The First ‘Bitcoin 2.0’ Crowd Sale Was A Wildly Successful $7 Million Disaster

In April, a start-up in Scotland raised $7 million dollars in just 5 hours via a crypto-coin crowdsale managed by another Bitcoin-based start-up loosely based in Seattle. It was hailed as remarkable: a way for a company to raise funds without going through traditional institutions. The Wall Street Journal called it “manic,” highlighting a “hot bitcoin 2.0” even if the sale was “unorthodox” and had “wrinkles.” In fact, the wrinkles were Shar-Pei level (but far less cute). The start-up wound up with less than half that amount in usable money because the majority of its take was in an illiquid alternative crypto-coin, Mastercoin, with a trading market so anemic it can’t be cashed out. The value of that coin spiked before the sale and crashed afterwards leading to allegations of a pump-and-dump, and causing the start-up to revise its definition of the crowdsale as raising $5.5 million. Two weeks after the sale closed, the SEC published an investor alert warning people in the cryptocoin community to beware of “fraudsters and promoters of high-risk investment schemes,” saying investments that involve Bitcoin have a “heightened risk of fraud.” The appeal of Bitcoin and crypto-based investment schemes is that they slough off regulators and third party intermediaries to make financial markets operate more easily and efficiently. But there are downsides that come from going walking with big bags of crypto-value in a lawless area.

The company that raised the millions is called MaidSafe; it is a promising Internet start-up out of Scotland, headed by an earnest engineer named David Irvine who has been working on the decentralized storage system for eight years. He had funded it with $5 million in investments from family and friends, and by leasing out his skipper services: flying to France for example to pick up a wealthy person’s new yacht and delivering it to a dock in the UK. He was never sure exactly how he was going to monetize his service which would allow users to rent out storage space on their hard drives for other users to store encrypted files, like a digital Airbnb or a crowdsourced Dropbox. In January, David Johnston of BitAngels, a group of investors who put money into Bitcoin-related projects, flew to Scotland to meet with Irvine and his employees. “They were still thinking about a 1% user fee,” says Johnston, who is tall with a buzzed head and lives in Austin, Texas. “I told them they should think about a digital token. We introduced them to the core devs at the Mastercoin Foundation.”

Mastercoin is the brainchild of J.R. Willett, a developer in Seattle. He raised 4,000 BTC (worth a half-million dollars at the time) in his own fundraiser last summer based on a white paper he wrote about developing a protocol built on top of Bitcoin, that would use the Bitcoin blockchain to store digital contracts. You could use it for example to store car titles, extending the principles of Bitcoin — one person owns a certain value and is the only one who can unlock and transfer it — to lots of other kinds of property. Those who invested got the company’s own currency, also called Mastercoin, in return. “We’re a protocol layer on top of Bitcoin adding extra features,” says Willett, “We use Bitcoin like email uses the underlying layer of TCP/IP.” Willett wanted to quit his job, but with a wife and small kids, throwing his lot into Mastercoin full-time was not an option, so he hired employees and created a board of directors, including David Johnston of Bit Angels, who had invested in Mastercoin and was very excited about ‘crypto-ownership’ projects. “I helped [J.R. Willett] think through how to structure the organization,” says Johnston. Johnston implies that most of the Bitcoin that Willett got was from his group of Bit Angel investors.

