IPOs, meet ICOs
Initial coin offerings offer funding alternatives
”Blockchain startup raises $35 million in 30 seconds.” This startling headline piqued my interest.¹ More research introduced me to the world of initial coin offerings (ICOs), also known as digital tokens, an online mechanism to raise funds using cryptocurrencies for blockchain startups.
August 16, 2017
A blog post by Ankur Gajjaria, senior analyst at the Deloitte Center for Financial Services, Deloitte Services India.
Everyone, including investors, entrepreneurs, venture capitalists (VCs), and regulators, seems to be taking note of this new phenomenon, which, as of end July 2017, has helped blockchain projects raise nearly $1.3 billion since the beginning of 2017.2
Digging deeper, I came across articles pronouncing these tokens in a divergent manner, from the “future of finance” on the one hand to the “Wild West” on the other.3,4
So what exactly are ICOs? How do they work? Let’s try to answer these questions first.
ICOs are a hybrid between crowdfunding and initial public offerings (IPOs), used for funding the development of blockchain-based projects. Startups can develop a technical paper that outlines their project and create a new cryptocurrency asset or token, which is used for raising funds in exchange for existing cryptocurrency coins, such as bitcoins or ethers.
However, unlike IPOs, where investors get ownership in the company, ICOs provide investors with tokens, which are of some value themselves or provide access to certain product/platform features representing some value.5 Imagine these tokens as membership or loyalty points to access digital games, movies, or songs, which can be redeemed for entertainment purposes or exchanged with the loyalty points of other platforms on a public exchange.
There are two key differences between the ICO and traditional VC model. Traditional VCs limit their investor pool to accredited investors and have a time-consuming due diligence process. Compared with traditional VCs, ICOs allow any global blockchain enthusiasts to take part in the funding process, and also allow them to transact their invested tokens on different platforms. This enables blockchain startups to raise money faster, and provides investors with multiple ways to exit or transact their investments.
Initial coin offerings in the fundraising ecosystem
As the appetite for cryptocurrencies increases, detractors point to three key limitations of ICOs: regulatory uncertainty, limited investor control, and lack of business use-case. In fact, the Securities and Exchange Commission (SEC) has warned investors of a limited recovery in case of an ICO fraud or theft:6
- First, ICOs currently lie in a regulatory grey area, as the tokens are, according to a recent SEC case, subject to securities laws when certain conditions are met.7 Until this recent ruling, ICOs did not have any fundraising limits or reporting requirements.8,9 This area is ripe for continued regulatory scrutiny and improved clarity.
- Second, ICO investors currently cannot control any strategic, operational, or financial actions of blockchain projects. Promoters of such projects do not have any legal or fiduciary obligations to use the ICO proceeds for the benefits of investors.
- Third, founders in most of these startups are usually blockchain enthusiasts, who specialize in technical and coding knowledge, but lack the business and management acumen required to grow and sustain a business.
Considering the pros and cons of ICOs, they have come a long way in the fundraising ecosystem. In fact, they seem to have become the preferred mode of funding for many new blockchain startups, raising nearly four times as much money as blockchain companies did from VC firms (as of July 28, 2017).10
ICOs are now aiming to establish a foothold in the traditional VC arena by funding online projects that use cryptocurrencies and even non-blockchain real-world projects. A number of online projects utilizing cryptocurrencies has raised funds successfully using the ICO approach. The projects include an online browser with a new advertising platform, an integrated social messaging platform, and a currency exchange platform.11 In other industries, ICOs are being planned or have been issued for a varied range of projects. These include building a chain of co-working spaces, constructing a zirconium dioxide plant, funding solar energy projects, and hosting concerts in California colleges.12
Founders in most of these startups are usually blockchain enthusiasts, who specialize in technical and coding knowledge, but lack the business and management acumen required to grow and sustain a business.
As ICOs evolve from purely blockchain applications to real-world projects, they could compete directly with traditional VCs. A key question to consider: Can ICOs challenge VCs as the preferred funding approach for real-world projects? In place of a substitute, ICOs can actually complement the VC model by offering startups with a very early-stage funding, to help entrepreneurs progress from the idea and business plan to product development stage. However, challenging VCs as the de facto funding option is difficult and would require greater clarity in regulations and investor safeguards to be in place first.
For more detail on ICOs take a look at this recent publication, Initial coin offering: A new paradigm. I will surely be keeping a close watch on the progress of the recent and upcoming ICOs.
1 Jonathan Keane, “$35 Million in 30 Seconds: Token Sale for Internet Browser Brave Sells Out”, Coindesk, May 31, 2017. https://www.coindesk.com/35-million-30-seconds-token-sale-internet-browser-brave-sells/
2 Jen Wieczner, “Cryptocurrency ICOs Are Making Bitcoin Startups Richer than VCs Ever Did”, Fortune, June 23, 2017.
3 Brian Patrick Eha, “Blockchain Tokens may be the Future of Finance – if Regulators Allow it”, American Banker, July 28, 2017.
4 “SEC Clamps Down on the “Wild West” of ICOs”, ICO Crowd, July 27, 2017.
5Jonathan Chester, “A New Way to Raise Money: The Initial Coin Offering”, Forbes, June 12, 2017.
6 US Securities and Exchange Commission, “Investor Bulletin: Initial Coin Offerings”, Investor.gov, July 25, 2017.
7 US Securities and Exchange Commission, “Investor Bulletin: Initial Coin Offerings”, Investor.gov, July 25, 2017.
8 Justin Gage, “The ICO Craze Has A Predecessor That Silicon Valley Is Ignoring”, Crunchbase, July 2, 2017
9 Stan Higgins, “SEC: US Securities Laws 'May Apply' to Token Sales”, Coindesk, July 25, 2017. https://www.coindesk.com/securities-exchange-commission-us-securities-laws-may-apply-token-sales/
10 Jen Wieczner, “Cryptocurrency ICOs Are Making Bitcoin Startups Richer than VCs Ever Did”, Fortune, June 23, 2017.
11Smith and Crown, “ICOs, Token sales, Crowdsales”, https://www.smithandcrown.com/icos/ as of August 3, 2017.
12Smith and Crown, “ICOs, Token sales, Crowdsales”, https://www.smithandcrown.com/icos/ as of August 3, 2017.
QuickLook is a weekly blog from the Deloitte Center for Financial Services about technology, innovation, growth, regulation, and other challenges facing the industry. The views expressed in this blog are those of the blogger and not official statements by Deloitte or any of its affiliates or member firms.