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Blockchain investments and the new problem asset for conventional VCs

As of Q1 2016, in excess of $1.1 billion in private capital has been invested in blockchain and Bitcoin startupsby traditional venture capital firms and seed investors. But as decentralized applications and marketplaces continue on the road to maturity, there is a problem. VCs might be asking themselves — are we investing in the correct asset class?

Venture capital firms invest in the equity of private companies — they buy ownership in the corporation, act as advisors and resources for founders, and exercise control as part of the board of directors. They have a well-established legal framework for investments, for forming venture capital funds, and for exercising governance over their portfolio companies. In the hedge fund world, managers buy and manage assets (such as stocks) which their clients could in principle buy and manage themselves; but investors come to venture capital for the benefit of their unique access, relationships, and influence over portfolio companies.

Meanwhile, many startups operating in the blockchain space have simply bypassed traditional VC financing by using a radical new fundraising model: they generate capital by pre-selling their platform’s cryptocurrency prior to the development phase. In essence, each blockchain project with its own cryptocurrency is effectively born with a native business model and financing mechanism — a highly disruptive idea to the VC business. These sales help conserve company equity for founders, have raised over $200M in a single round, and create a base of early stakeholders and promoters for the project.

However, with the advent of blockchain products that run public, cryptocurrency-based networks outside of the direct control of their parent companies, the source of equity investor returns is less clear. The very investment structure is about to shift, and all eyes are on the cryptoassets.

This is especially true of products like OpenBazaar, Augur, Sia, StorJ, Mediachain, and SteemIt. These are examples of blockchain companies where, once the network is in production, it becomes autonomous and self-perpetuating. While the parent company is still the main authority on the technology, the network is no longer obligated to adopt their code updates or follow their lead. Where Amazon is the ultimate centralized arbitrator and rent-collector of its marketplaces, the parent company of a decentralized network becomes a respected curator and advisor to the network with diminishing advantage over any other player willing to assume a similar role.

This of course presents a problem for equity-holding participants: how will the curator company generate revenue? What is the viable business model to be deployed? And: if the company fails but the network succeeds, will I be left behind?

Two investment opportunities in blockchain companies

Some projects, such as OpenBazaar, are the first to admit their diminished influence. “There is no central authority controlling trade, taking a cut, or monitoring data,” wrote OB1, the parent company of the OpenBazaar network, in their funding announcement last year. “As a result, companies such as OB1 cannot act as a central authority on the network. OB1 will aid decentralized commerce by offering services such as dispute resolution, store hosting, and more.”

Union Square Ventures, a participant in the OB1 funding round, readily recognized the dissonance between private equity investments in companies curating a public, decentralized marketplace. “This begs the question,” wrote Brad Burnham of USV, “of how OB1 can be a for profit business that will generate a return on the investment we are announcing today” while acknowledging that “there is no way for a central authority to leverage network effect market power to extract rents from the participants.”

In a similar line of thinking, StorJ Labs, the curator company of the StorJ decentralized storage network, see themselves as providing “Data-as-a-Service, as well as […] tools and APIs for […] the average business and consumer” rather than maintaining and profiting from the network itself.

In other words, most curator companies are brainstorming offering “value-added services” to their decentralized networks for that sweet growth class of mainstream customers who hardly know, or care, about decentralization. Helping customers to “build tools and APIs” sounds an awful lot like technology consulting. And while centralized “hosting” may be necessary to convert blockchain un-savvy mainstream businesses, it is a weak business model to throw at a network whose value proposition is decentralization.

The larger point is that for decentralized applications there are not one, but two, investment opportunities: the speculative value of platform cryptoassets which tend to appreciate with network utilization and general success of the network, and the upside of the parent company business model embodied in private equity investments. As more and more companies in the blockchain space crowdfund autonomous cryptoasset-backed protocols, equity-holding investors are stopping to ask themselves whether they should be adding this new, digital asset class to their portfolios.

Why native cryptoassets matter

In this new dynamic of decentralized services, exposure to platform cryptoassets seems to provide a hedge against a brave new world of business models which have not yet been proven. As equal participants in the network, companies have to overcome a high standard of quality and innovation in order to successfully compete on a level playing field, indeed, with their users.

“The Augur project has ‘made its money’ from the REP token sale,” says Ron Bernstein, founder of InTrade and Augur advisor and investor. “Augur REP value now grows with the throughput of the open source platform. Private returns come from new invention on top of the platform.”

As an example, a private enterprise can build a market making business for prediction markets on Augur. By intelligently providing liquidity to strategic prediction markets, trading for profit, and collecting market creation fees, there is a short-term business a company associated with the platform’s development is particularly well-suited to undertake. In Augur, increased liquidity is exceptionally good for the product as it is highly likely to increase its overall throughput: a low barrier to entry and more markets translates into more users. Yet, the way that risk unfolds for market makers is that once competition starts to heat up — imagine, for instance, a battle for the best market making AI — only players who are Augur REP holders have an offset against sharp competitive drop-offs in opportunities.

