Tuesday, March 11, 2014

Why start or invest in Bitcoin companies? Why not free ride Instead?

Most of the companies building or servicing the Bitcoin economy require significant investments. But why would you invest that money in a Bitcoin company if instead you could just use the money to buy bitcoins and wait for those to increase in value?

Individual companies vs. the whole industry
The remarkable thing about the Bitcoin industry is that it is possible to invest in the industry as a whole rather than (or in addition to) in specific companies in that industry.

This is very different in other industries: You can't make investments in 'the car industry' or 'the food industry', only in specific companies in these industries. Similarly, the current state of the Bitcoin industry is sometimes compared to the early internet: still very underdeveloped but with great potential. Now in the case of the early internet it was not possible to invest in TCP/IP, the general protocol underlying it, or even in the protocols built on top of that such as HTTP. If you were excited about the potential of the internet you couldn't invest in the protocols themselves, only in specific companies creating and/or using these protocols.

With Bitcoin on the other hand you can invest in the Bitcoin industry as a whole, in Bitcoin as a protocol for financial applications, namely by buying bitcoins. If Bitcoin as an industry and protocol succeeds, your bitcoins will go up in value and price.

Bitcorati's overview of existing Bitcoin companies

Additional risk
Of course it may very well be the case that other protocols will emerge that outcompete Bitcoin, or that neither Bitcoin nor other protocols for financial applications will survive, but the risk of investing in the protocol as a whole will be considerably lower than the risk of investing in one specific company that is dependent on the success of the protocol.

For an investment in a Bitcoin company to succeed Bitcoin has to succeed AND the specific company you invest in has to succeed on top of that. Moreover, the money invested in the company cannot be invested in bitcoins, so there are significant opportunity costs.

For an investment in bitcoins to succeed, on the other hand, only Bitcoin has to succeed. Moreover, you can use all of your investment money to buy bitcoins and you don't have to use some to invest in the company.

At the same time, however, Bitcoin won't succeed unless there are a lot of Bitcoin companies building the Bitcoin infrastructure / Bitcoin economy. So there seems to be a classic public good / positive externality problem here: People are better off free riding on the efforts of others, but if everybody did that there would be nothing to free ride on.[1]

Is there enough potential to compensate for the extra risk?
Of course the idea behind investing in Bitcoin businesses is that the potential rewards of a Bitcoin company are greater than the rewards for just an investment in bitcoins and that this compensates for the additional risk involved. This is especially the case because it's a new industry with relatively few competitors and a lot of untapped potential, so that now may be the opportunity to make relatively small investments for a shot at becoming one of the dominant players in the financial industry in 5-10 years.

But if one assumes that if Bitcoin succeeds 1 bitcoin will for example be worth 100 times as much as it is now, then that's an ROI that's pretty difficult to beat for an investment in a company, even if the industry it operates in is a young and immature one with enormous potential.[2]
Bitcoin's price increase
Why do you do it? 
The encouraging thing is that despite these seemingly problematic incentives, we are witnessing the infrastructure being built around us, thanks to the heroic efforts of those who start and/or fund companies.
My main question though to anybody starting or investing in Bitcoin businesses is why? Why do you do it, why not just free ride on the efforts of others? From talking with others, including those who have started or invested in Bitcoin companies, it seems that several reasons may play a role:

Idealism: excited about the potential Bitcoin has for directly or indirectly improving the lives of many people investors and founders are willing to make investments with a risk-return ratio they wouldn't accept in other industries.

Non-monetary rewards: people find working in this new industry 'intrinsically rewarding' in the sense that it is intellectually challenging and/or a great way to meet interesting, smart people, so that they are willing to forgo an easier path to financial rewards?

The potential profit is worth the risk: Despite the additional risks the opportunities and potential for companies to become major players in a major industry are so great that it is worth the additional risk.

Risk mitigation: If you start or invest in a company that is positioned so that it is capable not just of working with Bitcoin but also with other types of protocols and currencies you may actually be reducing your overall risk as you won't be dependent on the success of Bitcoin in particular, but would be able to profit from whichever protocol and/or currency would come to dominate.

To increase the value of one's bitcoin holdings: If one has a large investment in bitcoins it becomes relatively more rewarding (than for people with small bitcoin holdings) to help build the Bitcoin ecosystem so as to indirectly increase the value of one's bitcoins.

Regulatory or institutional constraints: Some investors may face regulatory or institutional constraints on the types of investments they are allowed to make (e.g. a venture fund may only be allowed to invest in businesses and not in currencies).

If you've started or invested in a Bitcoin company, please leave a comment and tell us about your experiences and your motivations.


[1] As somebody who commented on an earlier version of this post pointed out: because buying bitcoins itself also entails a huge risk, it is problematic to call it 'free riding'. My main point, though (that it is even more risky to start or invest in Bitcoin companies than it is to simply buy bitcoins) still stands.

[2] It seems then - although it is difficult and/or kind of meaningless to make any kind of general statement here - that given these incentives there will be less investment in the Bitcoin economy in the form of investments in Bitcoin companies than in... 

That's one part I'm not really sure of: What is the proper comparison? Less investment in the Bitcoin economy than in what? Than in the average other industry? Than in mature industries? Than in young and immature industries in which it is not possible to make a direct investment in the industry as a whole? Than there should be? 

To take the latter, given the additional risks involved it is tempting to say that there will be underinvestment in the Bitcoin infrastructure but of course I have no idea what the 'correct' level of investment is or whether it even makes sense to speak of such a thing. 

As somebody who commented on an earlier version of this post remarked, it may even be that there actually is relatively little investment in the Bitcoin infrastructure but that this is a good thing: Perhaps the deflationary nature of the currency results in fewer resources getting squandered through malinvestment. It's hard to say either way.


  1. The reason as I see it is pretty simple.
    Earn more bitcoins.
    If you buy 10000 BTC (230000 usd as of today) and bitcoin rises 100 fold, you have 23 millions usd.
    If you invest 230000 usd in a business that allow you to earn more than 10000 BTC (a casino, an exchange or any venture) you will earn more than just by buying BTC.

  2. Bitcoin is a form of digital currency, created and held electronically. No one controls it. Bitcoins aren’t printed, like dollars or euros – they’re produced by people, and increasingly businesses, running computers all around the world, using software that solves mathematical problems. It’s the first example of a growing category of money known as cryptocurrency.