Should You Consider an Initial Coin Offering to Fund Innovation?

ICO's can be an effective way to raise capital for your next venture, but they should be used with caution. Find out what you need to watch out for.

Written by
Emily Maxie
on
November 15, 2017
Filed under:
Blockchain

Are you considering turning to an initial coin offerings (ICO) to raise capital? It can be a unique way to fund innovation, but it’s not a simple as some people make it sound.

There’s a lot of hype around ICOs. Startups are raising millions of dollars in cryptocurrency overnight. By August 2017, the amount of money raised via ICOs had surpassed early-stage venture-capital funding for internet companies, CNBC and other news outlets reported, citing Goldman Sachs.

Some of the successes amount to little more than smoke and mirrors. However, many ICOs are legitimate, and their success could change the course of how startups are financed.

Perhaps the most interesting offerings come from existing companies with existing customers who are using ICOs to fund innovation and blockchain development. Only a handful of organizations have taken this approach so far, but the number is growing. It’s attractive, because ICOs can provide a massive injection of revenue. But often, the rewards are not worth the risk.

Before we start discussing the pros and cons, let’s start with an overview of what an ICO is.

Understanding the ICO

Think of an ICO as a hybrid of venture capital, crowdfunding, and an IPO. At its simplest, it’s just another way for companies to raise money.

Instead giving up equity in exchange for some VC funding (or, in addition to VC funding, as we’ll discuss later), these firms issue their own digital currencies, or tokens, that anyone can buy. Investors receive the tokens, which are equivalent to shares in the firm, in exchange for the money they invest.

Potential investors pay for that token using another cryptocurrency, like Bitcoin or Ether.

In some respects, it’s like buying stocks, except the company sells tokens, not shares. It’s similar to crowdfunding because ICOs provide a way to get funds from many different people in exchange for a share of the business. And transactions happen on a blockchain. (At the most basic, blockchain technology is a tool to keep data in a distributed, encrypted ledger – and control who has access. Because there’s no centralized repository, there’s no single point of vulnerability. That doesn’t mean it can’t be hacked. It’s just a lot harder. No single authority can approve transactions or set specific rules to have transactions accepted.)

A good example – suggested by TechCrunch – is this: A gaming startup pre-sells tokens to players. The players would use the tokens once the site is up and running. By selling tokens to its customers, the company helps ensure those customers are invested (literally and figuratively) in the company’s success.

For a health information technology firm, the “investors” might use their tokens to buy storage space on a blockchain-enabled electronic health record.

Tokens don’t necessarily represent equity as conventionally understood – but in a broad sense, they do. The more successful the company, the more valuable the token. And that leads to another comparison to stocks: Generally, the tokens can be traded on secondary exchanges.

The company establishes the initial price, but, via dynamic pricing, its value is ultimately determined by real-time market supply and demand.

An ICO for existing businesses?

There’s no reason an ICO can’t be used to facilitate many existing business activities. That’s actually starting to happen more and more. Existing businesses are turning to ICOs to raise capital. These are often called “reverse ICOs,” and sometimes “secondary market ICOs.”

Here are three examples, all of which, it should be noted, had previously raised traditional VC funding.

  • Messaging app Kik – launched in 2009 – raised $97.5 through its Kin token sale. Of that, $47.5 million came from more than 10,000 backers in 117 countries. The rest came from institutional investors, Tech Crunch reported. Kik calls Kin “one of the most widely held cryptocurrencies in the world.” It plans for the Kin token to be a tradable internal currency within Kik’s platform and ultimately, to be used as a currency outside of the Kik universe.
  • Gaming and eSports company Unikrn – founded in 2014 – took a similar approach with its UnikoinGold tokens. “This isn’t an investment; it’s a purchase of a product that we developed that has utility on our platform and our users love and demand. We already have users and adoption, and now the UnikoinGold token will unlock even more functionality and value for our community,” says CEO Rahul Sood.
  • Thai fintech start-up Omise – founded in 2014, raised $25 million in an ICO to develop a decentralized payment platform. With that July ICO, it became, according to TechCrunch, the most established tech company to date to launch an ICO.

Is this something you need to consider? Let’s weigh the pros and cons.

Pro: Cheaper, with less hassle

ICOs allow startups – and increasingly, other companies – to raise capital without the hassle of an IPO or dealing with VC firms. Because ICOs allow a business to create its own token-based economy, that business can bypass traditional bank and venture capital funding. Moreover, IPOs – and even crowdfunding – can be a paperwork headache. In comparison, all you need to do take part in an ICO is create a white paper detailing your project. That’s not only easier – it’s significantly cheaper.

Pro: Exposure to new investors and potential customers

ICOs “democratize venture financing,” to borrow a term from Taizo Son, CEO of the Japanese venture capital firm Mistletoe. They give individuals access they may not have had in the traditional venture capital space.

An ICO’s liquidity makes it attractive to nontraditional investors. Investors can cash in and out whenever they like. This, however, could be changing; some ICOs this year locked up tokens so they couldn’t be sold for up to a year, TechCrunch reports.

