The Coinbase IPO Explained

Faraz and Vasanth break down the technical and financial aspects of the Coinbase IPO.

Faraz Abidi: @fzfromcupertino

Vasanth Thiruvadi: @NextVasanth

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So the song, I have a question for you. Why are you not a millionaire? How do you know I'm not a millionaire because you told me to buy Ethereum at $8 a share a few years ago. And I didn't. And neither did you. And now both of us are looking like idiots. I feel like I've been early, but at the time always thought I was late. And I think that's the, and that's why you just didn't buy it. That's no, that's no, that's not the reason I didn't buy it. It was also while at the time I didn't have any money. I was 19 years old. You had more than $8. I had more than $8 of my parents' money, which I guess, I guess I could have thrown it into this thing called Ethereum and then had to explain it to my dad, like where $500 went, which I, maybe I could have, but no, no, it's not, it's not something, you know. Yeah. If here's the question though, you know, and I'm 25. If I came across in equivalent to Ethereum, would I invest in it? Happy you is my question. Do you have any, I was going to ask, do you have any other tips? My investing framework now is a lot like this, which is when I see something that's sort of in its inception and not a lot of people believe in it. And in fact, it's very non-consensus and the vast majority people are against it, and it doesn't make sense to them. That's when I throw a little bit of my money into it, maybe a percent of my savings, like 1% of my savings. And then I just sit back and then maybe it goes to zero, but then if I do, I do this like pretty often. So, you know, maybe 15% of my portfolio is in 15 different, tiny things that. Everybody thinks it's going to fail maybe one actually a hundred exes. I can't tell not enough time has passed the VC strategy. It's the VC framework. Yeah. Okay. Well I guess one hot new potential item that came up in the news is Coinbase. So I think this would be a very interesting conversation for us to go through. First of all, what are the technical details behind Coinbase? What was the financial data behind Coinbase? Does it make sense for it to be valued as highly as it does? I definitely know cryptocurrency the deep technical level, the soft knows the business and the finance at a very deep level. So between the two of us, I think we should be able to have a conversation that you're not gonna be able to find anywhere else and learn a lot about this. Definitely. So welcome to another week of what can you tell me about software, where we discuss software and I guess this week, cryptocurrency and Coinbase let's get into it. For us explain to us what claim basis. Sure. So I think the best way to understand what Coinbase is, is to first understand the world as it was before Coinbase existed. So quick story. I have a family friend who was giving a speech at the university, I think in like 2015 or 2016. And. They wanted to pay him for it. And he said, no, I just give these speeches for fun. I just want to tell people and educate them. So they said, all right, how about this? We'll give you this. We'll give you this gold coin. It's worth like five bucks. It's got this thing engraved on it, which is called a Bitcoin private key. And he's like, what's Bitcoin. And they said, Oh, it's just this random thing. That's, that's blowing up right now. It's not really worth anything, but you know, it might be fun in a few years. This is okay, great. I'll take it. So it sits on it. And like a year later he discovers that this is now worth like. A thousand bucks. So his nephew he gets his nephew to help him sell it, but there's nowhere to go to sell this at this time. So they find some dude on Craigslist and they meet up with him and in like a home Depot parking lot or something, and they sell him their their Bitcoin their engraved physical Bitcoin. And there's a lot of problems with this, as you can imagine. So first of all, It's pretty shady. Like this is not the best way to sell something. But second of all, if we're talking about a digital currency, which just exists as ones and zeros, it's kind of ridiculous to have to physically meet someone to transact. So this is really not how the world should work when you're exchanging cryptocurrency for the U S dollar. So Coinbase is a cryptocurrency exchange, meaning that they allow you to pay with us dollars or whatever your local government backed currency is for cryptocurrencies, such as Bitcoin, Ethereum, or any of another 50 cryptocurrencies. Right. That story doesn't sound quite decentralized. So how does Coinbase store your money? So what you have to understand is that. Cryptocurrencies work on a system called public private key encryption. So essentially there's no physical. Dollar right. There's no physical bill. Even despite that story, there was a physical coin, but the coin that, that, that my family friend had, it didn't matter. What not matter was the number that was written on the back of the coin. And that number is what's known as a private key. So that is essentially cryptographic proof that I own this coin. I own this token. You want to keep that private key, extremely hidden, because anyone who asks that. Access to that private key can then sell, can then move your cryptocurrency. That's someone stealing your private key is equivalent to somebody breaking into your bank vault and just taking all the money out of there. So it's a really important to have a very secure place to store all of your private keys. So essentially when I buy. Hey cryptocurrency, I am giving us dollars. And in exchange, I am getting back private keys that say, I own this amount of Bitcoin, or I own this amount of ether. And every time you make a transaction like this, if