>Benjamin Gaines

Bottom Line Up Front

  1. Initial Coin Offerings (ICOs) are an emerging fundraising method
  2. ICOs are conceptually similar to Initial Public Offerings (IPO). Unlike IPOs, however, they are decentralized and unregulated by the SEC
  3. In ICOs, companies issue “tokens” in exchange for money
  4. ICOs are still new and are largely speculative. Potential investors should thoroughly research the space before investing

The cryptocurrency world has continued to gain investor attention over the last decade. Blockchain, once a fringe concept, is now a widely used technology. Most businesses have an idea of how blockchain works, and definitely have an awareness of “bitcoin.” Initial Coin Offerings (ICOs), however, are not as well understood. Given the amount of attention they are drawing, they merit more explanation and less hype.

The purpose of this post is to:

  1. Give a high level overview of ICOs
  2. Review common fundraising techniques
  3. Explain the purpose behind an ICO
  4. Summarize how ICOs work
  5. Highlight the pros and cons of ICOs
  6. Identify noteworthy examples
  7. Provide resources for further exploration

ICOs are fundraising method involving the use of cryptocurrency. Through an ICO, a company seeking to raise capital can issue “tokens” directly to investors in exchange for money, usually in the form of Bitcoin or Ethereum.

Companies benefit from this transaction by being able to bypass the regulation and inertia associated with more commonly used fundraising methods (which will be discussed in more detail later). Investors, on the other hand, are drawn to ICOs through of the possibility of high returns.

Opinions on ICOs vary drastically. They are considered a “revolution” by some, and a “scam” by others. This paper does not aim to offer any opinion, but instead a closer, objective look at the ICO market.

What are the common methods for startups seeking to raise money?

They best way to shape an understanding of ICOs is to address the question of why they exist in the first place. ICOs serve as a way for startup companies to raise money. This, of course, begs the question: what are the existing ways to raise money, and why are those methods not considered sufficient? Some of the more common ways startups raise money include:

  1. “Bootstrapping”
  2. Grants and/or business loans
  3. Crowdfunding
  4. Angel Investors
  5. Venture Capital (VC)
  6. Initial Public Offerings (IPOs)

“Bootstrapping” is a colloquial term used in the startup community to indicates when an entrepreneur starts a firm with little to no assets. To borrow from the age old expression, they are “pulling themselves up by their bootstraps.” Usually this means the entrepreneur needs to invest their own savings, or at least forego the salary they would otherwise be earning if they weren’t starting a company. There are, of course, obvious scale challenges with this method of operating. Often times founders do not have the available money to take needed steps for their business to grow, which is why they have to turn to outside sources.

Applying for grants and business loans is a common way of raising money, but not all companies qualify. Federal grants are often quite restrictive, as they are mostly reserved for funding companies within niche spaces of particular interest to the government (e.g. aerospace). Loans can be difficult to obtain as well; several young startups do not have enough credit or cash flow to meet standard application requirements. For those who do, the loan process can be cumbersome and the lending rates can be steep. Banks can charge in the 5-10% range, depending on the business, and alternative lenders like Kabbage and OnDeck can charge well over 15%.

Crowdfunding platforms like KickStarter, Patreon, and GoFundMe have become increasingly popular over the last fifteen years. These platforms allow individuals to post information about their business ideas and specific funding needs to open communities, and then enable others to contribute amounts towards the funding requirements. These websites are great for humanitarian or artistic endeavors wherein contributors are not necessarily seeking a return. But these websites are not as attractive to large-scale investors seeking to back an emerging company. Crowdfunding sites typically don’t allow for the negotiation of term sheets, which makes investors leery.

Angel investors and venture capital (VC) firms are attractive option for startups. The space has certainly been growing, but the probability of a given company receiving money through an angel investor or VC firm is often overstated. It is safe to assume that less than 10% of firms who are seeking VC or angel investors will receive it. For those that do, term sheets can still vary, and the entrepreneurs may not like their options.

Initial pubic offerings (IPOs) are the process of offering shares of a private company to the public for the first time. This is more commonly referred to as “going public.” IPOs are highly regulated and structured, meaning they are a better fit for mature companies than for startups. A thorough explanation of IPOs is out of the scope of this post, but a brief overview follows. It is worth noting the general steps of an IPO because the process can be used as a benchmark for thinking about ICOs as well (which will be covered further later).

