On ICO as a funding source for startups

I had an interesting debate with a fellow HEC Paris MBA yesterday who's working at E&Y now, advising corporate clients on blockchain-related subjects.

Obviously he warned me that ICO has become a real way of fundraising (true) and it'll impact my business as a VC (also true). However, just like 3 years ago the proponents for equity crowdfunding, he and other people outside the industry who argue that ICO will replace VC funding miss a serious point: it's all about interest alignment.

There's a very good reason why our industry looks as peculiar as it is, with main players being straight-up VCs and founders. Every now and then there'd be some innovation, but most don't last. For the most part the tried and true model of tight relationships between VCs and founders triumph.

Granted, a few innovations are real and changed the VC industry for good. Explicit expert networks brought by A16Z to its startups are a great example. USV's community-oriented deal sourcing is another good one, one that inspired us to create the Hardware Club. So is YC that pioneered the accelerator investment model. On the other hand, most other seemingly novel ways of funding either lost traction very soon, or were buried in the noise of even newer ways of funding. Even YC looks more like a straight up VC today than a pure accelerator, taking in more and more non-pure-software startups that don't have KPIs that could monitored and accelerated by 6~10% per week. Not to mention that YC started YC Continuity Fund that looks like a straight-up VC fund.

So why is it so difficult to "innovate" the VC model, especially on the funding side?

It's actually very simple and it has something to do with the core of a startup business. Venture startups are all about holding the right people (founders, investors and employees) together via equity ownerships to work toward long-term (5~10 years) success. Anything that's slightly off this core picture risks misalignment of interest and derailing the whole deal.

This is why VCs care so much about who co-investors and previous investors are. This is also why, just like equity crowdfunding several years ago, ICO will probably not be part of the startup success stories very often. It's a horror for a VC to think about being on the same cap table with a bunch of anonymous equity owners who at best won't distract the founders and at worst could lay a shareholder lawsuit against the company after a big round, seeking to leverage a $1k investment into a $1M compensation settled at the court.

How about the argument that a startup can just ignore VCs and keep raising money from ICOs? Well, if the founders don't need an exit a couple of years down the road, I agree that this is ok. But as long as an IPO or acquisition by a large and often public corporate is something planed on the timeline, just the fact of having raised money through ICOs would almost diminish the potential of such exits.

First, no creditable auditing firms will want to sign off on accounts of companies that have done ICOs since it's a mess to trace down equity owners. It's not worth risking the reputation for a not-so-glamorous auditing fees. Even if an auditor is willing to do the labor and sign off the whole thing, SEC might have an opinion as their top job is "to protect the public market investors".

Going with the same logic, expecting Google or Facebook to buy the company would also be a dream. They face even more scrutiny in as they have tons of cash on the balance sheets. It's possible that they will just buy the assets, not the company, thereby avoiding such headaches. But then that also means that it's not a real exit and the shareholders of the startups will have no say on how the proceeds should be distributed.

Above anything, raising money through ICO instead of via VCs really put a question mark, IMHO, on the founders' ability to convince, which to me is the key quality of a good founder. Keep in mind that there's no shortage of capital in the VC industry. A founder that could convince VCs to invest probably has a higher probability to convince talents to join the company, clients to sign contracts and stakeholders to help out.

If a founder simply says "Fuck the VCs. They are morons" and instead does an ICO raising from anonymous (and most of the time innocent and ignorant) individual investors, more likely than not it's that he's not convincing enough. Even if he now has the money to pursue his vision, he might not be able to convince Sheryl Sandberg to join or Google to buy. So it might very likely be a lost cause despite all the money raised through ICO.

The readers should also take notes that I have NOT even talked about the usual concerns about ICOs such as bubbles or frauds. What I described above were all based on well-meaning founders building real businesses seeking capital. And already there are tons of warning signs. 

To summarize it, just like I wouldn't invest in a startup that has relied on equity crowdfunding to raise money, I will mostly likely pass on startups who do ICOs without trying genuinely to raise from VCs. 

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