Mastercoin has been very open about how it’s spent its Bitcoin funds with a public spreadsheet of its expenditures. It offers “bounties” to develop a Mastercoin ecosystem in order to make the coin valuable, paying a group out of France, for example, to set up MasterXchange to allow people to trade Bitcoin for Mastercoin. Despite that Mastercoin is notorious as being illiquid among cryptocoin traders. Yes, there are cryptocoin traders. Bitcoin is open source and easily copied, leading to the release of hundreds of imitators from Dogecoin to Sexcoin. Some coins actually have innovative features that set them apart from Bitcoin, such as Darkcoin and Zerocoin, which have enhanced anonymity features, but others are, essentially, jokes that have taken on actual trading value. Some cryptocoin investors make bets on a particular coin to succeed while others have discovered they can arbitrage with altcoins, doing quick trades that take advantage of price differences in the exchange rate. So for example, if you trade Bitcoin for Dogecoin, then convert Dogecoin to Litecoin, and then convert Litecoin to Bitcoin again, you can come out with more Bitcoin if the market’s imperfect. (An altcoin contraction may be coming though; another early cryptocoin Ripple has been wobbling after a co-founder announced plans to dump his holdings, a sizeable amount, with no explanation why.) Mastercoin’s market cap has been as high as $50 million, making it one of the most valuable altcoins, but its cap is less important than its trading volume when it comes to actually realizing that value. And its trading volume has been one of the lowest of the altcoins. It’s hard to sell it. “With $23,000, the price of a Honda Civic, you could crash the Mastercoin market to $0,” says Dan Held, founder of Bitcoin market information app ZeroBlock, and director of product for Blockchain, a Bitcoin wallet service. “Owners of Mastercoin are stuck holding an absolutely illiquid currency.”

Mastercoin’s primary business model now is to issue business-specific cryptocoins to allow any entity to create its own cryptocurrency for its platform. Upon Johnston’s advice, Irvine decided this was the answer to funding MaidSafe. He planned to use Mastercoin to issue 400 million Safecoin to sell for $8 million. Like Bitcoin itself, Safecoin would be both a store of value and a payment mechanism. Safecoin is the virtual currency for MaidSafe’s crowdsourced Dropbox service, the currency people will use to pay for storage space and be paid. It was implied that Safecoin would increase in value if the company’s services took off, though everyone involved avoided calling it “stock” in the company. MaidSafe like Mastercoin registered its foundation — which was accepting the cryptofunds — as a nonprofit. Other start-ups approached by David Johnston to do start-ups on the Mastercoin protocol say he encourages the non-profit model as a better way of doing business. “We took advice from the US lawyers via BitAngels and also local lawyers in Scotland,” says Irvine by email.

Kathleen Moriarty, a partner at Katten Muchin, who is assisting the Winklevoss brothers in their application to the SEC to create a Bitcoin exchange traded fund looked over articles associated with MaidSafe and Mastercoin and wasn’t able to deliver a concrete opinion on how securities laws do or don’t apply. “When I see a discussion about an alt coin ‘securities exchange’, I usually can’t tell exactly what the structure is and whether securities laws might be implicated,” she said by email. “I think until things begin to shake out, leaving but a few competitors, that the landscape will be very murky and hard to keep up with.” A spokesperson from the S.E.C. “decline[d] to comment beyond what we said in this recent investor alert.” On Tuesday, the SEC announced that it charged Erik Voorhees, an early Bitcoin entrepreneur, for selling shares of Bitcoin gambling site Satoshidice and FeedZeBirds for Bitcoin without registering the offerings with the SEC. He paid a $50,000 penalty.

“All issuers selling securities to the public must comply with the registration provisions of the securities laws, including issuers who seek to raise funds using Bitcoin,” said Andrew J. Ceresney, the SEC’s enforcement director in a press release.  “We will continue to focus on enforcing our rules and regulations as they apply to digital currencies.”

The Mastercoin and MaidSafe crew don’t see the sale of a limited supply of digital tokens that will function as a currency on their platforms as a “security.” “We try to be really conscious of the language we use. There’s no promise of dividend or equity. You’re just buying a password to access this software and you should do that if you think that software is valuable,” said David Johnston by phone last month. “There’s been no calls from the SEC yet.”

