Initial Coin Offering (ICO): Crowdfunding meets block chain

Legal/ tax and helpful subjects

New methods for crowdfunding and equity crowdfunding

13 minute read

The world of cryptocurrencies offers a new financing model: Initial coin offering (ICO). Although this form of financing is still in the crib, it has already caused a lot of commotion. News of yet another crowdfunding record is frequent since ICO-funding brings in three-digit million sums of investments for tech startups within a short period of time. But what’s the deal with the hype around ICO funding? Can it advance the areas of crowdfunding and equity crowdfunding?

 

An ICO funding is the combination of crowdfunding or equity crowdfunding with digital currencies. ICO stands for Initial Coin Offering, which infers the term initial public offering, the entry into the stock market. Company shares are also offered during an ICO; however, they are not in form of shares but in the form of coins from a digital currency (so-called tokens).

These tokens are a kind of digital voucher. Investors buy them either with an already established cryptocurrency (e.g. Bitcoin) or with a classic currency (e.g. dollar, euro, or yen). In most cases, the tokens serve as financing means for the project behind them. These are usually software projects that are based on block chains. After the ICO, these tokens are traded as new digital currency on the most common platforms and stock exchanges. ICO funding provides investors with the opportunity to get involved with a cryptocurrency before it is traded publically. If the financed project is successful, the value of the tokens increases rapidly as well.

ICOs are used by startups in the tech industry in order to work around the strict regulations of the financial market. As in crowdfunding or equity crowdfunding, they put together a pitch deck, in which they describe what problem they are solving and how they will do so. Then they determine a financing goal, in which they explain their financial needs to realize the project.

The amount of the tokens on offer is often limited, thus an ICO can be overdrawn when the demand is higher than the supply in the same way as in the offering of a company share. The founders keep a share of the tokens for themselves, just as they do in an equity crowdfunding. That way they have a strong financial incentive to lead their project to success. Another similarity to crowd investing and crowdfunding: when an ICO doesn’t reach its financing goal, the campaign is considered to have failed and the investors get their money back.

While classic initial public offerings (IPOs) are more similar to equity crowdfunding through the sale of company shares, ICOs are more similar to crowdfunding. This is because the supporters are often convinced of the idea from the start. Returns are not the primary argument for them, as these are far too speculative. The startups that count on ICOs often call it a donation that gets paid back with interest after a given amount of time, rather than an investment. ICOs are often closely tied to a technological development that comes from cryptocurrencies: blockchain.

 

Blockchain is a new technology in the area of software. It was developed initially to make the digital currency Bitcoin possible. There is a distinction between public block chains that any internet user can access and private block chains that are accessible only to a private user circle. The name is derived from the blocks of data that form a data chain. Every new entry is added to the chain as a block.

The data blocks of public block chains are visible to every user, which increases the transparency of the dataset in the event of changes. Every user can immediately see and track the activities within the network. Next to transparency, blockchain is known for efficiency and security. After all, the blockchain network is not stored within a single computer, but rather in the computers of all participants.

Similar to a cloud, the division of the blockchain network’s computing power drastically reduces the costs for computing operation. That way, it is also protected against manipulation: forgers would have to change all subsequent data blocks if they wanted to manipulate one single block. For this, they would need more computing power than all participants of the network – a rather hopeless undertaking.

Blockchain is applicable in many areas. The primary focus currently is on financial transactions in form of digital currencies like Bitcoin. Blockchain has drastically reduced transaction fees and enabled transnational payments within seconds. All transactions are recorded in the blockchain and visible to every user at every time. It thus serves as a form of decentralized cash ledger and provides evidence that a transaction was carried out.

The majority of blockchain pilot projects occur in the area of financial transactions. For example, the big clearing house DTCC is planning on transitioning the bulk of its derivatives business to blockchain. The Deutsche Bank also sees in blockchain technology a “paradigm shift in the existing financial system” and “one of the first truly disruptive ideas from the FinTech branch,” according to an article in the manager magazine.

Its usage is not limited only to financial transactions but can be applied in all areas that place great value on transparency and traceability.

