By Bloomberg
December 18, 2017

In the salad days of bitcoin, venture capital firms bought into the craze in a roundabout way. Instead of simply purchasing bitcoins, they invested in companies like Coinbase, which makes a wallet for digital currencies, or 21.co, which aimed to improve the process of mining coins. Some of these bets were better than others. 21 has changed names and business plans, but Coinbase’s app hit the No. 1 spot on Apple’s App Store this month as the hyperventilation over bitcoin reached an extreme.

Meanwhile, the value of a bitcoin went from about $110 when Coinbase received its first major round of venture funding to $19,000 as of Sunday. “All the money that’s been put into Coinbase, etcetera, would have returned much better if it was put directly into bitcoin,” said Travis Scher, an investment associate at the Digital Currency Group, a bitcoin-centric investment firm.

This realization complicates the basic concept of venture capital.

A new wave of entrepreneurs, dreamers and hucksters are raising capital through initial coin offerings, where they invent their own currencies, then sell them for cash and trade them on open markets. The service VCs offer to their investors is unfettered access to exciting private companies, whose shares aren’t publicly traded. If ICOs become a durable way for anyone to get a piece of a hot technology—a big “if,” to be sure—where do VCs fit in?

Driven by a combination of enthusiasm and fear, venture firms are developing new tricks to cash in on the cryptocurrency frenzy. Instead of taking an ownership stake in a company, some of the biggest investors in Silicon Valley have begun buying the rights to acquire tokens ahead of an ICO through novel legal agreements. In other cases, they’re adding language to traditional equity deals guaranteeing investors get tokens if the startup ever decides to hold an ICO in the future. “If there’s an exciting new area, and we think a lot of new value will be created, it’s our job to participate in some way,” said Matt Huang, a partner at Sequoia Capital.

The most straightforward way to bet on bitcoin, of course, would be to buy bitcoins. Many tech investors have been doing so with their own money for years. Chamath Palihapitiya, a former Facebook Inc. executive and founder of the venture firm Social Capital, began buying in 2012. He holds the currency in a retirement account and through Social Capital via an investment in a business partner’s company. Palihapitiya said he and his partners held about 5 percent of bitcoins in circulation five years ago and maintain a smaller, though still sizable, stake today.

Other VCs prefer to keep their crypto-investments private. One investor expressed cybersecurity concerns. People with known bitcoin holdings have been subject to hacking attacks and threats of physical theft. Bitcoin is different from most types of financial investments because if someone steals it, it’s gone forever.

To get in on the boom without worrying about managing digital currencies themselves, several high-profile venture firms, including Andreessen Horowitz, Union Square Ventures and Sequoia Capital, have invested in so-called crypto hedge funds, such as Polychain Capital and MetaStable. These firms make money trading bitcoin, as well as other digital currencies like ethereum or litecoin, and dabble in ICOs markets.

VCs are also buying new types of currencies in lieu of investing in the companies creating them. Sequoia Capital, Union Square Ventures and Bain Capital Ventures all said they’ve made deals to acquire digital tokens. To do this, they use a new type of legal contract known as Simple Agreements for Future Tokens, or SAFT. Andreessen Horowitz has done about 10 such deals and is considering dozens more, said a person familiar with the firm’s business, who asked not to be identified because the details are private. The firm has also been adding provisions to standard investment contracts to address ICOs—a practice other firms are adopting as well, according to several investors, who spoke on the condition of anonymity.

Startups have raised more than $3.6 billion in ICOs so far this year, according to the research website Coinschedule. That pales in comparison to the $52.6 billion from VCs worldwide, according to PricewaterhouseCoopers and CB Insights. Experienced investors are skeptical about token sales as fundraising—in part because they can undermine the masochistic tendencies helpful for nurturing a startup. In traditional venture deals, entrepreneurs typically must wait years to turn their paper wealth into cash. An ICO, by contrast, can give them millions immediately. The newly rich aren’t always motivated to work through the weekends.

Huang, of Sequoia Capital, said the token sales the firm is taking part in have developed structures that mirror traditional venture deals. The firm prefers that companies dole out tokens over time, mimicking vesting periods in equity deals for startups. “Just because it’s novel doesn’t mean we have to reinvent everything from scratch,” he said.

Venture investors will need to reckon with a similar temptation. Exchanges for digital tokens operate around the clock, offering immediate payouts. VCs aren’t used to constantly reevaluating a company’s market value to find the perfect moment to sell. “We are long-term investors; we did not invest to buy and flip,” said Scher, the investor from the Digital Currency Group. “But even if you’re long-term bullish on a project, how do you say, ‘I’m just not going to sell,’ when something goes up 6x in 48 hours?”

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