I make 10 purchases of Bitcoin, I will have 10 private keys. So I need to store all of these private keys in a secure place. And I also need to be able to reuse them if I want to sell my Bitcoin. So. That essentially is what a cryptocurrency wallet does. I've simplified it a fair amount, but the broad strokes, a cryptocurrency wallet is something which stores all of your private keys as well as tells you how much those private keys are, quote, unquote worth. So this private key points to a Bitcoin value of. Let's say 2.3 Bitcoins that I purchased earlier. So I have my wallet and my wallet will say I have $5,000 worth of Bitcoin, but actually under the hood, it's saying that I have one private key that's for $200. I have one private key that's worth $550 and it adds it up and shows it on the wallet. So. Under the hood, what the wallet is doing when I sell it, as it uses those private keys to make the sale. And when I see how much it's worth, it adds up those private keys and it shows me one simple number. So the long story, short Coinbase stores, private keys for you. That's how it stores your cryptocurrency. So I think that distinction is often lost on new users to Coinbase. When I went on Coinbase, I was aware of this wallet and the way the wallet works, but I actually did not come in touch with my own wallet. I was able to just purchase coins and they appeared in my portfolio where did the wallet go did as part of the genius Coinbase disappearing, this extra intermediary extra step, those typical in purchasing cryptocurrency. I would, yeah, I would definitely say so. I mean, how many people like lay people who aren't coders would really understand the concept of a cryptographic wallet? It's not, there's not a clean metaphor, whereas if you're talking about a bank account, does how much money I have in my bank account. This is how much, or this is how much stock I, I hold and just how much stock I can sell. It's a really clean, very easy to understand thing. So I think by abstracting away the private key aspects of the cryptographic wallet and Coinbase just literally making it like holding stock, it allowed a lot more people to come on the platform. It made it far more accessible. That makes sense. And I think the, sort of the two big stories that are always seen the last five or six years in relation to cryptocurrency, and even in relation to. Various exchanges that existed. One was this idea that people would lose their private key. And then they would, they were out on millions or hundreds of millions of dollars. Like they forgot the password for this computer. And then they're like, I have five guesses. Otherwise I lose $5 million. Right. Right. And the other thing that I see is all these hacks that were occurring. You'd think that something as complicated, sophisticated, you just described, wouldn't be able, wouldn't be hackable. But they were, and I think the most famous one was Mount Gox. It was a particular exchange. I don't know if you know much about that. Yes. So I do know a fair amount about mountain gawks. So as I mentioned earlier, you know, this concept of converting this complicated cryptographic wallet into a simple stock trading system, it actually seems pretty obvious. You know, it begs the question. Why hasn't anyone thought of this before? And the answer. Is that someone has thought of this before. And that was such a disaster that people were very, very wary of trying it for several years. And Coinbase had to do some very hard work to rebuild the reputation of cryptocurrency exchanges. And this disastrous events was known as the heist of Mt. Gox. So not Gox was the first huge. Cryptocurrency exchange. I believe they only traded Bitcoin, but there were this gigantic cryptocurrency exchange at their peak. They were doing 70% of all Bitcoin transactions. And in 2014, Mt. Gox was hacked for $500 million worth of Bitcoin. So, you know, This had huge ramifications on the entire crypto industry. I think Bitcoin dropped by like 30%, just because of this. People were like, this is a system like Bitcoin, even going to work, forget cryptocurrency exchanges. People were saying, can we even trust Bitcoin? If things like this can happen or people are going to be sophisticated enough to be able to trade Bitcoin? You know, if I get my credit card hacked, That's whatever, you know, there's all these fraud prevention mechanisms. The bank will let me know. They'll put it on hold. But with private keys, there's no intermediary. This is like one of the premises of Bitcoin. There's no trusted third party. It's completely trustless. You only need one person to approve it. So this made Bitcoin seem far, far more dangerous. So the high, the highest amount Gox, first of all, reduced a lot of people's confidence in Bitcoin, but. 10 X or a hundred X or reduce people's confidence, two currency exchanges. So Coinbase had to do a lot of work to prove that they were very, very cryptographically strong, that they were falling a lot of great security practices, but they had a lot of smart people who ranked security that if something bad happened, it would be only isolated to small, small areas. That was. The major innovation of Coinbase was not to make a stock system. The major innovation of Coinbase was to make a very, very secure system. So would you say then that Coinbase is impenetrable? I only ask this because one of the sort of underlying issues with investing in cryptocurrency and bankrupt, a currency on an exchange versus just, you know, putting cash into a bank account is that your cash is FDAC insured. You're the money are the coins that you hold in Coinbase is not insured. So if it isn't impenetrable, then we're all at risk of having our money stolen the same way the money Mt. Gox was stolen. Right. How do you trust you? Trust you trust the security measures and everything