by Dmitri Boreiko
Every business venture, be it a single entrepreneur or a large corporation, needs financial resources in order to make investments, support the current operations and ultimately to create value to the owners, thus generating domestic output and benefiting all the society. Every standard undergraduate-level corporate finance book teaches that the financing comes from three sources – internally generated funds, external borrowings from financial markets, and equity issues.
Focusing on the start-ups, entrepreneurial ventures (EVs) and small and medium enterprises (SMEs), rarely is the internal funds are sufficient to finance their investment projects. Since the business profits are highly procyclical, this is especially true during the economic downturns. Indeed, up until recently, the finance-hungry entities had only two possibilities – to borrow from the local bank or to sell part of their companies to outside investors, i.e. venture capitalist (VC) in case of the start-ups and institutional investors or general public in case of the SMEs, although the later was rarely an option for a relatively small company.
The rapid technological changes, internationalization and advent of the Fintech in the financial industry, and its inability to adapt rapidly to the ever-changing and more volatile needs of SMEs and EVs, have led to unheard before, new and innovative financing methods by which the capital from financial markets is funnelled to the corporate borrowers, bypassing or altering the conventional financial industry’s channels, that were severely adversely affected by the ongoing financial crisis started in 2007. In the ongoing research project (https://www.researchgate.net/project/Alternative-Finance-ICOs-as-new-financing-mechanism) we attempt to survey the modern ways of financing that are available to SMEs and EVs, who in many modern economies represent the driving force behind innovation and technological changes and also make up the largest part of the respective economies.
Hardly anyone has not heard by now the words bitcoin, cryptocurrencies, blockchain, or smart contracts. The new disruptive financial technologies (fintech, in short) threaten hardly-benign existence of the financial industry, attacked from all sides for its appetite for risk, introversion, red tape and reliance on too-big-to-fail idea. New fintech start-ups offer now a completely new paradigm of a financial intermediary instead of a conventional commercial or investment bank, stock exchange or other players. In this article we would like to introduce the new method of financing for fintech (and not only) start-ups which is termed Initial Coin Offerings (ICOs). Below is the brief account of the basics.
Initial Coin Offerings
The great and fastening stride of the Fintech revolution continuously transform once-static traditional financial industry and provision of credit in particular. A decade ago born crowdfunding was first regarded as unsuited and illegal for business lending, with subsequent post-factum acknowledgement by the regulating authorities worldwide that had to tailor the existing or develop a completely new regulation to already burgeoning market. A similar story is being happening with new innovative way of obtaining crowd financing. Similar to crowdfunding and conventional public offerings (IPOs) in some respect but fundamentally different in many others, unregulated by any jurisdiction, the initial coin offerings (ICOs) currently face a detailed scrutiny from the regulators worldwide with some of them ordering a complete ban on the activity (China and South Korea in September 2017), some issuing warning statements and still investigating the matter (US in July 2017) and some taking no particular stance.
ICOs in a nutshell can be considered as an alternative form of crowdfunding financing that has emerged outside of the traditional financial system. Since the essence of any ICO is to obtain the external funds for the company or project development, this represents a peculiar channel of new Alternative Finance (AF) market. The traditional financial industry representatives regard it as new version of the Ponzi scheme, the opponents of the fiat money treat ICOs as a new legitimate way of raising capital based on new digital-era “gold coin” equivalent – a currency “minted” and supported by the users for the users without the need for a financial intermediary. Notwithstanding the critique and being currently unregulated, the market is growing rapidly reaching large amounts of capital attracted and therefore deserves a closer look at its process and main actors.
The development of the decentralized digital assets (first Bitcoin, then other assets such as Ether and other assets termed cryptocurrencies) and associated transfer protocols (termed blockchains) allowed easy secure transfer and trade over the Internet without a centralized intermediary like a bank or an exchange. With the ability to virtually record everything of value and the blockchain revolution will challenge and disrupt present centralized business models and the financial services sector – the fact that is already has been acknowledged by global financial players who tacitly or openly study the technology adaption to the conventional banking business model. The blockchain protocol allows for easy creation of other cryptocurrencies that can be offered for sale to the interested investors, who can keep them or resell on the secondary market.