 

Ethereum

The most well-known example of a successful ICO funding is Ethereum. Ethereum is a blockchain network for the implementation of so-called smart contracts. These are contracts that fulfill themselves when a predefined condition takes place – for example, a payment is automatically made when goods are delivered. Ethereum’s tokens are called Ether.

Ethereum’s ICO funding started in 2014. The project collected around $18 million, and the value of the new cryptocurrency settled at $0.40 per ether. When the platform went live in 2015 and the success of Ethereum was foreseeable, the share price increased rapidly. Currently, it is at $285 per Ether and Ethereum has a market capitalization of more than $26 billion.

Today, the blockchain application is popular in various areas. For example, the Australian agricultural company AgriDigital relies on the Ethereum network. Farmers can use AgriDigital to sell their crops to wholesalers and are paid automatically on delivery. This saves time and money in accounting because payments are no longer delayed. Smart contracts can also be used in the container shipping sector. When a container load is unloaded at the destination port, the payment would be released automatically.

Bancor

Bancor is a digital currency based on the Ethereum blockchain. The Israel-based startup behind it collected capital of around $153 million for its start – in a period of only three hours. Bancor collected the capital in form of 390,000 Ether. Sales began on June 12th. A total of 79.3 million Ether tokens were made during the ICO, around half of which were offered to the public for purchase.

The other half was held back for a future capital increase. More than 10,000 buyers participated in the auction. The startup was able to collect 390,000 Ether, more than their initial target of 250,000. An anonymous buyer invested the equivalent of $27 million in the startup. The renowned venture capital fund Draper Fisher Jurvetson is said to have been among the buyers.

The Israel-based startup wants to use Bancor to develop an improved software protocol for digital currencies. The currency’s liquidity is supposed to be increased by retaining a buffer in a reserve currency in the event of shortages. Furthermore, determining the crypto currency’s price should become more transparent and quick through continuous actualization by buyers and sellers. Accordingly, Bancor has named this new generation of cryptocurrencies smart tokens and wants to be a pioneer in this field.

DAO

The second highest ICO crowdfunding record is held by the investment fund DAO (Decentral Autonomous Organisation). It is an automated venture capital fund that invests in innovative startups. DAO does not have any management or employees; instead, its operation is fully automated. In the beginning, the company also refrained from having a physical place of business (later on, a place of business was registered in Switzerland).

DAO is based on the Ethereum technology and was developed by the brothers Christoph and Simon Jentzsch, to programmers from the college town Mittweida in Saxony, Germany. Both of them previously worked for Ethereum for a long time and thus knew all the ins and outs of the blockchain. At an ICO in May 2016, DAO set the equity crowdfunding record by collecting $150 million worth of capital in the form of the digital currency Ether.

The idea behind DAO is this: No longer should only a handful of powerful VC investors decide in what direction technology develops.  Instead, an electronic, fully automated, and decentralized investment firm should act as a holding company for both profit and non-profit oriented companies. DAO consists only of so-called smart contracts and an e-voting system.

With this e-voting system, every investor can use his or her voting rights – proportionate to his or her investment sum – to participate in the investment decisions of the fund. External access to the organization is not possible. This is to prevent DAO from being broken up or the company from being shut down. The investment fund will only be closed if all investors unanimously decide to discontinue business operations.

Aragon

Aragon is a software project for decentralized companies based on the Ethereum blockchain. The software is supposed to help managers run their companies more effectively. In order to accomplish this, all necessary processes of the company management, such as accounting, fundraising, payment of wages, contract drafting, and overview of the shareholder structure are bundled together in one application. This is supposed to increase efficiency and save costs. In May of 2017, Aragon broke the record of the quickest ICO financing. The startup collected around $25 million in the form of Ether tokens from more than 2,400 buyers worldwide within only 15 minutes.

 

This form of capital investment bears several risks for investors. For one, the purchase of cryptocurrencies is a speculation that the underlying technology will be successful. Furthermore, this area is completely unregulated, which is the precise reason that tech startups use it. They don’t want to deal with the often strict and complicated regulations of the financial markets or cannot bear the costs thereof.

