Initial Coin Offerings: The Future of Start-up Funding or Risky Businesses?
By: George Bashforth
Independent Non-Executive Director to Hedge Funds, Private Equity
After the boom and bust and boom of bitcoin, the next hot topic in the world of cryptocurrency is initial coin offerings (ICOs), an innovative form of crowdfunding that uses digital currencies as the investing mechanism for startups to raise capital. Built on the same blockchain technology that powers Bitcoin, an ICO involves a company selling digital tokens or coins, primarily ether or bitcoin, that enable investors to use the software or service that the start-up plans to produce. Through ICOs, funds are usually raised in about 30 minutes and investors are not given any stake in the company or voting rights. Once the ICO is over, the new tokens trade on one of the many cryptocurrency exchanges, and if the startup thrives and use of the token increases, its value will increase.
Since the launch of ICOs four years ago, ICOs have gained exponential attention and growth, enabling numerous companies to rapidly capture crowdfunding opportunities and allowing investors to diversify into cryptocurrency assets. Currently, on average, about 20 ICOs enter the market every month. According to a study published by Autonomous, a financial research provider, almost $1.3bn has been raised so far this year by start-up technology companies via initial coin offerings, a figure well above the $300 million made in previous two years. And while early ICOs mostly raised money for cryptocurrencies, cloud computing systems or core technology platforms, the list of current and upcoming ICOs suggests that they have become all pervasive in logistics, payments, banking, financial trading artificial intelligence, sports events, and augmented reality – in short, a truly diversified market.
There are several reasons for the popularity of ICOs. Firstly, ICOs provide efficient and low cost funding to promising start-ups or early-stage projects that is accessible to any participant across any geography reducing their entry barriers; secondly, they provide an investment opportunity in a new and disruptive technology to gain on future potential of blockchain while allowing the participants to diversify their current exposures in cryptocurrencies along with high liquidity. Unlike the case of initial public offerings, where much of the value is already priced in at the IPO launch, or even the traditional venture capital system, an ICO allows investors to not only become financial backers but also early adopters, since the investment coin’s long term value is in future products or services.
But despite the potential, investing in ICOs entails significant potential pitfalls and risks. Firstly, since the issuing of digital currencies has existed in a legal grey area outside the remit of securities law and in the absence of a framework of enforceable customer protection, the risks for investors are sizeable. Unlike IPOs, ICOs lack proper auditing of project funds and clear pricing mechanisms, increasing the risk of potential frauds. Perhaps the most noteworthy failure to date, that of a startup called the Decentralized Autonomous Organization (DAO) which sold itself as a sort of crowdsourced hedge fund, took around $150m of investor funds with it, after vulnerability in the code was discovered which allowed funds to be siphoned off by an anonymous attacker. Secondly, given the state of relative infancy of the industry, a review of market participants highlights how there are still no examples of “successful” ICOs with an established track record that are capable of generating real value for a sustained period of time. Finally, the surge in small unknown companies raising millions of dollars within minutes is raising fears of a bubble burst similar to the dot.com era.
The lack of transparency around the issuance of such coins has recently emerged as the foremost concern for both investors and regulators. In July of this year, the United States Securities and Exchange Commission (SEC) took a critical first step to rein in the growingly speculative bubble surrounding these start-ups when it issued a report concluding that such coin offerings should be predominantly classified as securities offerings, and hence mandated to fall under registration, disclosure and other requirements that apply to securities, regardless of whether those securities are purchased with virtual currencies or distributed with blockchain technology. The SEC warned that ICO promoters had skirted securities laws by issuing digital tokens on behalf of “virtual” companies, rather than selling traditional securities. Transfers of tokens are recorded in distributed ledgers called blockchains, and buyers pay for the instruments with cryptocurrencies such as bitcoin and ether. Predictably, the ruling’s effect has been chilling, with prices of existing digital assets immediately falling by 10-20 per cent on the news.
The future remains uncertain: while it’s beyond dispute that the technology surrounding cryptocurrencies is potentially powerful, it may be that blockchain start-ups needing funds will find that, with the additional red tape, coin offerings do not provide much advantage over crowdfunding, venture capital or even traditional initial public offerings of stock. As the industry grows, so will competition for investment: given how every startup has a different set of challenges and circumstances, while raising funds through an ICO may make sense for some, others would be best served by more traditional methods. Despite the buzz around cryptocurrencies their share of the total economy is very small, and it is fair to argue that this crowdfunding mechanism is still evolving towards more maturity, transparency and stronger market players. Pointing to the changing face of this industry, there is broad expectations that regulation and transparency will increase over time, as more mature professional and institutional investors and established venture capital funds and new infrastructure platforms that will provide technology to host ICOs for preliminary due diligence come into the market. Similarly, the recently enacted regulatory obligations are also seen as key towards bringing greater compliance and maturity within the industry.