ICO – A revolution in startup funding?

Posted by Adrian Haase and Julian Albrecht

April 2017

Most traditional financial institutions and investors are still getting to grips with Bitcoin and other cryptocurrencies, and their origins in blockchain technology. But before these new developments are discovered, transferred and perhaps even integrated into business models, the financing market needs to come to terms with more new players and financing facilities. Initial Coin Offerings (ICO) are the latest example of young tech ventures’ creativity and investors’ willingness to take part in an experimental, risky and (allegedly) unregulated financial innovation.

Here, and in two other brief articles, we answer three questions about ICOs:

  • What are they? (introduction)
  • Who needs them? (economic relevance)
  • How do they work? (legal implications)

It is no coincidence that the term ‘ICO’ contains echoes of ‘IPO’ (Initial Public Offering), which refers to the initial emission of a corporation’s shares on the stock market. Initially, ICOs were used for the development and market-placement of cryptocurrencies. Many of the best-known and most widely-used cryptocurrencies, such as NXT, Mastercoin, Ether and Factom, were launched with an ICO. In 2016 alone Smith + Crown counted 64 ICOs with a total investment volume of US$102 million.

The funding environment for startups and ICOs

Currently, startups need to incur liabilities to cover their financial needs, for example by taking out loans (debt financing), by issuing new shares in connection with capital increases (equity finance) or by using hybrid forms (mezzanine financing, convertible loans). ICOs do not fit into any of these categories. This is why:

  • Companies that issue cryptotokens do not usually incur any liabilities (≠ debt financing).
  • Shares and related shareholder rights (dividends, etc.) are generally not issued (≠ equity finance). In other words, cryptotoken-holders have the same influence on the startup as someone waving a banknote has on the policy of the European Central Bank: none whatsoever.
  • Cryptotokens cannot be converted into loan receivables or shares (≠ mezzanine finance, convertible loans).

Ultimately, ICOs are a hybrid form of financing located somewhere between crowdfunding and equity financing (venture capital). On the one hand, investments are generally made in an initial idea that cannot yet be reliably valued because of unsuitable rating criteria for ventures in the pre-incorporation phase. Like crowdfunding, ICOs often pose an emotional incentive to investors by enabling them to benefit from the product’s success. On the other hand, tradeable objects are issued which – similar to shares – at least to some extent symbolize the economic success and (depending on the ICO) grant certain legal rights comparable with rights under corporate law.

Progress of an ICO

To a certain extent, ICOs stand for one of the most original forms of corporate funding: the sale of a startup’s own product and the subsequent generation of turnover. The progress of an ICO also inherits components of the grass-roots democratic origins of the internet. In the pre-phase, the ICO’s initiators involve interested stakeholders, investors and enthusiasts on online platforms such as Bitcoin Talk or Reddit (project development). Next comes the main phase, which is divided into three parts. First, the initiators prepare and publicly distribute a white paper. This contains information on the project or the corporation (to the extent available), the required capital, the base currency (typically Bitcoin) and other administrative aspects. Second, the initiators will typically launch a large-scale PR campaign as a digital counterpart to an IPO roadshow. Finally, the actual ICO – the emission of cryptotokens – can begin.

What gap do ICOs fill?

Although some developments are purely coincidental, most developments in corporate financing are reactions to an existing funding situation. It is widely acknowledged that equity financing and venture capital financing emerged from restrictive lending policies caused by the lack of collateral held by most startups.

Unlike crowdfunding, which addresses investors’ more altruistic motives and enables the realization of projects that would not be commercial competitive, equity financing through IPOs or the issuance of shares is subject to multiple regulatory requirements. It is designed to establish the institutionalization of shareholdings in a company – an effect that founders and/or investors do not necessarily want.

ICOs offer a different option. By means of an independent currency, the ICO gives investors immediate access to the product and enables them to participate indirectly in the project – and its success – when the value of the cryptotokens increases. What’s more, the founders and initiators retain their decision-making authority in the early stages of the project, while generating new capital at the same time.

Challenges, domains and potential developments

Will ICOs become more than just a financing sideshow for Blockchain startups in their earliest stages (combined with high entrepreneurial risks for investors)? Or will they prosper into a flexible alternative in the financial market? That remains to be seen. In the next blog posts in our ICO series we will examine the economic relevance of ICOs and the legal implications.