that Coinbase has done since this highest enough to put your crypto in there so you've actually asked two different questions. One of the questions is, is Coinbase impenetrable. The second one is, do I trust them enough to put my money into it? Yeah. The answer to the first question is no, nothing is impenetrable and it thinks we're only impenetrable as far as we know. So the entire basis of security on the web is based off of this concept of cryptography and. Most of the cryptographic systems that we use like elliptic curve, cryptography, and RSA encryption. These haven't been broken yet and they haven't been broken in decades, which is why we have a great deal of confidence in them. But I can't imagine that anyone would say that they're completely impenetrable. The idea is just that you put out cryptography out there. And you make it public. You make sure that everybody knows how it works and if no one is able to break it, then you're far more confident about that. Then some secret algorithm that, that you just hope that by, because it's so obscure, no one will crack it. That's actually the whole premise of cryptography is you want to make it public. And the one thing which survives the public the longest is the most trustworthy. Now the other question is, is the risk worth the benefit? And that is something which I personally believe yes, for the amount of money I put in. I'm not putting my life savings into it, but the amount of money that I put into Coinbase, I feel that the risk is worth the benefit. That makes sense. So now I have some questions for you on the, on the valuation and finance side, the first question, which is probably pretty obvious is Coinbase IPO at a hundred billion dollars. What do you think of this valuation? So maybe we should just put a disclaimer out there and say this isn't investment advice. Not that. And not cryptography advice either. Yeah. Yeah. And don't even take the, whatever we mentioned earlier, the cold open as investment advice either to put money into things that seem we will fail. Wow. What do you stop listening after the cold? Open it and then put their money in. Are we liable? If they put their money in and they made money, then I expect 20%. If they lost money that you don't feel listened to the rest of the episode, you should. It was exactly. So to your question on Coinbase, having a a hundred billion dollar valuation on IPO, making any sense, I think there are a number of factors. If I had to put it, I put it in two buckets, the bucket that makes it make sense. And that bucket is this. Coinbase has made more money in Q1 of 2020. That is all of 2019. They made $1.8 billion in revenue and just Q1 at three months and all 2019, they made $1.3 billion. They're also profitable, which is a significant thing for a fast growing startup that enters the capital markets. You don't see that often, but actually this is also a signal to their competitors, which I'll come to later. The other thing that sort of supports this valuation is that all these institutions are leaning into crypto. You've probably heard of Elon Musk buying Bitcoin. He actually used Coinbase to buy the Bitcoin. They broker the transaction. Other institutions are going directly to Coinbase. So not going to some of the lesser known exchanges. Coinbase has institutional backing, which in many cases means everything. When you have something new and the big players are all backing one particular player, maybe it makes sense to invest in that in the winner, take all player. The other thing that is maybe not being talked to. About as much, but should be, I think is the total addressable market for crypto hu in five or 10 years is likely to participate in the crypto market who is not participating now. Some people have suggested that it's everybody with a smartphone. So that's 3.5 billion people. I feel a little silly. I think it might be more like everyone who sells stock. I think that's a better fit. Well, you're treating, so, okay. That, that brings up another sort of a point of contention. Should you treat currency the way asset equities are treated, which is not everybody. Exactly what you said, which is not everybody participates in equity markets, but literally everybody participates in currency. Because it's a way, okay, this, this, this is a whole can of worms that we're opening up. We'll cover it. It'd probably a different episode, but the long story short is that you should think of Bitcoin more like gold than you should think about it. Like the U S dollar. So it's not, it's called a cryptocurrency, but you should think about it more like an asset, like gold. Dang. I actually completely disagree with you. I don't think you should treat it as gold or as a us dollar. I think it's somewhere in between. This is where a different episode we'll get to it some other time. And so I think that's the bucket that supports the valuation, immense growth, big players adjusting to it. And also. Total doesn't work. And they're also making a lot of money. Now, the bucket that throw some concern in the air is this crypto is inherently volatile. We know this and I think in 2017, Bitcoin, Pete, and then for a number of years it went, it, it fell, it troughed, and then it was flat. And during this time I remember reading a interview that Brian Armstrong gave who's the CEO of Coinbase. And he said, Coinbase is trying basically anything to get that money, to get that, to get the crypto market, you know, reignited and moving again. And they just couldn't do it. So what's to say, I mean, right now crypto is doing really well and Coinbase IPO at the peak, it seems like who's to say that we won't enter another crypto winter. I think that's one of the threats against Coinbase is IPO and their valuation and potentially their valuation increasing. Do you do like, did like fidelity and Robin