How Bitcoin Will Promote Radical Innovation

Bitcoin will kill incrementalism, not from its technology itself, but rather by raising the hurdle rate for venture capital

There is a debate within Bitcoin on whether its innovation is radical or incremental.

Some believe Bitcoin is simply the aggregation of several existing technologies that have been around for decades, like public key cryptography, computer networking, economic incentives, and social computing. And so, while each of the individual components were radical innovations themselves, their aggregation is not.

Others believe that this aggregation of knowledge is highly non-trivial and rare. So, representing transfers of value in a chain of blocks across a distributed network of computers is the very definition of radical innovation.

I am more in this latter camp, as I believe systems integration as a tactic for innovation is extremely valuable and qualifies as innovation itself. The iPhone, the Tesla Model 3, the James Webb telescope, and the autonomous drills used in shale fracking are all examples of supreme systems integration. (Perhaps the best counterexamples of radical innovations that did not involve “just” systems integration would be the atomic bomb, the airplane, and the transistor, though I think a case could still be made.)

But I don't believe that Bitcoin's impact on innovation will come from replicating blockchain technology, nor on inspiring new forms of distributed computing or cryptography. Rather, Bitcoin's chief impact will flow through its monetary innovation. It will raise the opportunity cost of innovation capital.

Financing Innovation

Today, broadly speaking, there are three loci of innovation: startups, large corporations, and academia/non-profit labs. All of these places do not operate independently unto themselves, but require capital. That capital buys equipment, hires talent, and can ease and circumvent bureaucracy. Venture capital, the chief instrument for financing startups, gathers money from institutional investors (like sovereign wealth funds, university endowments, and pension funds), and reallocates it to innovative startups.

VCs are, therefore, financial intermediaries; the head of the Abu Dhabi Investment Authority does not know the differences between the latest spate of San Francisco AI companies. We can debate whether the capitalists are fairly or properly compensated, but they have played a role in the world economy in the last 50 years, and I do not see that vanishing anytime soon.

The model of venture capital historically has always consisted of a handful of winners that pay for a bevy of losers. It's impossible to know ex-ante who will be the next Facebook, and so VCs put their chips on the table with many different companies. The best VCs probabilistically have more wins than other VCs, where a win is an exit of some kind, either an IPO or acquisition.

While it's true that a successful win can involve a return of 20, 50, and even 100x the initial investment, that is not the average return in the portfolio. The portfolio's return must include the losers, many of which return nothing, so that the average return across the portfolio is smaller, somewhere between 10 to 30%. How do we know that the VC returns are not on north of, say, 50%? If it were, then pension funds like the Texas Teacher's Retirement System would invest only in venture capital, but it doesn't. It invests in a wide selection of assets, and so VCs compete with other assets, like equities, bonds, and real estate.

Enter the new asset class: Bitcoin

With Bitcoin now available to institutional investors, this will raise the opportunity cost of capital. Large institutional investors will always seek to place their money at the highest risk-adjusted return. With Bitcoin on the table, institutional investors will no longer be satisfied with the traditional returns. Ultimately, Bitcoin will raise the hurdle rate for the VC industry. Rather than expecting a 20 or 30% return, VCs will need to at least beat Bitcoin's return.

This is possible, but it will transform the venture industry. For one, it will starve funding for incremental innovation, the kind that does not lead to outsize returns. And so, the glory days of B2B SaaS companies will come to an end, as those returns simply won't make the cut. Industry-changing investments like generative AI likely would clear the hurdle, and VCs will, therefore, keep an eye out for other such low probability, high return investments.

The net effect will be that VCs will only fund world-changing innovation. This was how the venture industry started in the 1970s, funding internet infrastructure and personal computers. However, the industry took a detour into SaaS companies, social media, and mobile apps; many which returned lackluster returns. Those industries will not go away, but I don't believe they will be funded through future venture capital. Rather, they will continue through private equity or even corporate intrepreneurship.

Perhaps the biggest long-term benefit of all this will be the shift in human capital. Young people will now truly swing for the fences, because that is what the market will reward. And that could be Bitcoin's greatest impact on human civilization: to inspire the next generation of young people to aim for the stars like never before.