On the other hand, in the decentralized storage space companies like Sia or StorJ will have a harder time raising money against “value-added” business models. Storage is a commodity, and especially when the value proposition of the platform is efficiency and lower cost, revenue falls off too. Should Sia and StorJ do some form of “market-making” like adding their own proprietary storage to increase network capacity? Maybe. But without a new economics which contains a Bezosian “virtuous cycle”, such as in the Augur system, more storage does not translate into more users. For the equity investor, the success of these value-adds is now correlated with the size and ability of the company sales team to sell alternative products to small-to-medium businesses, a rather uncharted territory for blockchain.

Looking at new cryptoasset economics based on the “speculative capital” business model invented by SteemIt — the new, growing social publishing platform which compensates its users for quality content and curation — virtuous cycles are central to maintaining the health of the system. “Buying and holding Steem is a way of owning and participating in a new age Reddit and Ebay in a decentralized, fungible way,” says SteemIt’s CEO Ned Scott. “It’s also an opportunity to bolster business operations by increasing a person or company’s influence in the marketplace through added ability to promote their goods and services.”

Mainstream users of SteemIt enjoy incredibly low entry barriers: they can post content and get compensated in cryptoassets right away without the learning curve of buying cryptocurrency, and the value of their holdings is upheld by the market demand for the platform asset. In turn, larger entities like content publishers and advertisers could eventually create demand for the asset by purchasing influence and audience reach, thus validating the long-term position of asset holders. Today, SteemIt’s ability to literally pay acquisition costs directly to customers has translated into impressive growth. “If you extrapolate our current growth metrics,” says Ned Scott, “we could be in the millions of users by the end of the year.” And if so, then the core growth opportunity of the SteemIt platform will be embodied in its cryptoasset, long before any major traditional funding round had a chance to take place.

Finally, in marketplace platforms that facilitate payments in Bitcoin, the lack of a native cryptoasset may be a downside because the private equity business model is the sole investment opportunity. “It’s a team bet,” says Ron Bernstein. “Can these guys build a good enough product such that there’s more incentive to just use and improve it than to compete against it?”

Overall — and this is the point — if decentralized platforms are poised to take off, risk-averse investors stepping into untested waters may be better off taking advantage of the high-growth and high-liquidity characteristics of the platform cryptoassets themselves.

Challenges and paths forward for conventional VCs

As cryptocurrency is increasingly seen as a legitimate asset class and as the economics of particular products make cryptoasset growth opportunities more and more attractive, our team at CoinFund predicts that traditional investors will venture into cryptoasset investments sooner rather than later. Today, from the cultural and regulatory viewpoints, there are still many nuances and challenges.

In the cryptoasset asset class, the line between venture capital and stock investing is terrifically blurred. Investors can engage product teams directly and use cryptoassets as a digital proxy for private equity while taking advantage of high liquidity net all the pesky paperwork. But diversified holdings of this asset class are reminiscent of stock portfolios. The practice of cryptoinvesting requires technical expertise in the securing, trading, and managing positions on 24 hour markets, and it may go against the grain of the VC investment style to assume a vocation similar to that of hedge fund managers. Are conventional VCs comfortable with a shifting role that falls outside of their usual investment model?

From the perspective of the product team, platform cryptoassets serve multiple useful purposes. Not only do they drive the product’s decentralized network, cryptoasset sales conserve company equity. When purchasing cryptoassets, VCs would find themselves less board seats and their typical governance structure. Is a form of passive governance in their investments acceptable to VCs?

Finally, the overall demeanor of regulatory agencies has been decidedly open-minded toward cryptocurrency and “distributed ledgers”, but as Shingai Thornton points out in his excellent survey of U.S. regulatory activityto date, there is still “significant action” to be expected from the SEC, the CFTC, FinCEN, and even the Department of Homeland Security on the topic. Solid legal research has been done on crowdsales and DAOswhich suggest avenues for decentralized crowdfunding compatible with securities laws, but court cases are yet to cement the legitimacy of this type of offering and legal departments will be wary of treading this new territory.

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Forget the “Next Apple.” This Is How to Invest in Technology Stocks.

This article originally was published here:

Picks and shovels. Picks and shovels. Picks and shovels.

If I could drill just two words into the brain of every investor searching for today’s most promising technology stocks, those two words would most certainly be “picks” and “shovels.”

The term, for those who aren’t familiar already, refers to the underlying products and services that enable an industry to operate. It dates back to the California Gold Rush, when thousands of prospectors were hitting nothing but dirt, while the people selling them picks and shovels were quietly making a killing.

In the high-profile world of tech, everyone wants to “strike gold,” so to speak, but not enough people pay mind to the metaphorical picks and shovels driving operations that are much lower in risk and often higher in reward.

That is, most investors think the easiest way to get rich buying tech stocks is to find the next Apple or the next Google, when the truth is far from the case.

