Blockchain in Crowdfunding and ICOs (Part 54)

Welcome to the 54th part of the 100-part series on Blockchain.

Most traditional business funding takes one of these three forms: self-funding, bank funding, or venture capital.

Need for crowdfunding

The problem is that for most people, self-funding is incredibly limited. Bank funding requires having an existing business that has good revenues and cash flow. And venture fund capital nearly always requires a product or service that has mass appeal. Traditionally, if you want to raise capital to start a business or launch a new product, you would need to pack up your business plan, market research, and prototypes, and then shop your idea around to a limited pool of wealthy individuals or institutions: banks, angel investors, and venture capital firms, thus, limiting your options to a few key players. This makes traditional funding either very limited or very hard to get for businesses and can inhibit growth even for products and services that have huge potential.

Crowdsourcing business funding has been one of the miracles of the modern Internet age. Crowdfunding allows businesses with really great products and service ideas to raise funds from a large number of people in small investment amounts. When it works, it can really give your business a big boost. By using crowdfunding platforms like Kickstarter or Indiegogo, you can access thousands of accredited investors who can see, interact with, and share your fundraising campaign. The 3 primary types of crowdfunding are donation-based, rewards-based, and equity crowdfunding.

Donation-Based Crowdfunding?is a type of crowdfunding campaign in which there is no financial return to the investors or contributors. Common donation-based crowdfunding initiatives include fundraising for disaster relief, charities, nonprofits, and medical bills.

Rewards-Based Crowdfunding?involves individuals contributing to your business in exchange for a “reward,” typically a form of the product or service your company offers. Even though this method offers investors a reward, it’s still generally considered a subset of donation-based crowdfunding since there is no financial or equity return. For instance, the maker of a new soap made out of bacon fat may send a free bar to each of its investors. Video games are a popular crowdfunding investment for gamers, who often receive advance copies of the game as a reward.

Equity-Based Crowdfunding:?Unlike the donation-based and rewards-based methods, equity-based crowdfunding allows contributors to become part-owners of your company by trading capital for equity shares. As equity owners, your contributors receive a financial return on their investment and ultimately receive a share of the profits in the form of a dividend or distribution. Equity-based crowdfunding is growing in popularity because it allows start-up companies to raise money without giving up a significant level of control to venture capital investors. And on the other hand, offers its investors the opportunity to earn an equity position in the venture. As the organization grows, investors get more returns.

Risks associated with crowdfunding

But there are a few risks associated with crowdfunding through today’s online platforms or social media, which are as follows:

(i) Fraud is perhaps the worst of the problems crowdfunding faces. Overly ambitious or inexperienced investors may not only channel support to the wrong projects but also expose themselves to unconditional fraud. Fraudsters use adulterated information that is hard to distinguish from authentic projects to conduct illegitimate fundraising. Despite the efforts of platform creators to filter out such fraudulent information, the concept of crowdfunding is an appealing target for expert and organized criminals. Online forums and social media are ideally suited for equity crowdfunding because they offer wide reach, scalability, convenience, and ease of recordkeeping. But these very features also make it easy for fraudsters to set up dubious attractive ventures to attract equity crowdfunding from investors. Investors who do not conduct due diligence on fundraisers before investing may end up losing their entire investment to fraudulent crowdfunded schemes.

(ii) Crowdfunding platforms can also be a safe haven for money launderers behind the facade of investors. In order to avoid detection from legal authorities, the criminals perform money laundering to create an illusion that the money they obtained from illegal activities originated from a legitimate source.

(iii) Some entrepreneurs even see their entire business model collapse before they even get a chance to start production. When their idea becomes popular on the crowdfunding platform, other experienced entrepreneurs get inspired and enter the market early with all the resources they have and rush to beat them to market with a nearly similar product. Even with copyright in place, you might only be giving more ideas and more inspiration to your top competition.

(iv) The other problem with crowdfunding platforms is empty promises. Modern crowdfunders typically contribute money in exchange for a promise. Depending on the contribution level, this could be a copy of the new product when it comes out or something more exciting. Unfortunately, those promises can be broken. Multiple highly popular crowdfunding campaigns have turned out to be scams. People never get the products they paid for months ago.

(v) Crowdfunding platforms are also vulnerable to attacks from hackers and cyber-criminals. There can be credit card or identity theft risks from a crowdfunding portal.

Blockchain- The solution

Blockchain technology can support and improve crowdfunding in several distinct areas:

(i) The distributed ledger in a Blockchain system would allow for accurate record keeping of all campaign activity: before the campaign starts, during the donation period, and after the campaign is funded. This level of visibility into a project helps all parties involved, including the fundraisers, investors, and platform administrators. Smart contracts can lock a part of the funds in an escrow. These funds will be released to the fundraisers only if they meet specific goals and milestones. This will ensure that investors can trust the fundraisers to deliver on their promises.

(ii) Blockchain technology also ensure digital identity verification to keep a check on fraud and money laundering. Know your customer or KYC verification process is one of the most important checks implemented to prevent fraud and money laundering activities. The KYC data of a lender or a borrower verified by financial institutions will be stored on the Blockchain platform. This verification aims to find out where a fundraiser or entrepreneur is from, whether their names are on defaulter lists of financial institutions, what kind of credit history they have etc. Blockchain technology creates an immutable, permanent record of every single transaction performed, which allows all transactions can be traced back and thus controlling fraud and money laundering activities.

