By SARAH E. NEEDLEMAN and SPENCER E. ANTE
Bitcoin startups are beginning to raise sizable investment capital even as industry leaders warn that hackers are abusing the Internet virtual currency for profit.
In the past year, fledgling businesses Coinbase Inc., Coinsetter Inc. and CoinLab Inc. have raised millions of dollars collectively from prominent venture-capital firms and angel investors, adding credibility to a digital currency that isn't backed by a central bank.
On Wednesday, Bitcoin, which can be used to make payments over the Internet without transaction fees or involving a financial institution, is expected to win its biggest validation to date with a $5 million investment in San Francisco-based Coinbase led by Twitter Inc. investor Union Square Ventures.
That investment would top last month's more than $2 million put into OpenCoin Inc., another virtual currency startup whose backers include venture firm Andreessen Horowitz.
"This is going to be a trigger point," said Union Square managing partner Fred Wilson of the Coinbase investment. "You'll see lot more venture money being poured into this space."
Coinbase operates an online service that allows users to buy Bitcoin, store the virtual currency in a digital wallet and pay merchants for goods or services with it. The company was founded last year by Fred Ehrsam, a 24-year-old former Goldman Sachs GS +0.59% trader, and 30-year-old Brian Armstrong, previously an engineer at short-term rental startup Airbnb.
In April, the Coinbase co-founders said the company had about 116,000 members who converted $15 million of real money into Bitcoin, up from $1 million in January. Mr. Ehrsam said its dollar conversions are increasing by about 15% a week, and its user base is growing at a weekly rate of about 12%.
"We are in land-grab mode," said Mr. Ehrsam.
Coinbase profits by charging users a 1% fee to convert dollars to and out of Bitcoin. "We have a pretty clear business model," said Mr. Ehrsam. "It's not like we're eating Ramen every day."
Bitcoin is gaining traction with some small merchants and others who want to reduce costs associated with accepting credit cards, such as content-aggregation site Reddit.com, and Human Rainbow Inc.'s OKCupid.com, a dating site. eBay Inc. EBAY -0.28% Chief Executive John Donahoe last month also said the e-commerce heavyweight is exploring ways to integrate Bitcoin into its PayPal payments network.
Supporters of Bitcoin, which was created in 2009 by a person or group that goes by the name Satoshi Nakamoto, say it offers anonymity and a cheap way to transact business across borders. But critics say Bitcoin faces so many regulatory and technical hurdles it will never mature into a mainstream currency.
Last month, Tokyo-based Mt. Gox Co., the largest online exchange trading Bitcoin, said its services were disabled for approximately four hours by an Internet denial-of-service attack.
"Attackers wait until the price of Bitcoins reaches a certain value, sell, destabilize the exchange, wait for everybody to panic-sell their Bitcoins, wait for the price to drop to a certain amount, then stop the attack and start buying as much as they can," according to the exchange.
That volatility is one of the concerns about the currency. Bitcoin rose in value from roughly $5 in June 2012 to a high of $266 in April and was down to about $108 on Tuesday, according to Mt. Gox data.
"If I really sat down and thought about writing a financial disclosure statement, I could probably list dozens of risks," said Union Square's Mr. Wilson.
Carol R. Van Cleef, a partner specializing in emerging payments and anti-money-laundering-compliance at Washington, D.C., law firm Patton Boggs LLP, said government financial reporting regulations likely will make it difficult for virtual-currency startups. The Financial Times reported on Monday that the Commodity Futures Trading Commission is discussing whether Bitcoin might fall under its regulatory jurisdiction.
Regulation is "going to force some players out of the market," Ms. Van Cleef said. Others, she added, "will bite the bullet and become compliant. But it will be expensive."
That isn't stopping venture investors. Jeremy Liew, a partner with Lightspeed Venture Partners, which has invested in three virtual currency startups including OpenCoin, said he's "incredibly bullish" because it allows for cost-free micro-transactions—such as buying a single candy bar—that would be too small for other electronic payments.
"The appeal of zero transaction costs is really strong and extremely disruptive for a massive industry, the payments industry," he said.
Chi-Hua Chien, a general partner at venture firm Kleiner Perkins Caufield & Byers who found the Facebook FB -2.47% investment while previously working at Accel Partners, said his firm is actively exploring investments related to Bitcoin and has already looked at more than two dozen such companies.
Mr. Chien estimates almost 100 companies are operating in the Bitcoin domain, including exchanges, payment processors and Bitcoin ATM machine operators. "It is completely crazy that money is not borderless," he said. "This is super-logical."
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