Revisiting first principles in the blockchain space

Blockchain projects have enjoyed access to amounts of funding and levels of public liquidity comparable to some small IPOs. Complacency, misallocation of resources, and failure in managing expectations are some of the reasons why most projects have failed to take off in 2018, despite the industry raising north of US$15 billion in funding.

A massive inflow surge in liquidity and funding for untested blockchain projects – without strict valuation models and metrics – mean that founders and funds alike end up with very little skin in the game, inevitably setting most currencies up for major correction.

Nascent valuation models

As a new asset class, crypto assets have yet to develop a clear set of expectations and guidelines around valuation models. There is significant information asymmetry between investors and developers, making it difficult to place valuations on crypto assets both in the form of actual development (unsystematic factors) and market hype cycles (systemic factors).

A popular model out there has been the velocity model where MV = PQ, which simply means that the flow money expenditure is equivalent to the total value of purchased tokens.

The velocity model is relevant because tokens that are not store-of-value assets (i.e. utility tokens) will likely suffer from high velocity. Users will only hold these tokens when they require the particular service such as decentralized file storage (Sia and Storj) or computing (Golem).

However, this model may be less relevant for valuating research-oriented projects such as Oasis Labs or Thunder Token, which have been predominantly focused on building for technological breakthroughs.

The network value approach, which values a project based on their market capitalization (i.e. total token supply), has also been frequently used by investors.

At the end of the day, questions surrounding valuations centers on where the value will ultimately accrue. The industry is so early that arguably, no single model can be used to value crypto assets.

Dangers of benchmarking

In absence of defined valuation models, many projects in the space have turned to benchmarking their projects against other projects operating in a similar vertical.

According to ICO Rating, the top Q1 ICO projects raised a mean of US$50 million, as did top Q2 ICO projects. However, the top Q3 ICO projects only raised a mean of US$33 million, a reduction in valuations synonymous with the movement of the markets towards the end of June.

Benchmarking is particularly dangerous for the industry since everyone ends up doing the same to stay in line with the competition. Teams should be raising amounts of money for the amount they need to avoid inefficient allocation of operations and resources. Teams that have raised too much money can often afford to be idle and not have any urgency to build anything, because they can rest on the assurance that there is sufficient cash in the bank.

Typically, a venture seed round might be conducted at, say, a US$3 million pre-money valuation, with a minimal viable product and maybe a couple of hundred users. So why is that blockchain companies are able to raise at valuations of well over US$50 million off the back of a whitepaper?

Perhaps, it’s time we really start digging into what these companies are building and the progress they have made – back to first principles of valuating companies.

Impact on blockchain companies

Traditional venture capitalists invest through “staged capital infusions,” which means that funding occurs in a series of rounds rather than through a single check. This is what we know as seed, series A, series B, and so on.

It is also the most potent control mechanism an investor can employ to keep companies accountable, as the prospects for future funding rounds are periodically evaluated on progress. Companies that fail to execute are unable to raise the next round of funding, so only companies that are hitting milestones and solving real problems survive.

2019 and beyond