clear that staying private and raising more money is causing a conflict between management’s love of the independence of being private, and investors’ demands for more control and liquidity. But, the idea of going back to the public markets for liquidity and less intrusive investors doesn’t seem to be a good solution. This is because the private market valuations that each successive round of financing have bestowed on these unicorns has caused private valuations to greatly exceed public ones. Between lower valuations, difficulty raising a lot of money, and scrutiny over their activities, these companies have limited desire to go public. What is a future tech billionaire to do?
Initial Coin Offerings (ICOs) Have Arrived
The answer is simple and comes in the form of a new type of financing: the Initial Coin Offering (ICO). ICOs are a great solution for managers of hot startups. In an ICO they get to raise money while selling ZERO equity. Seems like a no-brainer, huh? Companies seem to think so and Coin Offerings are gaining significant traction.
The last few weeks have seen some very large ICOs, with Tezos and block.one raising almost $400M. Not bad for two companies with zero revenues and only the hope of a future product. At $200M each, these deals match Blue Apron’s IPO in size, but were certainly more well received. The underwriters had to price APRN at $10, below the indicated range, and it still went straight down to its recent close of $7.33.
Obviously, if investors are willing to give $200M to a company with zero revenues, and reluctant to take equity in a more seasoned one like Blue Apron with $800M in revenues, Coin Offerings are well received (a recent WSJ article details this well). But, what exactly are they? And, should they be this popular?
Bitcoin and Etherium Pave the Way
Before we discuss ICOs, we need to discuss Bitcoin and Block Chain technology. Most everyone knows about Bitcoin, the first and most well-known digital currency. Bitcoin has had ever increasing popularity among investors, traders and the younger generation that is willing to trust some of there hard earned savings in an electronic wallet. This popularity has resulted (as predicted) in an ever increasing price for each Bitcoin. Here’s the 1 year chart…not bad performance, huh?
Bitcoins are making people rich. Blockchain is the technology that underlies Bitcoin. It basically creates an open ledger for all to see of every transaction that occurs in Bitcoins on a network of public computers. It is truly a revolutionary technology and it has many applications beyond Bitcoin; the most obvious being that it can back any digital currency that you can create.
Bitcoin was the best performing “asset class” in 2016 and it has just continued. However, despite this amazing price action, it is not even the best performing digital currency this year. Etherium has gone up from $8 at year end 2016 to $241 today, an increase of 30X on your money…
With returns like that from Bitcoin and Etherium, and with a technology that can back endless digital currencies, it only makes sense that there would be more coming. And that is how we get arrive at the Initial Coin Offering.
How to Invest $200M and Get Zero Equity
An initial coin offering is just what it sounds like; a new digital currency is created and you can purchase it at a price that is determined by the creator. The new coins are priced in other digital currencies and tradable between them. For instance, I could create a Tailwinds Buck and make the initial price equal to one Bitcoin. Then, after it starts trading, it would find its own valuation based on supply and demand.
ICOs are more than just a new currency, however. To sell them, there would have to be more to it. Since Bitcoin and Etherium are well known and heavily traded, they are a good currency for someone to buy if speculating. Why would someone buy a Tailwinds Buck instead of the others?
In order to raise real money with a new coin, companies are issuing them as a proxy for future products. It works like this; a company is working on a future product. They issue coins that are the only means of purchasing the future product. If they come to market with a hit offering, people will be paying up to buy the coins necessary to purchase their product and the speculators who purchased their coins on the Initial Coin Offering would likely receive many multiples return on their money.
Thus an ICO is a digital currency that has one specific purpose; it can be used to purchase a future product that has probably only been developed to the point of a well thought out concept in several entrepreneur’s minds. You have no equity in the business. It’s a real no-brainer for an entrepreneur…raise $200M and give away no equity. It’s genius and my next company will fund in this manner, for sure.
How Will This All End???
The smartest investor I know, Kevin Muir (the MacroTourist), wrote a great piece (My Great Bitcoin Bungle) about why he missed the Bitcoin move, despite being one of the early adopters of mining for coins. While it is commonly accepted that Blockchain technology will indeed change the world, it’s very tough to simply buy a digital currency based on supply and demand hopes. Look at real currencies; central banks have unlimited supply available.
Yet, the digital currencies continue to go up in price. And more are coming. Having seen quite a few in my day, I will suggest this is a bubble. And, the ICO is simply another way to get money out of a bubble while it continues to expand.
At Tailwinds, it is our belief that digital currencies are the future. However, I don’t pretend to know which ones will be left standing at the end of the day. I do know we don’t need thousand of them.
I also don’t believe any government is going to be happy to see investors buying hundred of millions of dollars of Initial Coin Offerings. This screams potential fraud and definite future SEC involvement, as suggested here.
For now, however, the bubble is growing. ICOs are coming quicker and bigger. Buyer beware.