Sunday, March 25, 2018

Governance Needed for Initial Coin Offerings

Traditional board-like governance can provide credibility for companies raising capital via ICOs.

The market for initial coin offerings (ICOs) is booming. The latest example is Telegram’s plans to attract US$1.2 billion in funding. With all the hype, there is surprisingly little said about the importance of ICO governance. The problems of governance are not unique to Telegram; they apply to any company that wants to attract investors’ money.
The wild swings in the value of cryptocurrencies and the lack of official recognition for them suggest that ICOs are riskier that investing in the stock market’s initial public offerings (IPOs). However, both IPOs and ICOs are subject to the same principal-agent problem: The agent (e.g. issuing company) makes decisions on behalf of principals (e.g. investors in tokens). The agent’s interests might not always be aligned with those of the principals. For example, should the founding team increase its compensation or invest funds in ecosystem growth? In an ICO, investors buy virtual tokens, but they cannot be considered company shareholders in a conventional sense. ICOs are not regulated. But token investors contribute their capital to the company’s operations. Hence, investors should be entitled to at least some mechanisms that would align their interests with those of the management team.
One solution for the ICO issuers could be to create a board of directors. Just like in the non-cryptoworld, the board should consist of individuals who ensure that the company works in the interests of token holders. Where should companies find directors? One option could be token-curated registries. To simplify, imagine a platform where potential directors submit their profiles to be considered by the broad community as a “qualified ICO director”. To post their profile, these individuals also put a significant monetary deposit. Individuals deemed by community members to have good potential director qualifications get on the list and get their money back. Those who are not chosen, lose their deposit. Companies that plan ICOs could draw directors from these lists.
Conventional boards can disagree with the CEOs and even replace them. This would be difficult to implement in the cryptoworld (e.g. it is hard to think that any board can replace Telegram’s founder Pavel Durov), but the board should be able to publicly object to the company’s strategy and/or value-creation approach. One can envision an open registry that gathers directors’ votes on the company’s plans. The investors would see an aggregate index of the extent to which directors agree with the founders. Investors could then take notice of variations in this index and react by buying or selling tokens. If the board mostly agrees that the founding team continues to act in the interests of the investors, this could help to boost the token price. Directors could identify themselves with unique IDs and their votes made visible to all.
Follow the money
Normally boards have an audit committee which validates the company’s accounts. Blockchain technology should help facilitate this committee’s work. If one can trace how the money is spent on blockchain across different accounts, then one should also be able to trace how the company spends the money it collects from token sales. I am not sure how much disclosure of the company’s financials is necessary, but those who put their money into the company ought to know whether the value of their tokens is justified. Just like in a conventional annual report, token owners ought to know what their company’s costs and revenues are, where they come from and how they evolve over time. And the board should validate these results by public votes.
Most of the ICOs already have “advisors”, i.e. individuals with some credentials in the cryptoworld (and beyond) whose reputation could suffer if the company goes under. But reputational penalties in case of company failure are unlikely to be enough: The interests of directors should be very strongly aligned with the company’s long-term health. For example, the directors should get all their compensation in the form of tokens with a delayed maturity (e.g. every 12 months). Essentially these compensation tokens could be released via smart contracts, unlocking value for directors upon attainment of previously agreed milestones. If the tokens become worthless within 12 months, newly allocated tokens should be worthless too.
A recent idea by Vitalik Buterin, the creator of Ethereum, is to improve the ICO funding model by incorporating elements of decentralised autonomous organisations (DAOs). After an ICO, investors’ money goes into a smart contract (called DAICOcontrolled by token holders, ideally, the investors themselves. At certain intervals after the ICO, the investors can be asked whether they are willing to release a new pool of funds from the contract to the development team, subject to the achievement of certain milestones. One can imagine a variation of DAICO in which only company directors are authorised to initiate such polls.
Leaders of some companies that now plan their ICOs have a disdain for any form of authority and think of an ICO as a way to quickly crowdfund capital. However, the board should be more than a vehicle to run a company; it should also be a mechanism of oversight. The pioneering leaders who create board-like governance mechanisms prior to launching ICOs will be sending a signal of their quality to the investors that would be difficult for a lower-quality company to replicate. After all, trust is and will always be the most important currency in either physical or digital world. Even for Telegram.
This is a repost from my INSEAD Knowledge article:

Friday, January 12, 2018

When Others Mine Bitcoin, You Can Make Money on Its Ecosystem

What is a similarity between a Bitcoin day trader or an Etherium miner of the 21st century and a Californian gold digger in the 19th century? 

The answer is that they are both looking for gold—digital or physical. Another similarity is that their exploits will benefit the ecosystem of providers of complementary products or services. During the Gold Rush period, Levi Strauss made money selling jeans to the gold diggers. Jeans were a piece of a gold digger's ecosystem at that time. Today, wallets to store coins or computer chips which solve math problems play the same role as the jeans back then.

Making complementary products can be a way to benefit from someone’s risk-taking. The value of complements frequently rises with the value of the products that they are supporting. 

Take the crypto-wallet Ledger Nano S. This is a USB-like device with a cryptographic protection that allows the owner to store digital currencies off-line without the risk of hackers stealing the funds from an online wallet. 

One could have ordered this product in November 2017 in France for the price of 60 euros. By the end of December 2017, the price was 80 euros and then the Ledger Wallet, the company that makes this device, even stopped shipping until March 2018. It simply ran out of stock. now has these wallets on sale for 400 euros, although Amazon now sells them for 199 euros. By the time you read this post, the price can be different.

Clearly, many people bought a lot of digital gold (silver or "dogcoin") during the bit- and alt-coin trading frenzy over the Christmas break. Fearful of the hacker attacks, the owners of the digital currency started to look for a secure way to store them, and the stock of the Ledger Nano S was gone. If the price of crypto-currencies goes up or down, the maker of the wallet will still make money because people will need to store their more (or less) valuable coins somewhere.

Nvidia is another case in point. Its share price is up over 200% since last year. A large part of this growth can be explained by the market for its graphics processing unit chips, which were used by the “miners” to run the operations that generate the digital currencies. In other words, Nvidia benefited from the fact that people were not using its chips to play video games, they were using the chips to mine digital gold. A perfect parallel to Levi Strauss.

Complements help avoid the pain

In general, the best strategy to piggyback on a new ecosystem is to build a complementary product or service. The complements have to address a user pain point. For example, the Ledger Nano S addresses the pain point related to storing cryptocurrencies. Levi Strauss addressed the pain point of gold diggers who couldn’t find pants sturdy enough to withstand the stress of hard physical labour.

How do you know which pain point to address? Become a core product customer and observe your own pain points. As they’re likely to be shared by other users, it can give you ideas for what the market may need. If you discover multiple pain points, these can be addressed during the product iteration process. The more pain points your product or service addresses, the more likely it is to be taken up by customers.

Beware of creating your own pain points, however. The navigation system of the Ledger Nano S only has a basic LCD screen and two buttons, which makes it painful to enter passwords or security phrases. The company recognised that pain point and has now launched Ledger Blue, an iPad-like device with a touch screen. This creates a nice set of a low-cost product (for price-conscious customers who don’t mind the two buttons) and a differentiated product (for those willing to pay more for ease of input). 

Despite the volatility of the crypto-currencies, there is a non-zero probability that some of them are here to stay. What their price will be in 12 months is anybody’s guess. Could be big, coule be close to zero. But what is more or less certain is that there was a lot of money made last year not on buying and selling digital coins, but rather on the making of complementary products to them.