When a little known cypherpunk project called Bitcoin launched in 2009, few expected that cryptocurrency would become a household name. The blockchain market exploded onto the global scene in 2017, reaching a fever pitch in December and peaking at over $800 billion. Despite the fact that the market has yet to return to these highs, investment continues to flow into blockchain projects, funding a new generation of crypto startups.
Blockchain projects raised over $21.6 billion in 2018, which marked the peak of blockchain investments to date. In the first half of 2019, blockchain projects raised only $2.6 billion, a marked decrease from H2 2018, during which blockchain projects raised about $4.1 billion. This figure was a far cry from the tremendous fundraising performance of H1 2018, during which projects raised $17.5 billion, pushed higher by the massive EOS ($4.2 billion) and Telegram ($1.7 billion) offerings. Of the $2.6 billion raised so far in 2019, over $1.5 billion was raised via initial exchange offerings (IEOs). As the market has recovered from the crypto winter and matured further, the investment strategies and tactics have also naturally evolved. This article will look at the typical fundraising strategies and the nature of venture investments in the blockchain space.
Typical Fundraising Methods for Blockchain Projects
In general, crypto startups use three main methods to raise funds for their project: equity fundraising, token offerings, and a mixed strategy approach.
Equity fundraising for blockchain projects follows a similar dynamic to equity fundraising for tech firms in the traditional market. After agreeing on a valuation and deciding to commit an investment, a venture capital fund or private investor will send funds to a startup project in exchange for a predetermined amount of shares in the company. The investor will then hold these shares until an exit opportunity arises, which can be a subsequent private funding round, typically at a higher valuation, or an initial public offering (IPO), in which the fund can sell their shares to both institutional and retail investors on the open market.
From obscure beginnings, token offerings have emerged to become the most common type of fundraising method in the blockchain space. Mastercoin’s 2013 initial coin offering (ICO) paved the way for a completely new and unique style of fundraising that was fundamentally different from anything the investment world had ever seen. Investors would send funds to crypto startups in exchange for utility tokens, which do not represent any equity in the company or claims on revenue. This fundraising tool enables startups to raise funds without parting with any of their equity, retaining full control of their company. Investors get a speculative asset that can be liquidated much sooner than an equity investment by selling the token on a cryptocurrency exchange. Some early investors in select token projects were able to realize gains of over 100 times their initial investment in as little as one year, compared to an average exit time of about 3-7 years for a traditional VC fund.
Token sales typically come in three varieties: private sale, public sale (ICO), and initial exchange offering (IEO). A private sale is only offered to a select group of private investors, usually VC funds and family offices, which commit funds to a startup in exchange for a token offered at a steep discount compared to a public sale. At this stage companies sign SAFTs (Simple Agreements for Future Tokens) because startups aren’t able to provide tokens at the time of the offering. Public token sales, or ICOs as they are more commonly known, are offered to the wider public with few limitations, but all aspects of the offering are conducted by the project.
Initial Exchange Offerings (IEOs)
IEOs are similar to public sale offerings, but the offering is conducted through a cryptocurrency exchange, which handles aspects like KYC checks on buyers, listing, reporting, and others. Although IEOs are currently the subject of considerable hype, many market participants, including senior executives of the largest cryptocurrency exchanges, admit that IEOs are more of a PR and marketing tool rather than a fundraising option. Many projects do raise money, but they end up spending the majority of it (up to 85%) on market-making. For this reason, IEOs are also subject to strict conditions. For example, only a limited number of investors chosen by random lottery can participate and strict limitations regarding the number of tokens available per investor (usually under $10,000) apply. This tool helps to popularize projects and grow trader communities, but the usefulness of IEOs in terms of raising a significant amount of funds is questionable. IEOs help exchanges attracting new traders, increase trading volume, and drive additional revenue, but we have strong doubts about the real value for startups. Several cases of exchanges pushing IEO projects to decrease their IEO token price lower than a private sale price have been exposed, leading to investor concerns and complaints.
Rarely, a project will offer a strategic investor a mixed offering, either both an equity and a token sale or a convertible equity/token sale. Strategic investors that purchase both equity and tokens have more of an incentive to stick with the startup for a longer period of time because equity investments take longer to mature in value. Convertible equity/token investments are some of the most sought after deals in the industry, allowing a strategic investor to exchange tokens for equity and vice versa at their discretion. This situation allows investment funds to hedge against poor token performance on the one hand and quick liquidation of equity positions on the other.
Security Token Offerings (STOs)
Another fundraising method that has achieved significant hype is the security token offering (STO), which is a token offering tied to equity or other assets. However, this type of fundraising method has not achieved wide traction and so is beyond the scope of this article.
