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Capital Investment Trends in the Blockchain Space

Venture capital flows ticked up slightly in the first quarter of 2017 after two weak quarters in 2016. High water marks were established in 2015 and early 2016, following a sharp uptrend in both investment dollars and venture capital deals that began in

By Robert Neivert, Venture Partner at 500 Startups

Venture capital flows ticked up slightly in the first quarter of 2017 after two weak quarters in 2016.

High water marks were established in 2015 and early 2016, following a sharp uptrend in both investment dollars and venture capital deals that began in 2014.

In the first quarter of this year, about $27 billion was invested globally, not including seed money, according to KPMG’s Venture Pulse report. This figure was slightly up from just under $24 billion in the final quarter of 2016. Quarterly capital flows had exceeded $30 billion on numerous occasions during the recent peak.

While some overarching indicators suggest that we’re in the late stages of an economic cycle, Q2 figures for global investment continued to show growth, though not at the levels of 2014 through early 2016.

There were some big wins for certain: Airbnb scored an impressive $1 billion in the first quarter. And biotech startup Grail, which focuses on early cancer detection, attracted the second highest figure with $914 million. There has been somewhat of a trend this year into what’s considered to be safer bets. Money fed into larger funds that cover a spectrum of investments over long durations.

A sizeable number of U.S. investors are also seeking returns overseas, with later-stage companies attracting investments in the United Kingdom (in part owing to currency fluctuations), Israel, Spain, Brazil, and in China. Health care and robotics were particularly promising areas for new investment dollars. Pharma and biotech are seeing their share of the investment pool growing as well.

Initial public offerings, or IPOs — one way to raise an infusion of cash — while down in Q1, staged a comeback in Q2. But there’s a new phenomenon to watch: Initial Coin Offerings (ICOs) and Initial Token Offerings (ITOs).

Tokens Simplified

Digital tokens represent a form of currency. They generally fall into two basic types: tokens that offer the holder some ownership, profit sharing or governance rights in a company (security tokens), and tokens that can be redeemed for goods and services (utility tokens). When tokens are offered in a public sale, the sale is referred to as an initial coin offering (ICO), initial token offering (ITO), token sale, or crowdsale.

Security Tokens

Security tokens behave in a similar manner to traditional securities: the token holder has some share in the profits and/or voting power of the company, generally in proportion to the number of tokens they own.

The U.S. Securities and Exchange Commission (SEC), an independent agency of the United States federal government, has issued a warning that it may apply regulations to specific token transactions that reveal an expectation of profit. This is in accordance with the Howey Test, a 1946 Supreme Court ruling that, to this day, helps determine whether certain transactions qualify as “investment contracts” and thus warranting of regulatory oversight.

As interest in tokens grows across the general population, increasing SEC involvement is likely in the coming years. Kevin McSheehan of Minerva Technologies expressed that, “It is only a matter of time before the SEC makes an example out of a poorly conceived ICO.”

Indeed, the government in Canada has already responded. The Canadian Securities Administrators (CSA) recently released a staff notice, providing guidelines on how they will respond to ICOs and ITOs going forward. If a cryptocurrency has the properties of a security, they will be regulated as such if transactions fall within the confines of Canadian jurisdiction. For starters, an investor must receive a prospectus and the business issuing an ICO or ITO must be properly registered. There will also be the typical oversight into secondary trading, as there is for securities. It should be noted that not every token would necessarily be treated as a security, but if they’re deemed an investment tool, the CSA would rule accordingly.

China meantime has taken a harder line, halting the trading of cryptocurrencies altogether. Bloomberg reports that the Chinese central bank ruled that all ICOs are simply illegal. This of course sent jitters into the cryptocurrency exchanges, which some already thought were speculative.

Some companies, including Minerva, are considering offering ICOs to only accredited investors— those that have at least $200,000 in revenue for two consecutive years, or $1 million in net worth. The company has also taken steps to register with the SEC as a 506c private placement.

Utility Tokens

Utility tokens offer a safer alternative to security tokens. Using a non-digital analogy, a customer might purchase utility tokens in a beer garden, simply because he or she fully intends to spend them there. One could theoretically speculate on their value, should the token supply run short, or if the beer runs dry, and so on, but the majority of situations are quite normal: You buy a token, and then you leave the token in exchange for a beer. You can’t use your tokens outside the beer garden and you can’t bring your beer with you. More or less the same would occur in a laundromat, a pinball arcade, or if you purchase a city bus pass.

