Are ICOs the New Venture Capital?

 

Blog post by ELP Student Andy Walner (Computer Science | Class of 2019)

In 2017, a small startup called Bancor raised $150 million from investors around the world. Their product: just 40 lines of untested code, less than 0.04% as many lines as Bitcoin. Stories like Bancor’s have recently become possible thanks to Initial Coin Offerings (ICOs), the hottest new trend in the blockchain industry. In June 2017 alone, ICOs raised a total of $550 million for blockchain startups, more than all early stage venture capital (VC) funding in that month.

With ICOs rapidly growing in popularity as a vehicle for startup fundraising, the early-stage venture capital landscape seems to be shifting from what was once an industry dominated by private firms to a more publicly accessible opportunity in which anyone can get involved.

ICOs present a unique opportunity for startups to gain financial flexibility for a project without the need for founders to give up equity or power. But while the progressive ICO approach to funding has its advantages over the more traditional hands-on VC approach, it also comes with many questions and potential pitfalls for early-stage startups.

Why do startups love ICOs?

By going the route of an ICO, startups can bypass the rigorous capital-raising process required in the world of venture capital. Instead of making countless phone calls and sitting through fruitless meetings with potential investors, founders can jump straight to the task at hand: raising money.

More importantly, a startup can get a large number of people personally incentivized to promote their cause from the beginning by selling their coin. This coin has value that is directly linked to the success of the startup company; as the company grows, so does the value of its coin. Never before in venture capital could an early-stage startup grow a network at this scale of people personally invested in the success of their company. Venture capital firms can provide money and expertise, but ICOs have the power to immediately build a wide-reaching community of investors who all believe in the company’s purpose.

And to make things even sweeter in the eyes of a founder, they don’t have to give up any equity or power in their company. Coins that are sold don’t necessarily equate to voting rights or ownership in the company, which means founders get to maintain all the power, unlike when they accept an investment from a VC.

How do ICOs really work?

First, a blockchain startup will release a publicly accessible document known as a “whitepaper” which describes their startup’s purpose, how much funding they need raise during the ICO period, and how the funds will be distributed amongst founders and the company itself. If the startup is unable to sell their specified minimum amount of coins during the ICO period, all buyers are reimbursed for their purchased coins.

The incentive for investors is that they can purchase the coins at a low price during the ICO, and as the company grows, the value of that cryptocurrency increases.

When ready to sell, investors are paid out by converting their ICO cryptocurrency to a larger crypto like ether through an online exchange, which can then be converted to a fiat currency like USD.

Any ICO is considered a crowd sale, meaning that anyone is free to participate in the funding by purchasing the company’s coin.

One concern for buyers is that a fraudulent company would run an ICO and then take off with the money. In order to combat this and add legitimacy to their ICOs, many companies have been using publicly visible wallets to store their raised funds. These wallets (called “escrow wallets”) require multiple individuals to sign off before a transaction is processed using the money in the wallet.

That sounds too good to be true. Maybe it is.

Beyond raising money, ICOs do not provide all the same intangible benefits that companies gain with an investment from a VC. Venture capitalists tend to have strong industry connections and experience growing companies, which can prove invaluable to startups in their earlier stages. Many ICO-funded startups have already felt the pain of forgoing a traditional VC.

Security is always a concern that comes up when talking about cryptocurrencies. While the publicity surrounding an ICO draws in potential investors for the coin, it also draws in hackers.

Recently, blockchain startup CoinDash had $7 million worth of ether stolen after its ICO. The hacker later returned $3M of the stolen funds, but this represents an additional danger that comes with raising funds in cryptocurrencies rather than a fiat currency.

Tezos: a cautionary tale

Tezos serves as the perfect example of a company suffering from a severe lack of experienced leadership. Tezos raised a record-setting $232 million through its ICO in July 2017.

Following their ICO, the two Tezos co-founders had a falling out and accused each other of attempting to embezzle funds and take over control of the company. This conflict led to the two trying to remove each other from the board, and caused the launch of the Tezos network to be pushed back from November 2017 to July 2018.

Early investors of the coin are uneasy about the company’s future due to the lack of solidarity among the company’s leaders.

Some may say Tezos was doomed from the beginning, but the undeniable fact is that this type of event does not generally happen with companies backed by VC’s who help shape the company’s vision through hands-on mentorship and voting power.

Governments are stepping in with regulation

In July 2017, the Securities and Exchange Commission took notice of the large amount of funds being raised through ICOs, and passed a ruling that requires ICOs to comply with U.S. government securities transaction laws.

With this change, it is no longer so simple to create an ICO in the United States without understanding the legal aspect as well. However, companies like ICOBox offer services for launching ICOs that cover legal and compliance regulations, in addition to providing other services such as marketing and automatic escrow wallets.

Looking at a much more extreme example, China banned all ICOs within the country in September 2017, determining them to be “illegal and disruptive to economic and financial stability.” This event briefly hindered the cryptocurrency market, but prices quickly recovered and continued on to hit new highs for many cryptos.

While the current state of ICOs in China is uncertain following the recent rearrangement of Chinese Communist Party officials, the country’s leaders have made it clear that developing blockchain technology is an important part of China’s future. So, it would not be surprising if we saw Chinese ICOs declared legal again in some more regulated form.

So are ICOs the end of VC as we know it?

My answer to this question is yes, and no. The modern VC approach alone is not enough to adequately support a growing blockchain startup. The quick access and immediately committed user base that an ICO can provide is truly priceless.

However, traditional VC funding still has its clear advantages over a purely ICO approach. In order to reap the benefits of both VC and ICO, startups like Filecoin have introduced an “advisor” pre-sale which offers top VC advisors like Sequoia Capital and Andreessen Horowitz the opportunity to purchase coins for a lower price before the main ICO sale.

The presale approach has received some backlash, with the main criticism being that advisors get a much lower price for the coin than general public investors. The Filecoin founders specifically combatted this criticism by maintaining that advisors deserve a discount because of the value they will add to the company over many years, however some remain skeptical of this approach.

We are still in the earliest stages of ICO fundraising, but one thing is clear: VC is being disrupted in a big way. We can expect to see more and more companies adopt this hybrid VC-ICO funding approach.

Blockchain technology provides a vastly unexplored path for startup funding. In the near future we should expect even more technological advancements shake up the ways startups are funded as we head toward a new era for venture capital.