Some scene observers are already afraid that US stock exchange regulators may soon use harsh means to crack down on ICOs. But so far there is no legal framework to do so. For investors, this entails a high degree of legal uncertainty. In addition, every area where money is involved and where there is no clear set of rules and regulations also attracts fraud. This, in turn, increases the costs of investors for possible due diligence.

Furthermore, ICO funding is currently in the grey area between crowdfunding and equity crowdfunding. The investors do not receive promises of returns; instead, they usually talk about donations and win over supporters as in a classic crowdfunding. Nonetheless, the early supporters naturally also speculate for return, since they profit from their early engagement when the price of the cryptocurrency increases.

In this way, it is similar to equity crowdfunding and venture capital. Another similarity is the entrepreneurial risk. If the project fails, the tokens are worth nothing. This form of capital investment thus bears the risk of a total loss. In most cases, investors do not receive a say in the business the way they do when purchasing shares.

Finally, cybersecurity also plays an immense role as demonstrated in the case of the DAO hack. A software gap led a hacker to steal $53 million worth of tokens from the virtual investment fund in June of 2016. Despite the fact that the DAO team had hired a cyber-security company from Seattle for such cases. Evidently, however, the hacker was an expert with in-depth knowledge of the Ethereum programming code. He abused a function that was actually intended to protect investors.

It allowed investors to take back their money if they were unhappy with an investment decision of the DAO. The hacker used this function to take money out of the fund. Due to the gap in the program code, the system didn’t notice anything until it was too late. This case caused such a commotion that it resulted in a split in the Ethereum community. In order to repair the damage, the source code was re-written – an absolute taboo for many supporters. Since then, two versions of the cryptocurrency exist – Ethereum (with changes in the source code) and Ethereum Classic (without changes).

 

ICO funding is a fascinating technological development with the potential of replacing traditional financing forms. It combines aspects of crowdfunding and equity crowdfunding (small sums by many investors, high transparency) with modern technology (blockchain, cryptocurrencies). To young tech startups in the blockchain field, it presents a real alternative to expensive and complicated financing via traditional capital markets because they can turn directly to technically versed supporters.

The amount of the financing sums shows that it really is a form of fundraising that should be taken seriously. A recent data survey by the US company The Control shows that ICOs provided young tech startups with more venture capital in the early stages between April 2016 and April 2017 than classic VC investors. According to this study, about $330 million were invested in blockchain startups via ICOs, while VCs invested only about $140 million.

ICO funds are also interesting for investors. This is demonstrated by the fact that more than $180 million were already invested in various ICOs in 2017. A year earlier, this figure was $101 million, as data from the financial services provider Smith + Crown show. The number of software projects financed is also increasing rapidly.

Expert investor Fred Wilson, co-founder of the venture capital society Union Square Ventures, sees the future in ICOs. Wilson, whose company already invested in Twitter, Tumblr, Foursquare, Zynga, and Kickstarter, is considered to be an early supporter of cryptocurrencies and calls Bitcoin and Ethereum the two “biggest and most disruptive ideas of the past ten years.” He believes that Ethereum-based ICOs, in particular, can take on Silicon Valley for the first place in terms of startup financing.

On the other hand, ICOs are a very speculative form of investment. Investors who are unfamiliar with block chains and cryptocurrencies should exercise caution with ICOs. The subject matter is very complex and it takes some time to read into the background.

The number of projects is growing steadily, so it can be difficult to keep track of them and separate the wheat from the chaff. On various information portals (e. g.: Coinmarketcap, Cryptominded or ICO-List), forums (e. g.: Reddit), marketplaces (e. g.: Coinbase or TokenMarket) and blogs (e. g.: Bitcoinblog, Coindesk or ICONewsblog) investors can gather the necessary information and investment tips.

Ultimately, ICOs are a form of venture capital. However, the lack of legal certainty (for now) presupposes a lot of trust and knowledge about the scene and sometimes increases the costs of a risk assessment. In return, this form of financing attracts extremely high returns if the underlying project is successful. ICOs could be an interesting alternative for risk-conscious early-stage investors who want to speculate with a small portion of their assets.


 


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