  1. A team is formed with lawyers, SEC experts, underwriters, accountant and other subject matter experts
  2. A prospectus is created from data on the companies performance
  3. The companies financial statements are audited
  4. The prospectus is filed with the SEC and a date is set for going public

Startups who are mature enough to conduct an IPO are often still hesitant to do so for fear of losing control of their company. The fear is justified. Public companies have a number of limitations not faced by privately owned firms. One of the most significant limiting factors are the filing requirements by the SEC. Public companies are required to file annual and quarterly reports. These statements often keep management focused on short-term gains versus long-term value. They also increase the risk of company secrets being leaked to competitors. Public companies are also at risk for lawsuits, legal actions, and “hostile takeovers” that can substantially harm the company. Many startups simply don’t want this risk.

ICOs are used to bypass the rigors of traditional funding methods

One common theme from the typical fundraising methods is that they require some degree for proof of maturity in the company. For startups who only have an idea, and need money to develop the idea, this presents a challenge. Enter ICOS.

Through ICOs, startups (usually in the cryptocurrency space) can raise capital as easily as they could on a crowdfunding platform. That’s to say they can they can publish their ideas and funding goals directly to an open community without having to go through a bank or any other intermediary. In exchange for funding, the company will issue unique “tokens” to investors. The value of these tokens, like a stock, is tied to the success of the startup. If the company succeeds, the value of the token will rise. The possibility of high returns in this space is attractive for many investors, risky as it might be.

ICOs are conceptually similar to IPOs, but much more involved technically

ICOs are like centaurs. Up top, they look like something we are used to – sort of a blend of crowdfunding and IPOs. But down below, they are way, way different.

The tokens issued in an ICO are created on blockchain, usually on Ethereum. To investors, this is an important feature, because it guarantees the tokens they receive actually exist. All tokens are on a distributed ledger, and each has its own proof of work, meaning it is a unique and verifiable asset, regardless of how much it is worth. A brief overview of the overall process for an ICO follows:

  1. Create awareness
  2. Release a white paper
  3. Generate the tokens
  4. Choose a platform for the ICO
  5. Host the ICO

Generating hype around an idea is a big step for ICOs. Because they are largely speculative, investors first have to be won over by the merits of an idea alone.

In conjunction with creating awareness, startups also release a white paper to outline the specifics of their idea and how they will build it. White papers are similar to business plans, but tend to be more academic in nature. Broadly speaking, that’s to say they have a heavier focus on explaining details on technical concepts than they do how funds will be used. Whereas business plans focus on brevity, it is not uncommon for ICO white papers to reach the length of novellas. The Decentralized Autonomous Organization (DAO) white paper, for example, included over 25 pages of sample code.

Once startups have drafted a white paper and had it reviewed by subject matter experts in the cryptocurrency community, they then generate the tokens. In doing so, they have three major decisions:

  1. The amount of coins to issue
  2. The release date for the coins
  3. How long to hold the coin offering

Choosing a platform and hosting the ICO is a relatively straight-forward process. There are a handful of ICO platforms that operate similarly to sites like GoFundMe. (COINIST, for example) . These sites usually charge a fee for individuals to post info about their startup and the coin through which they are seeking funding. Potential investors can visit the site and choose which companies they want to fund and, in doing so, which tokens to receive.

The Good, the Bad, and the Ugly

ICOs have a number of benefits, namely:

  1. Easy for startups
  2. Huge possible returns for investors
  3. International reach

Compared to the alternatives, hosting ICOs is a relatively clear and easy process. It is also far less expensive than other methods of raising capital, especially IPOs. This, of course, is exactly why they have been so popular for startups over the last few years.

In 2017 and 2018, investors used their wallets to voice their opinions on the ICO market. The figures on investment in the ICO space were staggering. In 2018, over 2,000 ICOs reached their conclusion, which resulted in $11.4 billion being raised. In 2017, the figures were 996 and $10 billion, respectively.

International reach is a popular feature of ICOs. There are no barriers to investing in companies in other countries through an ICO, which has fueled their growth in regions with a strong tech presence.