What Investment Funds Look For in Blockchain Startups
Blockchain investment groups have become increasingly similar to traditional venture funds and private equity investors. In both cases, the driving factor behind the investment decision is the search for profit. As a result, the criteria for investment has become similar among blockchain and traditional investors in many ways, but still retains some differences. The top five indicators that blockchain investors analyze when considering a new project are the quality of the team, the product, the market, financials and expense structure, and the community.
The team is the number one factor that blockchain investors look at because the investor needs to be confident that the team can execute their idea and perform the necessary pivots when the situation demands. As any successful startupper knows, a company that has found its product-market fit has often changed their product significantly numerous times. A strong team has the mettle to deal with negative reactions from the market and use that feedback to create a product that enjoys strong demand. As mentioned, every investment is committed with the intention to profit, and only the most talented teams are able to deliver on their initial promise to grow despite a potentially cold initial market reception.
With rare exceptions, the most important factor that any investor will consider for any team hoping to raise funds is a demonstrated track record of success and expertise in the industry that they hope to disrupt. Team members with relevant experience have an intimate understanding of the problems, challenges, and inconveniences of their target market, putting them in a unique position to solve those problems. The founder should be a visionary, often with little relevant experience but with strong skills (for example coding, marketing, sales, or product management). However, at least one or two members of the startup’s senior management should have deep industry knowledge and experience.
In the blockchain sphere, the team should also be diversified in terms of skills, as this enables each member of the team to tackle a different set of problems, while each member also has insights into approaching different markets. The team needs to be open-minded and ready to seriously consider critical feedback, not just from investors, but also from users, clients, partners, and other stakeholders. Last, but certainly not least, each member of the team, especially the CEO, needs to be highly resistant to stress and to the threat of failure. The path of almost every startup is a rollercoaster and each team member should be mentally prepared to stick along for the ride.
When analyzing the product, investors want to see at least some sort of working product, at least a minimum viable product (MVP). Unlike the peak ICO period of late 2017, blockchain investors are no longer willing to invest in a startup at the idea stage. It is a huge bonus to the team when they already have feedback from their first customers. Product development is an ongoing struggle, even for the biggest tech companies in the world, so it is important to gather feedback and improve customer experience as early as possible.
Any startup that hopes to attract investment should be prepared to demonstrate to investors that their target market is large enough to provide space for the company to carve out a niche, preferably a multi-billion dollar market. Products or solutions that do not address an existing market present a much larger risk for investors, which will often result in a steep discount in the initial valuation of the startup, if the investor is even willing to consider participating at all.
Financials and Expense Structure
A startup that has already raised a fundraising round or has spent funds from personal resources should always be prepared to account for their spending to investors. Every investor would like to see a detailed breakdown of how previous funds were spent because it will help them form a picture of how the founders expect to use any new funds. Investors expect funds to be spent in the most effective and targeted manner possible. Of particular importance is the unit economy, which demonstrates to investors how the project expects to generate profit and exactly how much money they need to scale.
Last but not least, every project should strive to build a vibrant and active community around their product. This point is especially vital for any project hoping to conduct any type of token offering, including a private sale. Community members will be the first buyers, holders, and users of a startup’s token and become product evangelists to friends and family. Building a community is the first step to building mass adoption of the product.
Blockchain fundraising continues to become more sophisticated and professionalized, increasingly resembling the world of traditional fundraising. The number of blockchain startups closing fundraising rounds has slowed significantly. However, high-quality projects continue to raise a significant amount of funds and outperform after their tokens have been listed on secondary exchanges. One major new trend that we expect to see in the second half of 2019 and 2020 is second and third funding rounds for the few companies that conducted successful offerings during the peak and have survived into today.
About SMC Capital
SMC Capital is an NYC-based venture capital and advisory firm that specializes in blockchain infrastructure, stablecoins, and payments. Portfolio companies include Kucoin, Helis Network, WePower, Utrust, everiToken, and others. The fund was founded in July 2018 and is headquartered in New York, but maintains a presence in Seattle, Amsterdam, Singapore, and Hong Kong. Our advisory arm leverages our extensive network of investors, exchanges, and partners in Asia, North America, and Europe to deliver a range of advisory services to portfolio projects and external clients, including global events, capital introduction, PR, and exchange listing services. Partners of SMC Capital bring a valuable analytical approach developed from their experience as C-level executives for ICORating, one of the most well-known rating agencies on the market. The SMC team and SMC clients have been mentioned in leading media, including Forbes, WSJ, Business Insider, Cointelegraph, CoinDesk, and others.