The crowdsale was complicated, but provided incentives for investing early and investing with Mastercoin instead of Bitcoin. If you invested one Bitcoin worth $450, you got 17,000 Safecoin, but if you invested one Bitcoin into Mastercoin at its then value, you could get 34,000 Safecoin. Irvine and the MaidSafe team were happy to do this to help support Mastercoin, but they were told that those Mastercoin investments would be stopped at 25% of the total sale and that the rest of the Safecoin would be bought with Bitcoin. But the way the Mastercoin protocol worked at the time, all Safecoin had to be bought with Mastercoin, so Irvine’s team had to have Mastercoin in order to purchase of their own Safecoin on behalf of their investors. Bit Angels made a temporary loan of Mastercoin to allow MaidSafe to do that, which MaidSafe paid back with Mastercoin that they received from investors. I forgive you if you find that all confusing; so did most of the investment experts I spoke with.

But people who trade in altcoins understood what was going on. The MaidSafe sale valued Mastercoin at twice its worth which predictably sent Mastercoin’s worth soaring, and actually created some trading volume in an otherwise quiet market. It was the most trading volume Mastercoin had seen since it was first introduced. Thanks to the surge around the MaidSafe sale, some Mastercoin holders were able to cash out their coins. In a retrospective about the sale,  Jacob Farber of Perkins Coie who advises Bit Angels wrote, “It seems pretty clear that there was no intentional market manipulation. The question is whether there was an ‘appearance of market manipulation’, or an ‘unintended market manipulation’.”

Valuing Mastercoin as it was valued definitely brought trading hawks out. At least one person interested in the MaidSafe project tried to sound an alarm bell on a company forum before the sale. John Kypri, who is based in Thailand, warned that it was a huge business mistake, given Mastercoin the currency’s lack of liquidity and Mastercoin the company’s struggles as competitors like Ethereum enter the space. His criticisms were dismissed; MaidSafe employees said the majority of the sale would be for Bitcoin and David Johnston chimed in to defend Mastercoin and assured Kypri that trading volume would be increasing.

Irvine thought it would take 30 days to sell all the Safecoin, but when the crowdsale kicked off on the morning of April 22, Scotland time, the Safecoin flew off the digital shelf. And it was going terribly wrong. There was a flood of orders placed in Mastercoin, and they did not stop at the promised 25% mark. They had to abruptly end the sale within 5 hours. When people woke up in other time zones, they saw that the sale was already over, and they were stuck holding Mastercoin they’d hoped to turn into Safecoin. Irvine’s company meanwhile was stuck holding millions of dollars of Mastercoin, a completely illiquid, worthless currency instead of the $6 million in Bitcoin they’d hoped for. Irvine was very upset and asked Johnston and Mastercoin how they were going to fix it. Johnston says his Bit Angels group had traded a bunch of Mastercoin for Safecoin. He convinced some of those investors — who he declined to name — to sell Safecoin they’d bought back to MaidSafe to sell to Bitcoin investors. “We didn’t make any money,” claims Johnston. But the sale did allow a bunch of people holding Mastercoin to exit their positions.

I reached out to other investors that Bit Angels touts in press releases as being part of the group, such as Roger Ver, an early Bitcoin investor; Vinny Lingham, founder of Gyft; and Jered Kenna of Tradehill. All indicated little to no involvement. Lingham and Kenna both expressed dismay that their names were included on press releases. They thought of it as an email list, and were dismayed that the group takes credit for investments they made on their own, prior to the group’s formation in 2013 at the San Jose Bitcoin conference. BitAngels has publicly retracted taking credit for investing in Dan Held’s Zeroblock. “”I highly doubt BitAngels made anywhere close to $7M worth of investments. David Johnston knowingly told individuals that BitAngels funded ZeroBlock, which was a completely false statement,” says Held. “He later claimed this was done in error, however there was no room for miscommunication as ZeroBlock never sought to raise external capital.”

