I’m fascinated by Bitcoin’s potential. When I first started learning about it a few years ago I remember thinking it obvious that something like Bitcoin should exist as a fundamental building block on the web. The concept of having a secure global notary service for the web seemed like it should have the same importance as other popular application-layer protocols such as HTTP, DNS, SMTP, etc… I wrote a post on this almost two years ago when we started actively looking to invest in this market.

Two years later I have not yet made an investment in a bitcoin startup. One of the main reasons why we have not yet invested is the following paradox. If one believes that bitcoin will be successful, then in most cases the best investment decision is to invest directly in bitcoin. However the paradox is that bitcoin probably won’t be successful unless investors fund the companies that will help build out the bitcoin ecosystem – exchanges, wallets, vaults, multi-sig security services, mining pools, etc…

Most bitcoin companies have business models that are directly correlated to either the price of bitcoin appreciating, or to the volume of bit transactions increasing. Vaults and wallet companies are a good example – they typically project that over time they will generate revenue by charging their customers a fee that is a percentage of the bitcoin Assets Under Management (AUM); typically something on the order of 0.5%. Let’s think about what would be necessary for a company using the AUM model to achieve $100 million in revenue. The total market cap for bitcoin today stands at just under $4 billion. If we assume that a vault or wallet company can achieve 25% market share and will charge 0.5% per year, then today’s revenue potential based on a $4 billion market cap for bitcoin is $5 million per year ($4 billion x 25% x 0.5%). The total market, and hence the price of bitcoin, would have to grow by 20x, or to an $80 billion market cap, in order for this company to achieve $100 million in revenue. Let’s assume that the $100 million revenue business generates $30 million in EBITDA and is worth 20x EBITDA or $600 million. Now let’s compare investing in this fictional startup with investing directly in bitcoin. If I invest in bitcoin I can make a 20x return if I’m right and the price of bitcoin appreciates. In order to generate a comparable return through investing in the company I would have to invest at a post-money valuation of $30 million ($600 / 20) and would have exposure to all of the usual risks associated with building a company. At company valuations higher than that I might as well buy bitcoin directly, with the added benefit that I would have liquidity and could sell at pretty much any time.

Of course, when the bitcoin market cap was around $12 billion about a year ago the math looked very different. A year ago the revenue potential for achieving 25% market share with a 0.5% annual fee was $15 million. As an investor in this fictional company I would only have had to believe that the market would grow by 6.6x, which would not be too much of a stretch given the rapid rate at which the price of bitcoin had been increasing at the time. At that point the relative decision would have been to either invest directly in bitcoin with the potential for a 6.6x return ($12 billion market growing to $80 billion), or in the fictional company at a $90 million post-money valuation ($600m / 6.6).

The two compounding problems that many bitcoin companies face today is that not only are their business models correlated to the market cap of bitcoin, which has declined substantially, but they raised their last round of financing at a time when bitcoin was trading at much higher levels. Even worse, some of these companies had so much conviction regarding the price of bitcoin that they converted a substantial portion of the amount raised in USD into bitcoin – a triple whammy. Until the price recovers many of these businesses are stuck.

So what happens now? I’m not entirely sure. I would imagine that a small number of the bitcoin startups in the ecosystem have enough of a cash warchest to weather the downturn in bitcoin pricing. Long term these companies may actually benefit from this downturn as competitors begin to disappear. If the downturn persists, it’s possible that a new wave of bitcoin startups will emerge. Other startups have shifted their business models to sell software to help businesses develop block chain applications, although that market seems small today.

I’m trying to figure out the answer and welcome advice from members of the bitcoin community. However I can’t help but wonder whether the best investment decision right now is to simply buy bitcoin!