The use of digital tokens can be quite similar. For a customer, purchasing a utility token in advance is a way of committing to a purchase in advance, a form of both loyalty and up-front support. It raises capital for the company in question, yet the transaction isn’t speculative. The token is simply a credit for a future products or services. In many cases, companies offer discounted pricing to incentivize early purchases in the same way that airlines offer discounts if you purchase a ticket more than 21 days in advance.

One company, BurstIQ, is applying the utility token model to the health care data space. Individuals can use the BurstIQ platform to create a personal LifeGraphTM, which brings together medical records, pharmacy information, health app data, and any other data that the user wants to consolidate into a single view. In addition to being able to share their information with care providers for free, individuals can use BiQs (the company’s utility token) to purchase health-related products or services on the marketplace, and can receive BiQs for providing all or some of their data to service providers (who also use BiQ tokens for transactions on the platform). There’s even token credits for participating in medical research. It’s a novel solution for individuals, who get to own and control their own data, and for businesses that can access data and customers that were previously difficult and expensive to reach.

In BurstIQ’s case, the company’s utility token is the currency used on the platform, so holders of tokens can redeem those tokens for goods and services or to cover transaction costs on the platform. Token holders have no profit-sharing or ownership rights in the company, putting the company in very safe territory from a regulatory perspective.

The company is launching a token sale on September 19th, and is hoping to use the crowdsale to jumpstart consumer adoption of their platform. According to Frank Ricotta, CEO of BurstIQ, “doing a token sale was a natural fit for us. Our platform is already operational and we have institutional customers using it. But in order to launch the consumer-facing version of the platform, we needed to build a community of early adopters. A token sale is a great way to do that: offer discounted tokens in exchange for signing up early.”

That being said, even utility tokens aren’t completely immune from speculation. Just as the beer token can be traded outside the beer garden if demand outstrips supply, utility tokens based on standard digital currencies such as Bitcoin and Ethereum can be traded on secondary exchanges. “We’re certainly aware of that possibility,” says Ricotta. “It’s not what the BiQ token is meant to be used for, but there’s not much we can do to prevent it.”

Recent Trends

Across the industry, ICOs are beating VC dollars in the blockchain space in 2017. At least $1.4 billion has already been raised through ICOs this year, nearly triple the value of VC dollars in the same space, and dramatically higher than in previous years, including 2016. Some of this is surely speculative, but not some not. Data for crowd sales are unknown, but this is another way to raise capital. Note that crowd sales don’t entitle votes, status, nor profit sharing. However they are a means to buy into digital currency.

Venture capital investments in blockchain companies are also increasing, so the gap is not out of a lack of interest in the space. As recently as June, billionaire Mark Cuban, owner of the Dallas Mavericks, referred to bitcoin as a bubble. Of course, there is much speculation, some justified, some not, in the ICO world, especially where the ICO resembles an IPO, requiring governmental oversight. Nevertheless, now he’s predicting that blockchain technology will be used in both finance and healthcare and is considering exchanging some of his investments into cryptocurrency. He is backing a $20 million new fund called 1confirmation, though the amount of the stake is unknown.

Using blockchain technology and a distributed ledger system need not require the use of tokens. Indeed, Sprott Inc. is funding a blockchain solution in the precious metal space, matching buyers with stored physical gold. There are other blockchain settlement services in testing that involve major banks and miners. This trend may expand the pool of buyers if blockchain technology facilitates decimal (fractional) purchases of precious metals in a seamless manner.

It remains to be seen where other emerging technology companies in the blockchain space will continue to attract funds via ICOs and ITOs, as the investment of time and resources is non trivial and the outcome in some major economies remains unknown. And trends in raising capital in no small part will depend upon how the SEC asserts their regulatory authority.

That being said, should companies deploy tokens in their purest, non-speculative form, perhaps the crowdfunding approach can prove to continue on it’s upward trend. After all, such an approach helps consumers lock in reasonable prices while providing capital for companies developing emerging technologies, services, or products. Emerging companies need up-front dollars to secure infrastructure and resources. Token offerings generate liquidity to do just that. Frank Ricotta’s advice for companies considering a token sale? “Make sure you have a really good legal team.”

I’m pro-renewable energy. But I’m against worshiping any technology and blindly glossing over its drawbacks.