Initial Coin Offerings: Why SMEs must look before they leap

What is an ICO?

At a basic level, an initial coin offering is essentially a fundraising mechanism. It allows new projects to sell their underlying crypto tokens in exchange for cryptocurrencies such as bitcoin and ether*. 

To break this process down into its constituent steps, first, a start-up can create a new cryptocurrency or digital token via a number of different platforms. That’s what we mean by tokenization. Then the company will eventually do a public ICO where retail investors can buy the newly-minted digital token with established cryptocurrencies like bitcoin or ether. 

Thus, the process is somewhat similar to an Initial Public Offering (IPO) in which investors purchase shares of a company. However, there are important distinctions, the most critical one being that unlike an initial public offering (IPO) – or even venture capital – the investor does not gain an equity stake in the company. Instead, the ICO holds out the promise that the coin can be used on a product that is eventually created, thereby funding a potential innovation that will have a high market value. But, each ICO also shares the common hope that the digital token will appreciate in value itself and can then be traded for a profit.

Figure 1: ICO vs IPO

Credit: OECD's report titled 'ICOs for SME financing' released in Jan, 2019

This also leads us to the fundamental issue with ICOs - the fact that most of them raise money pre-product, making the investment very speculative and risky. However, there is no denying that ICOs are useful in incentivizing protocol development as this is typically the stage of business at which entrepreneurs have historically struggled to convince traditional financial institutions or even venture capitalists to fund their nascent projects.

* The native currency of a popular blockchain network called Ethereum, which has a toolkit that lets a company create a digital coin.

When did the first ICO take place?

In 2013, the ICO market suddenly burst upon the scene with several projects using digital tokens to try and fund their product development efforts. One of the foremost names, Ripple, pre-mined 1 billion XRP tokens and sold them to investors in exchange for fiat currencies or bitcoin. Next, Ethereum raised a little over US$18 million in early 2014, propelling it to the status of the largest ICO ever completed at that time, and laying a robust foundation for a blockchain network that currently sports the second largest cryptocurrency in the world by market cap.

Figure 2: History of ICOs

Credit: www.blockchainhub.net

Then, in 2016, along came DAO, the first attempt at fundraising for a new token on Ethereum. A form of investor-directed venture capital fund, DAO promised to create a decentralized autonomous organization that would fund other blockchain projects, and, most importantly, one where governance decisions would be made by the token holders themselves. While the DAO was successful in terms of raising money — over US$150 million — an unknown attacker was able to drain 3.6 million ether (estimates put the value at over US$60 million) from the organization because of technical vulnerabilities. 

However, even though the first attempt to fund a token safely on the Ethereum platform failed, it still managed to pave the way for other start-ups to raise capital in a far easier manner than the usual venture capital model. Indeed, never before have pre-product start-ups been able to raise this much money and in this little time. For instance, in 2017, start-up Basic Attention Token, a new, blockchain-based digital advertising and services platform, raised US$35 million in only 30 seconds! It is no surprise then that with few regulations and such simple functionality, the ICO climate has come under scrutiny from many in the community as well as various regulatory bodies around the world.

Risks posed by ICOs

While most articles and white papers focus on the regulatory uncertainty and arbitrage exploited by ICO issuers, an OECD report issued last month (‘ICOs for SME financing’) examines limitations in ICO offerings that go beyond these teething issues. Indeed, the report posits that pitfalls in the very design and structure of ICOs, issues related to authentication, disclosure and governance can lead to conflict of interests between founders and investors in token offerings. 

Figure 3: Key risks facing issuers and investors of ICOs

Credit: OECD's report titled 'ICOs for SME financing' released in Jan, 2019

First, the structuring of ICOs can give rise to conflicts of interest by the issuer, particularly given the ability of entrepreneurs to receive tokens issued on the back of a concept that is yet to be executed and without having taken any personal financial risk in the venture. In the absence of lock-up period requirements, the lack of any "skin-in-the-game" from the entrepreneur can be a rife source of conflict, leading to pump-and-dump schemes. 

Secondly, ICO issuers and subscribers are exposed to volatility, especially due to subscribers who are driven only by speculation and have no intention of participating in the newly-created network. This makes it difficult for SMEs to exercise their own pricing strategy when tokens may be the only way to consume the product or service. 

Thirdly, the absence of disclosure requirements in ICOs adds to the information asymmetries inherent in early stage SME financing. In addition to the lack of transparency, difficulties in applying traditional valuation methodologies further prevent investors (particularly retail investors) from making rational, informed decisions and exposing them to undue risks. 

Finally, there is a lack of financial consumer and investor protection safeguards in ICOs. Investors find it difficult to potentially avail redress and compensation in a situation where coverage by bankruptcy laws is not assured, and the risk of fraud is high. Operational risks related to DLTs, cyber risk and data privacy issues expose investors subscribing to ICO offerings and SMEs issuing tokens to significant risks. 

Benefits of ICOs

This is not to say that the ICO movement is entirely without merit. It is abundantly clear from many cases of successful start-up fund-raising efforts that ICOs enabled by Distributed Ledger Technologies (DLTs) and the blockchain have the potential to offer a new way to raise capital for projects. This funding mechanism benefits from efficiencies, cost savings and speed of execution, if appropriately regulated and supervised. 

Figure 4: Why ICOs are good for SMEs

Credit: OECD's report titled 'ICOs for SME financing' released in Jan, 2019

Further, regulated ICOs can be a more inclusive financing vehicle by allowing small retail investors to participate in the financing of businesses and start-ups. Depending on the type of rights assigned to ICO tokens, companies can raise risk capital without sharing ownership, thereby addressing one of the main impediments to the use of public equity financing – dilution of owner stake. 

Finally, SMEs are granted direct access to an unlimited investor pool, with the liquidity of tokens issued in ICOs being one of most important benefits of ICOs when compared to conventional start-up financing mechanisms such as VC funding.

The jury is out…

Most simply, there is no one-size-fits-all approach to the ICO market. Although ICOs are being hailed as a mecca for SMEs and a one-stop solution to SME financing gaps, ICOs are, by nature, not the right solution for every project. 

The OECD report highlights in particular that a differentiation should be made between blockchain-enabled projects or products/services and businesses or products/services that are not blockchain-enabled, as the former has a higher chance of benefiting from an ICO offering.

Figure 5: ICOs for blockchain ventures 

Credit: www.blockchainhub.net

It goes on to state that ICOs are particularly beneficial for products and services that are founded on the basis of a network. Token issuance allows for quicker adoption of the product/service and the creation of a customer-base before the launch of the project. 

“Most importantly, maximising value creation through the network effects present in newly-created networks of investors purchasing tokens is one of the major comparative advantages of ICOs when compared to other forms of financing. In the absence of a business model that can benefit from such network effects, launching an ICO offering may not be a viable and sustainable financing solution,” concludes the report. 

So, it is clear that SMEs must look before they leap into the ICO market. While it may be tempting to surf the new wave of lightning-fast fundraising by dealing in easy-to-use cryptocurrency, the creation and sale of digital tokens must not be taken lightly. To conclude, a network-based start-up with advanced product development efforts and the need to generate a pre-production buzz around a proposed innovation is best suited to use ICOs to leverage the consequent network effects and deliver real value to its investors.