When asked to name active investors in Bit Angels, Johnston said the fund made $7 million worth of investments in Bitcoin start-ups last year, and said 21 investors were active “who replied in a survey to confirm their participation” and that another 29 investors had been involved in the “popular” Mastercoin crowdsale — the group’s largest investment by far. Johnston is a serial entrepreneur; he says he has built 6 companies, including an online publishing company when he was 16, an online bank inside SecondLife when he was 18, and a “biodiesel investment firm that did algae research for Conoco Phillips.” He got into Bitcoin a couple of years back. “I’ve been dealing with investors for 12 years,” he says. “I only want people to invest what they’re comfortable investing, and I want people with knowledge to really understand what they’re investing in. Crowd sales are a natural filter because those who get involved already understand Bitcoin or Mastercoin and smart property contracts.”

When I spoke to Irvine via Skype a few days after the April 22 crowd sale, he looked exhausted. He said he hadn’t slept in a few nights. In addition to the Mastercoin sale allotment going wrong, a troll popped up claiming that Bitcoin stolen from Mt. Gox had gone into the crowdsale, though it turned out that it was just an incorrect tagging of an account on the blockchain — notations anyone can enter. MaidSafe wound up with $3 million in Bitcoin thanks to the Safecoin loan from BitAngels. That’s funding for three years at the start-up’s current monthly price tag of $100,000 for operations. MaidSafe is now one of the largest holders of a rapidly depreciating Mastercoin, sitting on around $2.5 million of it, the majority of which came from just 10 Mastercoin holders. There were 2,000 people total who appeared to participate in the crowdsale, 1,900 of them buying Safecoin with Bitcoin, which is actually valuable and liquid.

Irvine has no idea who most of the 2,000 people are who sent cryptocoin to his company. “They are just addresses on the blockchain to us,” he says by email. He doesn’t know their motives: whether they invested in Safecoin because they believe in Maidsafe’s promise, or because they were desperate to get out of Mastercoin, or because they hope to turn a buck in the complex backwater of cryptostock trading.

“We thought we’d have $7 million but we just have $3 million. That’s tough, but we’re coping,” he said by Skype. “This whole way of funding is new. It was like test driving a car, and we crashed into a few walls.” Irvine wrote a long candid review of the process in a blog post on “surviving a crowdsale.” To my great surprise, he says that if he were to do it again, he would still use Mastercoin.

Many knowledgeable observers called the whole thing a success. Irvine’s team wound up with three million in BTC after all. Ryan Galt, an investor who blogs as Two-Bit Idiot, noted the “pump-and-dump” that happened but said the number one takeaway was to make sure to get in early when a “hot new coin-related startup announces a crowdsale.” “You better be ready to buy the second it goes live,” he wrote.

Economist Daniel Krawisz has a very different take on the appcoin/altcoin phenomenon. In a post last month, he argued that appcoins are fraudulent, because, to overly simplify, it’s always going to be more painless to use Bitcoin, rather than elaborate schemes built on top of Bitcoin. “Appcoins are pump-and-dump scams disguised as Rube Goldberg machines, so don’t get fooled,” he writes.

Like a Rube Goldberg machine, these are some really complicated structures. I felt ridiculous trying to explain the crowdsale to experts: a cryptocoin fundraiser in which a non-profit in Scotland issues cryptocoins through a coin protocol built on top of the Bitcoin protocol developed by a decentralized company loosely based in Seattle, which issues its own cryptocoins that can only be traded through an exchange in France. Though some would certainly argue that there are equally complicated schemes cooked up on Wall Street. And many called Bitcoin itself a scam in its early years, until its value surged into the hundreds and heavyweights like Peter Thiel, Marc Andreessen and Jim Breyer started investing in Bitcoin start-ups.

“Appcoins are just copies of Bitcoin and make things more inconvenient because to use them, there are more transaction costs. You have to go through more barriers to be able to spend them,” says Krawisz by phone. “I can’t tell if the altcoin people are trying to deliberately scam people or just not thinking ahead to the logical conclusions of these schemes. They’re trying to hit another bubble. They regret not buying Bitcoin when they could have. So they want to replay it. It’s like replaying a childhood trauma to overcome it but you just make it worse.”

Mastercoin has nine more crowd sales planned in coming months. Caveat crypto-emptor.

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