hood and stuff tank when, you know, the markets went into recession? This is a good question. What we know about the equity markets is that people continue to trade maybe not the same volume as in a bull market, but in a bear market, they do continue to trade. And so in that way, historically in bear markets exchanges have always managed to make money and stay in business, but. A recent trend in exchanges overall is that they don't charge fees anymore. And they're more reliant on high volume trading. If in the next bear market trading decreases, I don't know what's going to happen. It could actually, it could be very different than what's happened historically. I can't speak to Coinbase, which is that Coinbase charges incredibly high fees, which is what I was mentioning earlier. It's one of the reasons they're so profitable. I think just basically set famously that your margin is my opportunity. And so when you see when all the other, when all the other competitors see that Coinbase is. You know, charging fat fees is valued, really richly. Their immediate reaction is let's charge, lower fees, give better incentives for people to come to our platform. Maybe we give people bonuses to come to our platform and leave Coinbase. And so I think that's actually what we can expect in the future in this particular competitive market. And that's also something that could hurt their valuation. And actually for us, I did want to ask you about this, which is it's you, you mentioned earlier that Coinbase has only 50 or so cryptos trading on their platform. It seems that Columbia has really high standards for which coins they allow on their platform. They don't know how to doge on their platform because it doesn't have any utility. Is that to their benefit or is that against them? And it's like a tick against them. I don't think that's against them. I think that's a really related to their benefit. It's a firewall, right? So like, if you're trying to make something that gets the crypto enthusiasts on your platform, then you know, you're going to make different decisions on Coinbase did. But what is the percentage of crypto enthusiasts versus general people or following CSN, BC and seeing. Oh, Bitcoin shot up to a trillion dollar valuation. You know, I should maybe take some of my money from the stock market and put into Bitcoin. Those types of people should not be exposed to these other kind of really esoteric cryptocurrencies. It's just overwhelming. It makes it less accessible. Surprisingly. I think you've made some interesting arguments for both in favor of Coinbase and against Coinbase, but let's dig into the financials a little bit. When you kind of peek under the hood at the numbers, what are they telling you? Yeah, I think that there's a, there's a much larger story about Coinbase that people aren't talking about, which is the way they've financially engineered their business to get to the point that they're at. When, when I found out that. Brian Armstrong still owned 20% of the business. I was really surprised. Wow. Typically when startups go through like six, seven rounds of funding, which is what Coinbase has done, they lose out the value. They get diluted all the original share owners get diluted. And you know, you've probably heard stories about startup founders to go IPO. They have like 5% of the company, which is typical. Brian Armstrong for some reason has 20% of the company. And I think this speaks to the fact that they've been profitable for many, many years and a lot of the share sales and the funding rounds that they've done have actually been reselling existing funding rounds. Let me make that more simple. So when you hear about the many funding rounds that Coinbase has gone through, it's really just been an existing shareholder who was there at the first round, selling new shares at a higher valuation in correspondence with Coinbase. So Coinbase isn't wasn't really, hasn't really been diluting all these years. They've been relatively stable. Year over year by making money and, you know, funding their own business. That's one really surprising and incredible thing. They're not VC backed to the extent they're losing money every year. The other thing that's really interesting is that Coinbase direct listed so what is the direct listing and what is the alternative. So typically you hear about companies IPO, and what does it mean to IPO? You have a certain traunch of shares called treasury stock in your balance sheet that you then sell to the public. And so you generate new cash into the balance sheet. So that's to say you've raised cash from the public markets. So, so when you, when you're a startup, you have a bunch of stock options. And you distribute some of these stock options to employees. So they'll come in to work for you, give some of these to your investors. And you're saying there's a third category of them, which are just keeping their in order to sell to, to raise money. Sometimes you just keep it there. And sometimes you literally created out of thin air and then you sell it. Which would be diluting. Everyone should be diluting everybody a little bit. You sell, you sell it and then so you'd get a bunch of cash, right? So maybe you raise $200 million and now you have brand new cash to fund your business and grow faster or do whatever you want with the cash. When you direct list, it's the employees and the VCs and the other investors and other stakeholders in the business that sell their own shares on day one. And those are the shares entering the market. So the people getting paid out isn't the company, but the actual employees in the company, the investors in the company, the founders, and so forth. So the company is not IPO going to raise money, their IPO, going to give everyone a happy payday. They're entering the public markets to provide a liquid