This week I attended a Bitcoin meet-up in Hong Kong where a serial Bitcoin / Blockchain angel investor gave a talk. His investment framework consisted of investing in companies that had low margins but could scale easily.
One audience member asked what he would do in a situation where margins went to zero or even negative. Many blockchain application businesses fall into this category. Part of his response was that due to quantitative easing (aka money printing) money was free, so investing in businesses with zero or negative gross margins can be done. If rates are more negative than the cash flow burn of the company, in our bizarro world that actually is outperforming.
I then followed up with a question on how his thesis would be impacted if interest rates rose. He responded that in the near future that wouldn’t happen, and even if it did policy makers would realise their errors and quickly revert back to printing gobs of money.
Whenever someone completely dismisses the possibility that a central tenet of their investment thesis cannot be invalidated, alarm bells ring. During the 2003 to 2007 US subprime housing bubble, the common refrain was that housing prices NEVER went down. By 2008, that central tenet of faith was proven grossly erroneous.
Central banks over the past 25 years have conditioned investors to expect lower interest rates every time there is a financial hiccup. In 1990 the US 10-Year Treasury Bond yielded 7.94%, today it yields 1.75%. The effect of falling interest rates has pushed investors further out on the risk curve to generate stable income.
Bitcoin / Blockchain startups primarily fund themselves by selling equity to investors, by issuing tokens through Initial Coin Offerings (ICO), or through retained earnings (assuming the company is profitable). Most startups in the early stages sell equity.
A Thought Experiment
Assume you are an angel investor and you share the worldview of the speaker I spoke about earlier. Essentially you invest in scalable Bitcoin / Blockchain businesses with the hope that a greater fool will emerge, allowing you to exit your investment. Remember it’s the 4th Industrial Revolution; you don’t want to miss out. You have a pool of capital that you will spread amongst various startups. Here are some assumptions about your investing strategy:
Initial post-money valuation: $5 million
Years to exit: 7
Your portfolio’s performance is benchmarked against owning high-yield US corporate bonds. While many think that money is “free”, it definitely is not unless you are an AAA-rated developed market corporation. Everyone else must pay to play.
I chose the BofA Merrill Lynch US High Yield Effective Yield as a proxy for what an investor can earn buying riskier corporate bonds. Investing in startups is infinitely riskier than buying high-yield corporate bonds, as these companies produce actual cash flow.
The Federal Reserve Bank of St. Louis publishes the historical effective annualised yield. The below table lists current and historical annualised yields for the index.
| Annualised Yield | 7-Year Compounded Return | |
| Current | 6.14% | 51.76% |
| Minimum | 5.16% | 42.22% |
| Maximum | 23.26% | 332.27% |
| Average | 9.28% | 86.12% |
The majority of the startups that you invest in will die within 7 years, and you will lose 100% of the money invested. A small percent will exit at a valuation that is multiples higher. Your performance depends on your ability to pick winners.
Break-even Success Rate = (1 + Opportunity Cost) / (1 + Exit Return)
Break-even Success Rate: The success rate at which you are indifferent to investing in startups vs. buying high-yield US corporate bonds
Success Rate: Defined as the % of startups in your portfolio that complete a successful exit
Opportunity Cost: The 7-year compounded return of the high-yield index
Exit Return: The return generated after the startup has completed an exit
Exit Return = (Initial Valuation / Final Valuation) – 1
The below table lists the Break-even Success Rate under different scenarios
| Current | Minimum | Maximum | Average | |
| Avg Exit Valuation vs. High-Yield Returns | 6.14% | 5.16% | 23.26% | 9.28% |
| $50mm | 15% | 14% | 43% | 19% |
| $100mm | 8% | 7% | 22% | 9% |
| $250mm | 3% | 3% | 9% | 4% |
| $500mm | 2% | 1% | 4% | 2% |
| $1bn | 1% | 1% | 2% | 1% |
It is hard to pin down the global average exit valuation for startups. From various articles I have read, startups on average exit with valuations between $50mm to $100mm. If we assume bond yields normalise near 10% per annum, 9% to 19% of your startup portfolio must successfully exit. Even in the current “low” interest rate rate environment, you still must be a very skilled investor to break-even (8% to 15% success rate).
Achieving a $50mm+ exit valuation is no easy task. Most likely after your angel / seed investment, the company will subsequently attempt to raise a Series A and then B to grow into a juicy acquisition target. Most likely after each round, your equity stake will be diluted.
The below table reproduces the Break-even Success Rate assuming each successful startup does two subsequent financing rounds and existing investors are diluted 20% in each round.
| Current | Minimum | Maximum | Average | |
| Avg Exit Valuation vs. High-Yield Returns | 6.14% | 5.16% | 23.26% | 9.28% |
| $50mm | 24% | 22% | 68% | 29% |
| $100mm | 12% | 11% | 34% | 15% |
| $250mm | 5% | 4% | 14% | 6% |
| $500mm | 2% | 2% | 7% | 3% |
| $1bn | 1% | 1% | 3% | 1% |
Instead of achieving a 9% to 19% success rate, you now must achieve a 15% to 29% success rate if interest rates normalise. Remember, you are only breaking-even. For all the hard work of identifying promising startups and mentoring them, you have not generated outsized returns. Wouldn’t it be much easier to log onto Interactive Brokers and buy a high-yield bond ETF?
Because you invest in companies with low to zero gross margins, your only hope is to pass the hot potato onto investors who are more risk seeking than yourself. You have no expectation of dividend income. As interest rates rise, the universe of assets that yield high returns with less risk grows. The pool of fools will decline, and your portfolio will struggle to break-even vs. investing in a basket of high-yield corporate bonds.
There are many Bitcoin / Blockchain businesses and business models that generate real revenue, and are defensible. One only has to look at Bitfinex to see how profitable a “properly” run Bitcoin exchange can be. For the full year 2015, Bitfinex generated US$7.03 million of Net Income on US$9.35 million of revenue.
Do The Twist
The BOJ was the first central bank to explicitly target a steeper yield curve. In a recent speech, Federal Reserve Governor Eric Rosengren stated that the Fed should engineer a steeper yield curve. Many financial analysts are calling this new form of yield curve targeting a “Reverse Operation Twist”. The original “Operation Twist” involved the Fed buying long-dated bonds and sellings short-dated ones in order to lower long-term interest rates.
Banks need a steep yield curve to make money. After printing money to stave off insolvency of commercial banks, central banks must now steepen the yield curve so that their stakeholders can return to profitability. The effects of a steeper yield curve are already working. JP Morgan, Bank of America Merrill Lynch, and Goldman Sachs have all reported impressive 3Q16 earnings.
As yields on the long-end rise, it will be easier to find positive yielding investments that are not as risky as punting startups that have no plan to ever generate a profit.