What Venture Capitalists Look For In A Blockchain Startup

By Jonathan Chester for Forbes

With over $1b invested in bitcoin firms and much more within the general blockchain ecosystem, many entrepreneurs, from experienced to aspiring and anywhere in between are looking at this technology and saying “How can I use this?” Just as importantly, they’re asking “How do I get my blockchain project funded”.  While the fundraising craze for Bitcoin startups of 2014 may have subsided, the hype right now is just as intense in both the enterprise and the venture capitalist world is around blockchain technology.  That being said, I have recently spoken with three blockchain venture capital veterans about blockchain investments.

Having raised $760k for Bitwage, I’ve developed relationships with a number of investors in the venture capital world. I sat down with Alyse Killeen, a venture capitalist with dozens of investments under her belt, including those made as one of the very earliest venture capitalists to invest in blockchain and bitcoin startups, to get her thoughts on investment within the space.

Killeen explains that there is a big difference when assessing Bitcoin and public blockchain companies

Market dynamics are different due to regulation and the way that companies must interact with various third parties they are dependent upon.  For instance, if you launch a social networking app, you can do so fairly autonomously, not beholden to independent parties for critical data, access to key gateways (other than the iOS App Store or Google Play Store, to which access is well defined), or the pace of development of a core underlying technology.  Blockchain companies on the other hand have both development dependencies and barriers as a result of regulation.  The pace of a blockchain company’s growth has to match with the pace of the third parties it’s dependent upon, and others general understanding of Bitcoin and blockchain.

Alyse says Bitcoin and blockchain investments are not just about a team’s ability to execute.  Every company in the industry is constantly balancing it’s relationships with traditional partners who are afraid of the technology due to thebad public perception developed through early media and a small ecosystem of industry players who must rely on each other to create a globally distributed network effect.  As a result, Alyse notes that blockchain-based enterprise technology companies have not typically had relationships with the standard channel partners and the question changes from “Which channel partners are you working with and what is the revenue sharing model?” to “can you access a smart channel partner?”.  What she means is that instead of working through big name branded companies who are afraid to work with Bitcoin blockchain companies because of the initial fears developed from early media, these startups must work with smaller or more targeted channel partners who have a stronger understanding of the value of a public blockchain.  Because these are the channel partners of today, it is much more important to have good relationships with other companies and members of the blockchain ecosystem.

Building relationships with others in the ecosystem is a key aspect of reducing risk for a company because “we as investors know that when these companies give their input, whether to the core developers, peers in the ecosystem, channel partners, or others, they are going to be respected.”  The core developers of a public blockchain are separate from the entities building various types of infrastructure and applications on top of the protocols.  As a result, being able to have your needs and comments as a company respected by these groups and individuals is important for the company’s ability to adapt to and work within a particular blockchain.

Pamir Gelenbe, a Partner of Europe-based Hummingbird ventures and lead investor in Kraken,a top 3 global cryptocurrency exchange, notes:

It’s important to remember we are at the very start of this industry and being too early can be dangerous. I therefore focus on companies that have the potential to scale their revenues (and ultimately profits) in a reasonable amount of time despite the industry’s relative immaturity. In many cases, one invests in a company that already operates in a large market; in the Bitcoin space it is different – it is a fast growing but small market; the key is therefore to identify companies that can scale quickly in spite of the initial small size of the market.

While the immaturity of the blockchain market leads to interesting problems when it comes to new kinds of counterparty risk, Pamir notes that the rate of growth within the market requires a team that can scale quickly when the opportunity arises.  Earlier this year the price of Bitcoin has been hovering around the $400, however, from April 1st to June 16th, the price has jumped from $420 to $730.  Having a team that is able to scale fast and react appropriately to changes like this is just as important as the team’s relationship to the various counterparties involved.

So what is it that a bitcoin or blockchain startup should not be focusing on when pitching a VC?  Pamir notes that “most VCs still don’t understand the transformational nature of cryptocurrency – all the hype right now is focused on blockchain tech.  When pitching to a VC that does not get it, don’t pitch to them in the first place; it is a waste of time and unfortunately no one gets a prize for educating VCs.”

Similarly, Tim Draper, a partner in DFJ and an investor in Bitwage through Draper Associates, notes that the worst thing for a Bitcoin or blockchain pitch is “People who think that they can add blockchain to their pitch and have it be interesting because it is trendy.”

While the buzzword “blockchain” may be enough to get you into the first conversation, it is important to have a good business plan, the ability to understand the unique risks within the industry and a good reason as to why you are using the blockchain.  If you do not have these three things, you are likely better off trying a different kind of company.

Because of the relative immaturity of the markets being developed under these new technologies, Alyse notes that there are two different areas where investment is interesting: “Given the current state of the blockchain ecosystem, I am excited about companies focused on infrastructure, like Blockstreamand Netki, and companies that drive end user growth by addressing a current acute user pain point, like Bitwage. These are the types of companies that match well with the maturity of the surrounding ecosystem.”

From a venture capitalist perspective the types of companies that make sense in the short term are those building out of various protocols that will be needed from mass adoptions at either a consumer or enterprise level, or building out the applications that these users can directly gain benefit today with the current technology available.  Companies that focus on mid-term returns rest on the assumption of broad market penetration of blockchains and/or cryptocurrency, and it’s still too soon to pick likely winners there.

So how might blockchain technology change the way investment happens in the future?  Tim Draper foresees dramatic changes, “A company that only uses Bitcoin can have their entire account on the blockchain.   If all their accounts are in Bitcoin, then the company needs no accountant. All accounting is automatically done on the Blockchain.  I hope the future of investing doesn’t need lawyers or accountants, allows anyone to buy or sell shares without friction, and keeps every contract as a smart contract on the Blockchain so there is no question who owns what in a merger or distribution.”

These dramatic changes aren’t as farfetched as they might sound; The DAO raised $150m during the month of May and Draper’s predictions are basically their playbook. They expected to raise about $5m and their growing pains are the sort of thing Pamir would note as signs they’ve arrived too soon.

So are you looking to raise money or invest in a blockchain startup?  Just remember that this is not your ordinary, everyday pitch.

First appeared at Forbes