ICOs: What’s lurking beneath the surface?

There are, however, risks to consider in the ICO market, to include:

  1. Scammers
  2. High risk of failure
  3. “Whales”

Not only are ICOs easy for startups; they are also easy for scammers, and there are several in the space. There isn’t much stopping someone from posting a bogus white paper, hosting an ICO, and walking away with a lot of stolen money. This was especially common in early 2018.

Even legitimate companies hosting ICOs in good faith and for good reasons are subject to failure. The plain reality is that majority of startups fail. This trend holds true for those in the ICO space as well. In fact, it is reasonable to expect that firms who used ICOs to raise money are more likely to fail than those who use other methods like VC funds or angel investors. Traditional banks, investment banks, VC funds, and angel investors all require proof of a company’s health or promise before investing. With an ICO, no such due diligence is required, meaning a firm seeking to raise money through an ICO could be an especially risky investment

“Whaling” is another problem with ICOs. “Whales” are essentially investors with deep wallets who offer high mining fees so they can get in an ICO ahead of others. They buy massive quantiles of a token early in its release, then resell it for a profit shortly thereafter. As a result, a lot exciting ICOs are not accessible to ordinary investors who cannot pay as much in mining fees early in the release of an ICO. This is surprisingly another similarity between ICOs and IPOs.

The strategy used by whales is quite similar to the strategy used by investment banks who help a company in an IPO. It is common for investment banks to buy large quantities of the shares for a company going public before they do so, then to sell those shares at a higher price early in IPO process.

There are also some “ugly” factors to ICOs:

  1. Not regulated
  2. Banned in some countries
  3. Not well understood

The unregulated nature of ICOs is attractive to some, and repulsive to others No side of the argument is clearly right or wrong. For some, the lack of regulation allows speed and flexibility in the funding process that can benefit both startups and investors alike. Others, especially investors, prefer to work in a well-regulated environment.

While ICOs are unregulated in the U.S., they are banned altogether in ten nations, to include China. This is not surprising given China’s strict monetary policy and remarkably repressive government. ICOs, and cryptocurrencies in general, are a major threat to such a centralized system.

Memorable ICO leaders & stories

There has been a lot of sensational ICO stories and memorable cryptocurrency pioneers over the last decade. Reviewing these stories highlights just how brilliant, dangerous, and even goofy the ICO world can be. A few fun examples include:

  1. Vitalik Buterin
  2. The DAO hack of 2016
  3. Wu Tang Clan’s Cryptocurrency

Vitalik Buterin is leading figure in the cryptocurrency and ICO community. A Russian-Canadian programmer, Vitalik is a cofounder of Ethereum, an open-sourced, blockchain based platform that facilitates smart contracts. He wrote the Ethereum white paper in 2013, at the age of 19. At 20, he dropped out of school to work on Ethereum full time. He has been incredibly successful in his work, and is considered one of the leading computer scientists, economists, and philosophers of our generation.

It is nearly impossible to look into the ICO space without hearing about the infamous DAO hack. DAO stand for the Decentralized Autonomous Organization. The DAO was a decentralized venture capital fund that raised $150M through their ICO in 2016. Less than a month after the ICO, however, $50M was hacked, resulting in a hard-fork of the Etherum network created by Vitalik Buterin. In short, the Ethereum network was split into two branches. The new branch of the network that was not hacked continued on as Ethereum, whereas the hacked portion of the network was renamed “Ethereum Classic.”

Its not hard to find silly stories in the Crypo world, but the C.R.E.A.M. (crypto rules everything around me) network token is a favorite. In late 2017, the Wu Tang Clan’s Ghostface Killah cofounded a group called Cream Capital, and then launched an ICO to raise $30M to create a network of Bitcoin ATM machines. The price of the coin has bottomed out since the launch of the company, but Cream Capital still exists.

Summary

Initial Coin Offerings are a relatively new method of fundraising. On the surface, they can be described as a hybrid of IPOs and crowdfunding. They are, however, much more technologically involved.

The Crypto space is home to some of the brightest talent of our generation, making it an attractive focus for investment. There are no regulations for ICOs, however, and the space is full of scams. Potential investors should proceed with diligence and caution.