Locating the next Microsoft or Facebook isn’t nearly as easy as you might think, even if you are 100% certain the technology they are producing will make it big.

Consider Google, to start. Let’s say you were absolutely certain in the mid-’90s that search engines were going to permeate our lives to the extent they do today. Having that kind of assurance would have given you an incredible advantage as an investor, sure, but would it have been enough on its own?

Probably not…

The pressing reality is that Google wasn’t the only search engine out there at the time, and it certainly wasn’t the first. You also had Yahoo, WebCrawler, AltaVista, LookSmart, Ask Jeeves, Lycos… The list goes on for quite a while.

And like the many abandoned gold mines of the 1850s, most of these companies (and their investors) struck nothing but dirt and are now either irrelevant or completely defunct.

The same scenario applies to the idea of pinning down Apple. Maybe you believed to your very core that the mobile phone was going to be the $ 430 billion industry it’s become today. Would that information alone have you rolling in piles of cash today?

Slim chance.

Blackberry, Nokia, Motorola… each of these OEMs inevitably fell from grace and, at one point or another, managed to crush the hopes and dreams of countless investors despite operating right at the core of an industry destined to thrive.

This is the same kind of trap I see investors falling into every day when placing their bets on the “next big thing” in tech. It’s a pitfall I urge you all not to fall into.

You might be astute enough to know that virtual and augmented reality is soon going to evolve into a $ 150 billion market. And you might be bright enough to understand that automated vehicles are going to completely disrupt the transportation industry…

But if you’re only looking for the next big OEM, you’re simply prospecting for gold while someone is selling you picks and shovels behind the curtain.

The truth is hindsight is always 20/20. No one knew for certain before it happened that the iPhone would be the breakout mobile device. No one knew for sure that Google would knock every other search engine off its perch.

And you can rest assured that today is no different. Despite the many proclamations you may hear, no one knows which carmaker will lead the driverless charge. Will it be Tesla? Waymo? Ford? Uber? Lyft?

I know the ins ands outs of this stuff. I’m on my research grind every day, but I can honestly only wish the best of luck to anyone reading those cards and trying to pick a surefire winner out of the bunch.

The same crapshoot applies to all the augmented reality device makers out there. Facebook has the Oculus Rift, HTC has the Vive, Google has Daydream and Glass, Microsoft has HoloLens… you get the idea.

The key to avoiding this investor’s roulette spin (or at the very least increasing your odds of success) is to invest in the picks and shovels behind the curtain.

In the case of search engines, the picks and shovels were keyboards, mice, and computer monitors. It didn’t matter which search engine succeeded; these were the mainstays that made it all possible.

Logitech (NASDAQ: LOGI), the most prominent maker of these devices, was trading at about $ 1.06 the day Google was founded. Today, it’s $ 37.00 a share. That’s a much larger return than Google’s public stock has ever provided, even if you bought it at the very bottom.

In the case of mobile phones, the picks and shovels were things like chip sets and wireless infrastructure providers.

Take one look at the returns of the iShares PHLX Semiconductor ETF (NASDAQ: SOXX) or any wireless communications REIT like American Tower (NYSE: AMT) or Crown Castle (NYSE: CCI), and you will understand why pick-and-shovel tech stocks were the best bets on the mobile device boom.

Of course, understanding what makes a pick-and-shovel stock requires a bit more work than just knowing that a particular technology is going to be big. You need to dig a little deeper and understand what components are required to make that technology function.

My job, at its core, is to make that information as clear and visible to readers as possible.

So here is some basic advice to anyone and everyone who wants to cash in on the next decade of technological advancement: Identify the trends, and then figure out the gears and chains that make them work.

Personally, my top areas of focus right now are augmented and virtual reality, autonomous systems, artificial intelligence, the Internet of Things, and 5G.

As for the picks and shovels, you can either do the research yourself or find guidance from someone like me. No one can ever tell you everything you need to know, but I can assure you this kind of coverage on tech’s picks and shovels is a good place to start.

Until next time,

  JS Sig

Jason Stutman

follow basic @JasonStutman on Twitter

Jason Stutman is Wealth Daily’s senior technology analyst and editor of investment advisory newsletters Technology and Opportunity and The Cutting Edge. His strategy for building winning portfolios is simple: Buy the disruptor, sell the disrupted.

Covering the broad sector of technology and occasionally dabbling in the political sphere, Jason has written hundreds of articles spanning topics from consumer electronics and development stage biotechnology to political forecasting and social commentary.

Outside the office Jason is a lover of science fiction and the outdoors, and an amateur squash player at best. He writes through the lens of a futurist, free market advocate, and fiscal conservative. Jason currently hails from Baltimore, Maryland, with roots in the great state of New York.

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Forget the “Next Apple.” This Is How to Invest in Technology Stocks. originally appeared in Wealth Daily. Fortune Favors the Bold

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