(iii) Asset tokenization can mitigate the problem of empty promises made by fundraisers. Instead of crowdfunding to enable pre-orders of upcoming tangible products and waiting for weeks or months to receive the promised product, Blockchain could rely on providing utility tokens to provide investors with equity or some similar concept of ownership in the product. The utility tokens may offer investors several benefits, like a free product or discount, and these can be redeemed automatically in the future once the product is launched.

(iv) One of the drawbacks of a Crowdfunding investment is the lack of a proper and well-established secondary market, making it very difficult not just to early liquidate your investment if the funds are needed but also to have transparent and reliable pricing. But the Blockchain platform enables early liquidation of money and makes the funding process safe and completely transparent.

ICOs or Initial Coin Offerings

Blockchain crowdfunding is similar to other online crowdfunding platforms like Kickstarter, with the fundraisers posting their projects and then soliciting funds from a community of interested people who are interested in backing them. The fundraising organization can raise funds through Initial coin offerings or ICO. It differs from other online platforms in a way that the potential startups who are raising funds will make their own cryptocurrency to sell to potential investors. Initial coin offerings are offerings of this cryptocurrency in the form of tokens to the potential investors on a Blockchain platform in return for legal currencies or other cryptocurrencies like Bitcoin. These cryptocurrency tokens will be accounted for and kept track of by the Blockchain, which makes them immutable and impossible to forge. The tokens represent shares in the project, and these shares have the potential to increase in value over time if the company performs well. This is referred to as crypto-equity. The investors have the advantage of buying, selling, and trading of crypto-equity.

OpenLedger is one of the numerous projects that are popping up to apply Blockchain technology to the field of crowdfunding. When an organization wants to begin crowdfunding, it will release Initial Coin Offering (ICO) assets, which are the crypto equity. If the organization does well, these tokens can increase in value, as well as be traded on OpenLedger according to the desires and speculation of investors. The funds raised on the Blockchain crowdfunding platform are stored in a multi-sig account, but only one of three keys is held by the fundraiser. This ensures that a fundraiser can’t run off with the money, and it protects the investors. Also, this Blockchain crowdfunding platform aims to provide greater liquidity. Collected funds are held in escrow, allowing fundraisers to access them as needed and allowing investors to trade their shares back in exchange for fiat currency if they need it. This represents a more equitable blueprint than many current crowdfunding exchanges where the fundraiser holds the funds, and the investor is ultimately at their mercy once the money is handed over.

Many existing platforms are also planning to move their crowdfunding operations on Blockchain, including Kickstarter.

How does an Initial Coin Offering (ICO) work?

When an organization wants to raise money for the project through ICO, the first step is determining how it will structure the token.

Static supply and static price:?An organization can set a specific funding goal or limit, which means that each token sold in the ICO has a preset price, and the total token supply is also fixed.

Static supply and dynamic price:?An ICO can have a static supply of tokens and a dynamic funding goal. It means that the amount of funds received in the ICO determines the overall price per token.

Dynamic supply and static price:?Some ICOs have a dynamic token supply but a static price, meaning that the amount of funding received determines the supply.

When an organization is ready to offer an ICO, it announces the initial coin offering list, the date of launch, rules to follow, and specifics well in advance in a whitepaper. This helps investors to decide and be ready to buy the tokens in exchange for cryptocurrencies or other legal currencies on the said date. As soon as the investor buys the ICO, the money paid goes to a specific compatible crypto wallet address, and investors receive the tokens purchased in return.

If the money raised in an ICO is less than the minimum amount defined on the smart contract by the organization, the funds may be returned to the project’s investors. The ICO would then be deemed unsuccessful. If the funding requirements are met within the specified period pre-defined on the smart contracts, the funds become accessible to the fundraiser organization and is spent in pursuit of the project’s goals.

Difference between ICO and IPO

An IPO is used to describe the launch of a company on a stock exchange, also referred to as “going public.” The purpose of the IPO is to raise capital for the company by selling its company stocks to the public. On the other hand, ICOs sell coins known as tokens as a way to fund a specific project. The general idea is, that if the project is believed to succeed, the investor buys the tokens to fund the project beforehand at a discount, and he will be able to sell them later at a profit when the project succeeds.

In other words, unlike stocks, the tokens generally do not provide an equity stake in a company. Instead, most of the tokens provide their investors some stake in a product or service created by the fundraiser company.

Risks of buying or investing in ICOs

The potential earnings from investing in a successful ICO can be enormous. But the investors should also consider the following risks before deciding to buy or invest in an ICO.

(i) The cryptocurrency market is still under-regulated. Investors may provide false and misleading information to investors to raise funds from them. If the project fails, the fundraisers may run away with the investors’ money.

(ii) It can be challenging to get the full picture of the ICO returns before you invest. Many investors let themselves be tempted by the promise of tremendous returns by the fundraisers. Also, there can be a high risk that the ultimate value of the product/service will be far too low compared to the amount you invested.

(iii) The value of ICO tokens can be purely uncertain and subject to wide fluctuations. The hype of an ICO may also contribute to exceeding its actual value.

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Happy learning!