Initial Coin Offering (ICO) is becoming more and more popular in the last three years. According to Ernst & Young, a range between $ 4 bln to $5.6 bln as fiat equivalent has been raised in 2017 and according to ICOBench, until the end of 2018 almost $24 bln has been raised altogether with more than 5100 projects around the world.
Small and Medium-Sized Entities (SME) have the challenge to get access to capital markets as the investment is quite risky for traditional investment firms. Nowadays, ICOs are a famous application on finance in blockchain, opening an innovative way for SME to access financial markets even bearing in mind the uncertainty in the applicable regulatory framework. By doing an ICO, companies or the project team create tokens that grant the holder to access certain services, products or subscriptions. The digital tokens are used in exchange for fiat currency or cryptocurrencies such as Bitcoin or Ethereum. Thus, a central government authority like central banks or intermediaries (banks, brokers) are not needed generating efficiency gains in capital markets. The Initial Coin Offering allows SME to sell the tokens before the project is launched which is very similar to fundraising mechanisms.
Due to the development of ICOs and the increasing capital raised by these projects, the attention passed from “too small to care” to “too big to ignore”.
However, there is a big regulation debate as many tokens are scams and these markets are quite volatile. Furthermore, ICOs are currently in a bubble due to the increasing amount of projects in development. Organizing an ICO implies community building, technical expertise and foresight of regulatory compliance such as Anti-Money-Laundering (AML) and Know-Your-Customer (KYC) processes which is a challenge for many SMEs.
In order to understand how an ICO works, a briefly comparison with traditional finance mechanisms is shown:
ICOs are often compared with Initial Public Offerings (IPOs) probably due to similar terminology usage. Both, the IPO and ICO, establish public instruments in order to raise capital for a company. The main difference between the two instruments is that IPOs are conducted by mature companies with a proven operating business and healthy cash flow generation whereas ICOs are carried out by start-ups or only people with a project idea without a company incorporated. Thus, an IPO is an exit option to venture capital financing (A-D serie) and ICOs is looking for seed or early stage financing. Due to the structure, IPO financing is company-based while ICO financing is mainly project-based. Another major difference is attributed to the rights: An IPO is giving rights to the shareholder in the company depending on the type of shares issued. ICOs do not offer ownership rights but the right to certain services offered issuing tokens.
In both instruments the companies pre-sell a product or service that still has to be developed. Equity-based crowdfunding cannot be compared with an ICO as this one doesn´t confer equity rights. The investor decision to invest on equity-crowdfunding is financial-driven whereas the ICO motivation is reward-driven. An ICO doesn´t need an intermediary such as Kickstarter or RocketHub in a crowdfunding campaign. The ICO is more cost-efficient as there aren´t any correspondence costs. Furthermore, the reputational risk in ICOs is higher as a lot of projects are seen as scam while crowdfunding campaigns mostly select credible projects.
ICO vs. venture capital
Venture capital (VC) is a common instrument to access finance for start-ups as ICOs do. Both are financing vehicles for seed/early stage companies like for example FileCoin which raised 52 million USD thanks to venture capital investments. Venture Capital financing can be seen as a complementary to ICOs as many VC investors participate in ICO offerings. The main difference is that VC financing is extremely illiquid as it takes several years to exit unlike ICOs where the cash out can be immediately.
Summarizing, the ICO might be considered as an alternative for venture capital as start-up finance instrument which also can address the finance gap of SME. Due to the use of ICOs, SME finance can be democratized as no intermediary is needed. It should be noted that such a project needs technical expertise which limits the finance option mainly to the IT sector. But the regulation uncertainty is quite high and there is no investor protection. In order to analyze the project viability, investors should do a due diligence on the project team and the whitepaper which inform about the project and its terms and conditions.