Note: This piece has been adapted from an article I wrote at Harvard Business Review called What Initial Coin Offerings Are, and Why VC Firms Care
How about raising $8.2 million dollars in less than 20 minutes without giving up a lick of equity as a startup?
That’s what a Blockchain startup out of Poland called Golem Project did a few months ago.
Imagine open sourcing all your software and structuring the company as a non-profit foundation bypassing the VC route, designing your own currency and assigning a value to it and selling it… raising millions – and imagine doing all this without having even built any software and just putting an idea down on paper – essentially offering vapourware with a bit of math and text on a few pages called a ‘whitepaper’.
Swiss foundation DECENT did just that recently, pulling in 5881 BTC worth some $7 million in today’s BTC-USD price.
Welcome to the new world of Initial Coin Offerings (ICOs) – a phenomenon born from the Bitcoin community that is rocking the venture capital industry, who are now beginning to take a good, hard look at this new financial instrument which has both its benefits and its disadvantages as well as threats and opportunities to their own business model.
Also known as token sales, this new fundraising phenomenon is fuelled by a synergistic convergence of Blockchain technology, new wealth, clever entrepreneurs and crypto-investors backing Blockchain-fuelled ideas that are raising funds by creating their own cryptocurrencies and offering discounted rates on digital assets before they hit the cryptocurrency exchanges – sometimes up to 40 per cent. The investors can then opt to cash out to a fiat currency early via Bitcoin or Ether or wait for the currency to rise.
In other words a digital asset is created, a value determined – and by consensus reached by investment, value is settled by a network of participants rather than by a central authority or government.
Cryptocurrency pricing fluctuation is largely pegged to the Blockchain project’s performance and can be determined and influenced by a number of factors such as meeting milestones – but the principle pusher is the news cycle (new deals, partnerships, etc). Profits are moot as almost all the Blockchain projects that have done ICOs are still in development. Utility of the cryptocurrency can also have impact, such as gauging if the coin just being used for fundraising and has no other purpose or does it play a role in the startup itself as a digital asset?”
Venture capitalists, who generally have been standoffish to the ICO phenomenon are now becoming more interested for a number of reasons. One is profits – cryptocurrency investors are making huge returns on not only Bitcoin and Ether but also emerging cryptocurrencies born from ICOs. Ethereum doubled in just a few days in March. Yes in three days, people who invested in Ether doubled their money. Some cryptocurrency investors are earning massive ROI in weeks and this fact is spinning heads.
Liquidity is the second reason VC are interested. Rather than tying up vast amounts of funds in a startup or Unicorn and waiting for the long play – an IPO or acquisition – they can see gains quicker in ICOs and pull profits out easily.
What traditional investors don’t like is regulatory uncertainty, high valuations and over-capitalization, lack of controls and lack of business use cases. And like any industry, the ICO arena has had its fair share of outright scams, pump and dumps and blatant Ponzi schemes. However much of the criminal activity is now being mitigated by self-organised crowdsourced due diligence in the community and external parties such as Smith and Crown and ICO Rating who perform deep analysis on the ICOs.
One VC is willing to buck the trend. Leading industry investor Blockchain Capital is set to raise its third fund via a digital token offering in the first liquidity-enhanced venture capital fund via a digital token called BCAP.
ICOs are the Wild West of financing – they sit in a grey zone where the SEC in the USA and many other regulatory bodies are still investigating. The main problem is, most ICOs don’t actually offer equity in the venture, therefore are outside of traditional legal frameworks when it comes to securities. They only offer discounts on cryptocurrency before they hit the exchanges after the ICO, therefore do not fit into the current definition of a security.
Secondly, they are global instruments, not national ones and they are funded using Bitcoin, Ethereum and other cryptocurrencies which are not controlled by any central authority or bank. Anyone can invest and they can even do so pseudo-anonymously. Currently there’s no Anti-Money Laundering (AML) or Know Your Customer (KYC) framework though some companies are working on that such as Tokenmarket, who has teamed up with the Stock Market of Gibraltar to offer KYC and AML compliant ICOs.
Detractors of the new funding schemes scream for structure and protection, point out the scams, demand more control and say without equity there’s not enough skin in the game. Meanwhile, proponents retort there’s a real need for freedom to invest outside the accredited system which sees the wealthy get wealthier and the door needs to close on the domination of Sand Hill Road in Silicon Valley and other VC and investors in the tech industry who have been making massive returns off the backs of entrepreneurs for far too long.
For Blockchain startups it’s a win-win – there’s no equity stakeholders breathing down their necks and there’s many feel there’s finally a solution for non profit foundations who want to build open source software to find capital. As they hold a percentage of the total cryptocurrency in circulation (usually 10-20 percent) they also have a vested interest in building more value.
The market cap for Bitcoin is now 20 billion dollars and half of that is allegedly owned by less than one thousand people, called Bitcoin Whales. Many are in China, but there are also hedge funds and bitcoin investment funds who hold massive amounts of Bitcoin. Most made their money early by buying or mining Bitcoin when it was under 10 dollars in the early days (2011-2013) . It’s now worth approximately $1200. They are currently the ones who make or break many of the ICOs. Some of the enormous profits they have made in Bitcoin are being channeled back into innovation as they seek to diversify holdings as well as support the ecosystem in general.
Over 270 million dollars has been raised in ICOs since 2013 according to Smith and Crown (not including the $150 million raised in The DAO which was returned). Since 2013 there’s been about two billion dollars invested in Blockchain and Bitcoin startups from the VC community. ICOs are becoming more and more popular for startups seeking to get out of the self-funding, bootstrapping starvation mode and avoid being locked in by venture capitalists and watching their equity drowned in a sea of rounds. ICOs are dominating the overall crowdfunding charts in terms of funds raised with half the top 20 raises coming from the crypto-community.
In a recent conversation with the author, MIT scientist John Clippinger described the vast potential of this new movement, which if unleashed beyond the cryptocurrency community, has potential to rethink the concept of network value:
“The efficiencies, economies, and rate of innovation, learning, and adaptation are orders of magnitude greater and faster when digitized. It is not an adjunct; it is a new reality of the fusion of the digital and the physical. Digital networks can be designed to accommodate different social and economic purposes and the value of the assets and currencies that they issue and exchange are dependent upon the trust and equity that is built up in those networks. If the network is very well designed, secure, trustworthy and effectively realizes some social and economic purpose, then its equity value will increase and so will the value of its digital assets and currencies. There will be demand to participate in that network, and as result, the equity value of the digital assets will increase.”
“One way of thinking about a crypto-asset is as a security in a startup, which begins with a $10 million valuation and becomes a $10 billion dollar entity. Instead of stock splits, the founding crypto-asset gets denominated in smaller and smaller units; in this case 1000 to one. Here everyone in the network is an equity holder who has an incentive to increase the equity value of the network. All of this depends upon how well the initial crypto-asset and its governance contract are designed and protected. In this instance, good governance, e.g. oversight, yields predictability, security and effectiveness, which in turn, creates value for all token holders.”
Richard Kastelein is the publisher of Blockchain News, Founder of Blockchain Partners and interim Chief Marketing Officer of Humaniq – a Blockchain startup focussing on banking for the bankless that is doing an ICO soon. He’s also on the steering committee of the Blockchain Ecosystem Network and is organising in event in London in July called CryptoFinancing 2017.