ICOs are the new hot fundraising model. But should VCs be worried?

The excitement surrounding initial coin offerings is unmistakable, with claims popping up from all corners of the internet that the new fundraising model for blockchain-focused technologies could disrupt or altogether replace the traditional venture capital model.

Some are already declaring that blockchain’s 1996 internet moment has arrived, while others are still asking what on earth an ICO is and what it has to do with venture capital. And through all the positive talk, some in VC are raising caution flags.

“Theoretically it’s very fascinating stuff and I’m definitely bullish on the concept,” said Travis Scher, who runs the venture investments arm of Digital Currency Group, which builds and supports blockchain companies.

“But there’s a lot of greed driving this, and it has all of the hallmarks of classic speculative mania. A lot of people are moving into investing in the space who have no idea what they’re investing in.”

Blockchain startups are increasingly raising investment funds by selling digital tokens through an ICO. Such an offering can raise millions in as little as a few hours.

Some of the new tokens are built on existing blockchain currencies like bitcoin and ethereum, while others issue entirely new digital tokens.

Travis Scher headshot
Travis Scher, investments associate, Digital Currency Group

To the uninitiated the concept may sound bizarre, but it’s catching fire. In 2017 so far, recent and ongoing ICOs, token sales, and crowd sales have raised more than $230 million, according to data from the cryptocurrency research and analysis group Smith + Crown, more than double the $102.5 million raised in all of 2016.

In May alone, the decentralized cloud storage startup Storj raised $29 million through an ICO, according to Smith + Crown; mobile gaming platform MobileGo raised $53 million, and Aragon, a “digital jurisdiction” that enables the “borderless, permissionless creation of value,” raised nearly $25 million in 26 minutes.

And at least one venture capital firm has already held its own ICO, VCJ has reported.

The appeal is evident. The total market capitalization of cryptocurrencies, which includes many newborn tokens issued through ICOs, is currently hovering around $78 billion, compared with less than $9 billion a year earlier, CoinMarketCap.com, which tracks the prices of digital currencies, reports.

But there’s ample reason for caution. Cryptocurrencies are unregulated, and only one SEC official has offered her personal views on the sector thus far, calling for the protection of investors. Many point to rising prices untethered to business advances as evidence that a cryptocurrency bubble is forming.

And investors who spoke with VCJ think it’s unlikely that ICOs will supplant the need for traditional venture funding.

“In terms of disrupting the venture capital industry, that’s not something I feel is likely,” said Christopher Calicott, a managing director at Trammell Venture Partners, which invests in machine intelligence, cybersecurity and blockchain technologies.

He does see ICOs as potentially affecting seed investments from angels, friends and family. They can enable startups to raise vastly larger sums early on. “But I don’t necessarily think it’s a bad thing,” he said.

Having many early investors, instead of just eight to 10 angel investors on a cap sheet, means that a company can profit from a greater emotional and financial buy-in at an early stage, he said. “If you think about it in terms of a social graph, all those voices on a network evangelizing it exponentially and spreading the value of that company early on — strategically, this is huge.”

Christopher Calicott
Christopher Calicott, managing director, Trammell Venture Partners

And although ICOs may financially bolster nascent blockchain startups, they can’t provide the guidance and experience that comes from successful venture capitalists. “There’s always going to be a role for VCs to play here,” Scher said. “Venture capital is a people business, and it provides all types of support for the founders that the crowd could never do.”

Scher points out that many blockchain-based startups inherently lack business models and likely wouldn’t appeal to the traditional VC investor in the first place. “They’re necessarily decentralized and can’t go out and raise traditional venture capital. They live in the wild,” he said. “So to raise capital they have to do some of these token sales.”

Scher says the vast majority of blockchain startup companies don’t meet the criteria he follows when he invests. And he has some reservations about the amount of money that some blockchain startups are raising with ICOs.

“A lot of these companies are raising way more than they need and way more than they really should have. Companies that could not close a $500,000 or $1 million seed round are raising $10 million in ICOs. That’s a problem because that amount of funding is going to potentially lead them to be undisciplined.”

Even with the high risk for failure, Calicott says he’s hearing from LPs who are intrigued by the astronomical rise of the ICO, including a large endowment-scale institutional investor. “It’s a conversation I’m being approached about more and more,” he said.

When the current frenzy dies down, Scher says he see the potential for ICOs to someday transform investing. “It may be a healthy phenomenon over the longer term, like the late ’90s tech bubble where a ton of people poured a ridiculous amount of money into companies that didn’t make sense at the end of the day,” he said. “All the brush got cleared out, and the internet became what it is today.”

Photo of banknotes courtesy of JIRAROJ PRADITCHAROENKUL/iStock/Getty Images

Correction: A previous version of this article mistakenly identified Christopher Calicott. He is managing director at Trammell Venture Partners.