Most innovative start-ups in the Fintech sector, often at the stage of early project development and frequently working on the open-source based projects were facing difficulties securing funds not from banks, but also from usual early-stage financiers like VCs and angel investors and even from innovative crowdfunding platforms. The idea to attract the financing for growth in the form of existing cryptocurrency to be converted into fiat money to invest in a project and in exchange to offer a new, this-project-specific, currency that can be resold or used as a payment for services rendered by the issuer, was regarded first as a nonsense or as an elaborate scam. With the first ICO in 2013 raising meagre $500k and next two years witnessing only a handful of ICOs worldwide, in the year 2016 46 completed ICOs raised almost $100m and in 2017 by October 175 Fintech projects attracted $2.7b with 72 offerings still running and 113 more planned till the end of the year . General stat for all ICOs announced so fa is as follows:
Year – N of ICOs
2012 – 1
2013 – 2
2014 – 11
2015 – 9
2016 – 65
2017(till Oct) – 562!
Since the offering process entails issuing of a private cryptocurrency based on a developed or new blockchain protocol, most if not all businesses currently engaged in ICOs are coming from Fintech-related industries. Some of them do focus on gaming, gambling or adult industry but the large share of the issuers pursue the projects in financial services or high-tech industries. Around seven per cent of the ICOs claim to collect the funds to be used for investing as VCs or incubators of future Fintech start-ups. As an internet-based industry, many of them do not incorporate and represent a team of international developers without even disclosing the country of incorporation. The majority of companies come from the US, Russia or UK (Adhami et al. 2017). The ad-hoc developed practice envisages the production of an offering prospectus to the investors outlying the business model and other information about the invested project that the offering team is willing to disclose to investors. This is termed white paper in ICO jargon and sometimes contain little information useful for investors.
Since the ICO proceeds come in the form of the cryptocurrency, the identity of the investors is well protected and in theory impossible to find out. Whereas the first ICOs attracted mostly retail investors or true proponents of the cryptocurrency revolution, the anecdotic evidence and the size of the recent ICOs indicated that institutional investors take part as well. Each ICO attracts around 4000 contributors, who participated in order to access the future services rendered by the project, participate in the project’s governance or future profits distribution or simply in order to obtain the produced coins (or tokens as they are called) for speculative purposes.
The token-allocation mechanism selected by the majority of the offerings is similar to the share allocation mechanism in the book-building IPOs where investors who subscribe to the successful offer see their holding dramatically appreciate after the official trading starts. Similarly, the ICO campaigns reserve advantages for early investors and are run as capped sales with a limited amount of tokens (like shares in IPOs) available for subscription with blockchain start-ups often granting discounted rates and other advantages for investors that purchase their crypto-tokens at an early stage. This represents a speculation possibility, used by sophisticated investors like hedge funds who cash out immediately after the closure of the ICO subscription. Whereas, the IPO underpricing is believed to serve as reward for information revealed during book-building (Ljungqvist, 2007), here such activity and ICO mechanism in general leads to abusive and an unhealthy practice for the long-term growth of the ICO market.
Unlike the conventional crowdfunding platforms that run the screening and monitoring of the borrowers, the role of the intermediaries in ICOs at this stage is confined to mere dissemination of the information and collection of the statistics. The ICO firms can run the process independently, using the social media, news aggregators and thematic dedicated websites, often rewarding the contributors with additional tokens for spreading the information and attracting new contributors. Whether, similar to modern crowdfunding platforms, the ICO-promoting websites will mutate to assume more functions to act as an intermediary between the issuers and investors remains to be seen.
ICOs are at present unregulated in all the jurisdictions. The things are changing swiftly with many countries investigating the matter and issuing provisional statements. As ICOs represent the collection of the funds from public investors, the most intriguing legal aspect is whether they represent the securities issues to general public and as such are subject to corresponding national regulations like provision of detailed offering prospectus, accounting and financial data and other rules put in place to prevent the abuse of the retail investors. Rohr and Wright (2017) summarize the ongoing discussion and discuss whether and which ICOs resemble security offerings and how to develop an optimal regulation framework. Additional aspect is the inherent anonymity of the parties to any cryptocurrency transaction and as a result potential misuse for illegal or heavily regulated activity.
Recently, China and South Korea have outlawed the ICOs, putting a ban on all future issues claiming the activity to be predominantly used as a fraud. Other countries took a more cautious approach, looking into the matter and developing a more measured judgement. Some countries like Switzerland and Singapore, support the innovative potential of the blockchain technology, trying to develop the rules to prevent ICOs and blockchain in general violating money laundering and terrorist measures, securities trading provisions, and national investment or banking laws.
….more information and updates can be found on the researchgate’s dedicated webpage referenced above.