Originally Published By: Jake Ryan
Over the hot lattes from the cafe and the cool air off the ocean at the beach, I sit with a venture partner of a seed-stage investment company. We discuss the current landscape of the early-stage investor. We’re curious about how the initial coin offering (ICO) landscape will play out. No one really knows yet. Will ICOs become the best thing that ever happened to seed-stage investors?
I’m an angel investor. I’ve invested in 10 startups over the past 2 1/2 years. Five of those startups have gone on to raise subsequent rounds of funding and that’s a good thing. That means they’re growing. But, it also means my shares get diluted every time the company raises an additional round of capital. Of course, the overall value of the company should be rising proportionally, so it all makes sense for all investors in each round.
I’ve also had another path carved out for 3 of my angel investments. Three companies have completed or are in the process of completing an initial coin offering or ICO. Each company is raising, or looking to raise, $10 — $25 million through an ICO. I started to think about how the ICO will affect early stage equity investors.
Seed-stage investors investing in growth startups still do it for one reason. They are hoping for an exit either through an initial public offering (IPO) or buyout (a financial or strategic acquirer buys the company). This has always been the angle of all seed investors. One thing to mention is that seed-stage investors investments are illiquid. They can’t sell or access their shares. They are along for the ride until the company has a public exit or sells to an acquirer.
Most seed-stage investments are not going work out. Most investments are going to zero because the companies are startups. If they fail to grow, they die. The strategy of a seed investor, angel investor or venture capital (VC) firm is to have those few winners pay for all the losers in their investment portfolio. With the chance of making 10x to 100x to 1,000x return on their investment (ROI); seed-stage investors are looking to swing for the fences.
How venture capital works down the line, is that growth companies get investments in stages. First they may have a seed round then a series A or venture round followed by a series B or growth round and then a series C. They may even have D and E rounds. Each time a new series raises capital the previous shareholders get diluted. The overall goal is that value is still created higher and higher as the company grows. In the end, even after the dilution of each round, the seed-stage investor should be seeing multiples of their original principal investment in return. It’s a “paper return” until there is a sale (IPO or acquisition).
Initial coin offerings or ICO’s are different. ICO’s create the opportunity for a startup to sell a token which is an asset to potential employees/developers, users and investors. The token that gets generated from the ICO is an asset that sits on the company’s balance sheet. So, it’s different than equity. ICO’s don’t dilute the company’s equity since it isn’t involved in that part of the corporate structure. This means that there could be a good upside for token holders after the ICO if the token appreciates. The real winners are the equity holders prior to the ICO. They get all the benefit of the capital injection from selling the token without any dilution of their equity. These are interesting times and this will be an interesting fact to follow as we see early-stage companies continue to initiate ICO’s.
Think about that. Let that marinate. All the equity investors prior to the ICO get all the advantage of raising capital to further company growth efforts with none of the downside of having their equity diluted from future rounds.
There is still one downside to being a VC/Angel investor. If you’re investing in (private) equity, then your investment is illiquid. This means you can’t sell it. There is no market for it. That’s one of the benefits that cryptocurrency/tokens tout — you can buy or sell your coins on an exchange whenever you want. Those of us with equity must still wait for an exit, either an IPO or a buyout.
So, let’s walk through an example of a seed, venture and growth round in a typical VC investment and then walk through one with an ICO. Let’s say I’m a seed investor in a growth startup, a new blockchain company called ValueA. ValueA just raised a seed round and it’s got a pre-money valuation of $5m. I invested $50k of seed round. For round numbers, I own 1% of the company. Post-capital injection, it’s now $6m. Over twelve months it doubles in growth and, because of the growth rate, more than doubles its valuation. Now, it’s worth $12m in a pre-money valuation of a venture round. They raise $3m, which dilutes my shares by 25%. So, now I own .75% of a $15m company. My initial investment has grown to $112.5k. Now, ValueA the startup, grows again by a factor of 4 in 18 months. It looks to do a growth round at a $75m pre-money valuation. It takes in $25m in its series B round, diluting my shares 33%. Now, I own 0.50% of a $100m company. My investment is now worth $500,000. That’s pretty good right? I’ve got a 10x return on my investment.
Now, let’s walk through the same example that uses an ICO for its venture round. This company we’re about to invest in is a new blockchain company called ValueB. It starts out the same, I invest $50k for 1% of the company (round numbers) and with a post-money valuation of $6m. It takes in $10m in an ICO (after taxes) because it’s in such a hot industry. This can happen before any product is built and any revenue growth is established, which is accurate to the current ICO landscape. Now, after the ICO the company is worth $16m. Following the same example, it goes up by a factor of 8 (doubles, then grows by a factor of 4). Now, it’s worth $128m. I still own 1% of the company. My equity didn’t dilute during the ICO round. My investment is worth $1.28m, which is a 24x return on my investment. The difference is even greater with higher growth examples and higher valuation multiple examples. As a seed investor, I like ValueB’s ICO and what it’s done to my return.
Will it turn out that equity investors are the ultimate winners from the ICO craze? We’ll have to wait three–seven years, most likely, before we see an exit from one of the companies that are just now completing ICO’s. One risk is that the equity holders lie dormant, illiquid with no exit event happening, or a delayed exit since the company can continue to raise money via an ICO.
Only time will tell.
Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Please do your own homework.
Jake Ryan is the founder of Tradecraft Capital, a startup advisor, an angel investor & writer on investing. If you enjoyed this article “clap” to help others find it! For more, join us on Facebook, Twitter.
Jake is the Founder and CIO of Tradecraft Capital and handles all aspects of investment management for the firm.
He is the author of Crypto Asset Investing in the Age of Autonomy.