Along those same lines, an ICO can be a way to gain exposure to new customers and users. The hype around the ICO market draws attention. As a bonus, companies can position themselves as forward-thinking, something that’s especially important in the tech sector.

Con: Network congestion

The blockchain can be slow. For companies used to real-time transactions, the blockchain is bound to be frustrating. According to a March 2017 Bloomberg article, the number of transactions awaiting verification is more than five times greater than it was a year before. ICO activity, in particular, can make this worse, warns Ameer Rosic, CEO of Blockgeeks. He points out that during the Status ICO – which raised $100 million – the backlog was so great many potential investors couldn’t complete their transactions.

Con: The inevitable correction

Despite the huge surge in ICOs, and the corresponding rise in cryptocurrency values, experts expect a correction as the market slaps some sense into overly enthusiastic investors. When the correction comes – and it will – many of the firms buoyed by ICOs won’t remain standing. In fact, one expert, Nicolai Oster, head of ICO for Bitcoin Suisse AG, predicts a correction before the end of 2017. Others share his view, expressing concerns about over-tokenization.

While some predict correction, others predict catastrophe. Of course, some of those more dire predictions come from those with investment in the status quo. Case in point, JPMorgan Chase CEO Jamie Dimon is on record stating he’d fire any employee trading Bitcoin for being “stupid.” The cryptocurrency “won’t end well,” he told an investor conference in August 2017. “It’s a fraud,” he’s quoted as saying.

Expect a correction. Expect to see many ICOs ultimately fail. But don’t expect ICOs to fade away like pet rocks.

“ICO 2017 class is full of junk. But they will evolve and ICOs 2020 and later will liberate fundraising from Wall Street and Silicon Valley," tweeted Naval Ravikant, CEO and a co-founder of AngelList.

During the evolution, expect uncertainty.

Pro and con: A geeky wild, wild West

No matter how mainstream cryptocurrencies, blockchain, ICOs, etc. are starting to sound, they’re still full of risk. A favorite metaphor among experts seems to be the “wild, wild West.” For some, that means a world full of possibilities. But for the unprepared, it could mean a world of hurt. And while it may sound like a mixed metaphor, the ICO world will appear like a geeky subculture to those more used to traditional businesses.

Until the regulatory questions are settled, the nature of ICOs won’t be settled either. And that leads to the most important unsettled issue of all.

Beyond pro and con: Regulatory issues

The ways in which governments will regulate ICOs – and more broadly, cryptocurrencies – could determine their future. Across the globe, regulatory agencies are taking an active interest in cryptocurrencies, and ICOs in particular. For now, it’s a gray area. As Fortune points out, tokens are deemed neither a security nor a currency. But that may change.

The U.S. Securities and Exchange Commission said in July that the country’s securities laws may apply to the sale of new digital coins. But the guidance is limited.

And remember Kik? It barred individuals based in Canada from participating in the ICO after Canadian regulators determined that its token, Kin, was a security.

And Rosic, the CEO of Blockgeeks, takes a dim view of regulation, arguing it will destroy ICOs. “Various governments may simply decide to start regulating the ICOs. If this happens then this truly could be the death of cryptocurrency. The whole point of cryptocurrency is the idea of decentralization and being outside of government control.”

There is some regulation now, and the lack of clarity makes things difficult for companies that want to move forward with an ICO. As bad as regulation is, uncertainty may be worse.

It’s not just the SEC

Concerns about money laundering and other criminal acts are also raising regulators’ concern. The Monetary Authority of Singapore said in a recent statement that ICOs are “vulnerable to money laundering and terrorist financing risks due to the anonymous nature of the transactions, and the ease with which large sums of monies may be raised in a short period of time.”

The entity monitoring this issue, FinCEN, is a bureau within the U.S. Treasury Department. FinCen enforces a set of rules to prevent money laundering. You might be familiar with their work on the banking side. It’s their rules that require financial institutions to record transactions, know who their customers are, and report suspicious activity to law enforcement.

One Boston startup, AirFox, voluntarily took steps to comply with anti-money laundering rules. They screened contributors before allowing them to participate in the ICO. This caused a delay for its AirToken ICO and removed nearly 5,000 contributors for concerns related to money laundering.

“The days of randomly taking cryptocurrencies from anyone for an ICO are over,” the company said in a recent Medium post. “In order to comply with the law in a more regulated crypto and token sale landscape, ICOs will now have to register and regulate token buyers.”

Weighing the options

So, should you consider an initial coin offering to fund innovation? The answer is a very, very cautions yes. An initial coin offering can provide a welcome source of revenue, allowing you to fund innovation and take your company to the next level.

But just because an ICO is faster and easier than traditional sources of capital doesn’t mean it’s easy. You need to be able to

  • Separate the hype from the reality
  • Understand legal, compliance and security challenges
  • Educate your team – from the C-suite down

Even in this “wild, wild West” atmosphere, missteps can land you in legal trouble – or, at the very least, tarnish your reputation.

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