liquidation event for the founders, the employees, and the other stakeholders in the business. Science behind direct listing and like there's a lot of historical analysis on whether direct listings are better than IPOs, but what we've seen with the big direct listings, which is like Slack has been a big one, I believe Spotify was a direct listing. And now Coinbase is the biggest direct, direct listing of all time. Is typically they fall and then they they're down about 15 to 20% for many years before they come back up, which is what we saw with the big ones. And so there's an argument to be made. Well, yes. You provided an immediate liquidation event for employees with the direct listing, but then in the following two years, what's the morale going to be like at the company when the stock is down 15% from the IPO, right. And so that's the argument against direct listings. I see. Yeah. So, okay. I'll also say I also just also throw a disclaimer out there that IPOs are. Terrible in that they provide a lot of people. Who've who haven't been with the business very long to make a lot of money in a very short amount of time. And so that's sort of the argument against IPS and we can discuss it somewhat different. Okay. Yeah. So I think here's the big question that I still have a hundred billion dollars. It's just a really big number to me. I don't really. I don't know what that number feels like. It just sort of just a huge number. I don't really understand it. You know, if the number was a trillion dollars, the number was a hundred billion dollars. The number it was $50 billion, they would still feel like big numbers to me. So why a hundred billion dollars? So the founders and the, and the, you know, the stakeholders, key stakeholders, they must have looked at their financials and they ask themselves, which is the same things that I brought up, which is what is our total addressable market? How much money are we making now? Are we profitable? And our equivalents in the technology business, what are they being valued at? Currently? So we have certain types of frauds in this market that people have decided to value tech companies that are compounding incredibly fast at crazy multiples. So let's go back to the original number, right? Coinbase made $1.8 billion in revenue in Q1 multiply by four. That's about. $8,000,008 billion in revenue for 2020. They're growing. I believe that like I believe they're growing at 150% growth rate. So if you compound that over a few years, very quickly, they justify the a hundred billion dollar valuation. but of course there's also the, the fear that we enter another crypto winter, and not as many people are trading crypto. And there isn't the same sort of excitement that there is now. And in that scenario, of course, Coinbase wouldn't warrant a hundred billion dollar valuation and could very well fall. I mean, right now, I believe it's trading at an $80 billion market cap. So I follow a little bit, it's fallen a little bit. Yeah. Okay. Okay. Great. So there's one other really interesting. So obviously Coinbase is innovated in a number of ways. They they've been profitable really early. They're the first company in a new generation where dilution is not the base case. They direct listed the biggest direct listing of all time. And this is a lesser known and lesser talked about Wait in a way in which they've innovated, which is they didn't do a road show. So typically when a company is about to go public under the public markets, even if it's a direct listing, they'll go to a lot of the biggest funds on wall street, the East coast and tell them, look, these are the reasons that you should buy our stock when we IPO. They'll market themselves, they'll hire investment bankers and they'll go around and basically put the word up. Coinbase did not do this. And in fact, on IPO day, typically what a CEO would do is go to all the big media outlets like CNBC Bloomberg, and get up there and talk to everybody. They did not do this instead. They had each of their biggest investors interview them on different, smaller, lesser well-known media channels, like clubhouse that chose not to talk to big media at all. They assumed that the I, well, I guess the assumption was that. The word was already out. Everybody knew about Coinbase already. There was enough energy and excitement about the IPO that they didn't have to do this, and they didn't have to give any more power and authority to these established media organizations that they have no control over their messaging. And the media organization organizations decentralize it decentralized the narrative of their own company before the direct listing, which I think is incredibly cool. And I, I hope to see that more, but cool. Yeah. Awesome. All right. So I think that's everything that we want to speak on about this topic. This is obviously a huge, huge area. So there's stuff that we could have touched on, but I think this is a good balance between being informative as well as not being 10 hours long. So if you guys are intro into these types of episodes, if you want to find out more about current events or there's some topic that you just wish that we would speak about, I can do some research to the technicalities of it. I can write some code and figure out what's going on. The songs can look at the financials. And look at the books and see what's going on from that perspective. So I think you guys want to know about tech business. Just hit us up on Twitter. You can find me at F Z from Cupertino. and you can find the song at next, the song. So tweet at us say, Hey, I want to see an episode about why Elon Musk bottle, that Bitcoin or whatever else you find. Interesting. And we'll definitely do it. Make sure to subscribe to us on Spotify, rate us on Apple podcast, tell your friends about the show and we will see you next week.