Editor’s note: Tom Carter is a founder and managing partner of Fountain Partners, a San Francisco-based firm that provides equipment financing for venture, growth, and expansion-stage businesses.
Last year was a fun one to be in the business of evaluating and taking business credit risk in the venture sector. The unambiguous commercial success demonstrated by companies like Airbnb, Uber, and Whatsapp provided extra stimulation to the already fertile, and some said frothy, U.S. venture capital and seed-stage equity market. In the market of financing privately held businesses, which is where Fountain Partners primarily operates, the most interesting areas in terms of risk were bitcoin mining, cloud hosting, mobile messaging services, U.S. energy, and cannabis.
There was dramatic revenue growth in cannabis production and retail products in Colorado and Washington after those states legalized the recreational use of marijuana but few sources of capital. Fountain Partners and other lenders have had to say “no” to financing cannabis operations because we do not want to be in conflict with federal law.
New positions in domestic energy early in the year were no-brainers for us because, on the one hand we had an array of companies showing substantial revenue growth derived from oil production. But at the same time we knew that we could not get enough intelligence in a limited amount of time on how much production capacity was online and the point at which supply (not just of oil but of all the factors of the supply of oil and natural gas) would clearly outstrip demand.
Working and living in San Francisco, it was also not hard to factor in some growing impact of the adoption of electric vehicles. In the end, we put less money than we could have into oil-related businesses and took on much more exposure to electric vehicles.
In evaluating mobile messaging systems in 2014, we asked ourselves questions like, “Is 90 million users a critical mass for a closed communication system that isnot Facebook, Snapchat, or Instagram?” and “Can handset makers get traction from their own messaging systems?” Cloud hosting was less speculative than messaging, with more broad business use cases and durable revenues, but the questions of competitive positioning and the risk of “over building” capacity remained and will remain. But the most fascinating of all investment areas in 2014 from Fountain Partners’ vantage was whether or not to support bitcoin mining.
Mining for the truth about bitcoin
In 2014 we were offered a signed term sheet with compelling terms to finance millions of dollars worth of servers that had been designed and optimized to mine for bitcoins. We saw a developing sub-economy with special hardware needed to mine for bitcoins and companies that would mine for their own accounts, or as a service to others who wanted to mine. In weighing the opportunity, we had to evaluate basic questions such as:
- Why are bitcoin and blockchain technologies relevant, and what is their utility?
- What is the regulatory environment surrounding the use of bitcoin?
- What is the supply-and-demand environment for bitcoin, and how might it evolve?
We enjoy the challenge of figuring out the right investment decision in the least amount of time. In the case of bitcoin mining, there were more angles to understand than our usual diligence process encounters. I read Satoshi Nakamoto’s white paper and concluded that in order to ultimately commit capital, we would have to believe that the following suppositions were mostly true:
- The bitcoin ecosystem has utility even though it is not legal tender, and governments will not interfere with its use;
- There either is sufficient adoption of bitcoin or there will be sufficient adoption;
- The system has sufficient integrity relative to hacking and/or a marketplace for insurance against fraud will develop; and
- The system of creating bitcoins cannot be gamed.
If we could have confidence in these presumptions, we could move on to the basic supply-and-demand questions and evaluate the economics for bitcoin mining services.
It was obvious that at very low levels of liquidity and price, bitcoin mining would be unprofitable. In many bitcoin price scenarios, it was easy to imagine conditions where the value of our servers or mining effort would be continuously and rapidly eroded by other ambitious and well funded market participants.
Soon after initiating diligence a contact told me that the Chinese government was committed to maintaining or increasing its share of bitcoin mining activity suggesting that they were subsidizing electricity and server costs. Chinese subsidy or not, it was easy to imagine that advancements in hardware or some particular hardware/software combination could hasten the obsolescence of current mining hardware.
In the Satoshi white paper we learned that the integrity of the mining system depends on the condition that “honest nodes [must] control the majority of CPU power.” Whether mining and transaction power will be concentrated into a majority seems unknowable but possible.
There is a natural human bias to want to participate in the latest new thing, and it was tempting to contribute to support the growth of the bitcoin movement. Surely we all want more secure financial transactions. Fiat currency manipulation and debasement are worthy problems to tackle. Still, we passed on financing servers. Beyond the risks inherent in the mining business we were disappointed to learn the hardware used for bitcoin mining is so specialized that we could not expect to recover value on those assets.
Since we declined the investment we have seen a severe price decline in bitcoin and the unfortunate hacking of bitcoin exchange Bitstamp. Even so, the opportunity to consider financing bitcoin servers has us enthusiastic about other block chain implementations and the evolution of bitcoin. We can see that 2015 will be one in which the current crop of financial technology companies build upon their core foundations and execute against their 2014 capital raising activities.