The Rise of Security ICOs
Juan Villaverde is an econometrician and mathematician devoted to the analysis of cryptocurrencies since 2012. He leads the Weiss Ratings team of analysts and computer programmers who created Weiss cryptocurrency ratings.
Since early 2017, the Initial Coin Offering (ICO) marketplace has been growing at an unstoppable pace.
Even in 2018, in the midst of a crypto market that’s been mostly bearish or dead, new startups and companies are tapping into ICOs for funding in massive quantities.
I’ve personally spoken with many startup teams, always asking them WHY. Their explanation for this phenomenon is simple: There’s simply no other way they could get funding for their projects. Not from angel investors. Not from traditional venture capital. And not via an Initial Public Offering (IPO).
Look: The crypto markets as a whole are MUCH better capitalized than any individual startup fund. So projects that would struggle to raise a few hundred thousand dollars from traditional sources can expect to raise tens of millions in a successful ICO campaign.
This is a game-changer for the world of startups and investments. The capital is more abundant and more accessible. Plus, the independence that founders can enjoy is unprecedented in the history of finance.
They get both vast liquidity and great autonomy.
This also raises serious issues about proper disclosure, investor protection and regulation. And we will address these in another context.
Right now, I want to focus on another problem that many of these startups have encountered: In order to do an ICO, they need to sell a token. And this token must somehow benefit from the growth of their business.
Look at it from the perspective of a skeptical investor. You see countless ICOs with very capable teams and intriguing ideas. But you see no reason to buy their token. Why? It’s not because you don’t believe in their project. Rather, it’s because you see no connection between their token and the success of their business.
Moreover, in many cases, the token can actually become a barrier to adoption:
The companies twist the arms of prospective customers to go to an exchange and buy their token — typically a highly speculative, illiquid asset.
They then have to twist the customers’ arms again to use the tokens for the purchase of goods and services the company offers.
End result: Virtually no one buys the token. Virtually no one buys the product.
And after a period of hype, even those buyers they do manage to shoehorn into the program may often decide to sell out — frustrated by the poor investment performance.
The big disconnect: When you buy an ICO token, you do NOT get a share in a startup.
You may think you’re getting a piece of the action. But you’re not. All you’re buying is a “utility token” that might be, in some vague way, interwoven into the startup’s business model.
Here’s the issue in a nutshell:
ICO investors may think they’re buying SHARES in a company. In reality, all they’re getting is the crypto equivalent of coins distributed by Chuck E. Cheese, the national pizza chain.
Sure, the chain may be a lucrative business. Yes, it has stores all over the USA and around the world. But that doesn’t have anything to do with the value of its Chuck E. Cheese tokens.
The coins aren’t investments to begin with. They’re strictly meant to be spent — exchanged in store to play games, claim cheap prizes or just buy more pizza.
Solution: These tokens need to become SHARES in a company — e.g., security tokens. THAT’s the next giant step forward in the evolution of crowdfunding technology. Go back to the beginning and you’ll see why …
A Brief History of ICOs
The first type of “ICOs” were plain-vanilla donation campaigns on sites like Kickstarter.
When it first began, I was fascinated by the idea. You could raise, say, $200,000 from tens of thousands of people contributing as little as one dollar.
And suddenly, the world woke up to the power of the internet to raise funds in a decentralized way:
• No exchange listings.
• No big fees by banks and their lawyers.
• Just a website, a presentation and a “Donate” button.
• All with direct, person-to-project transactions!
Kickstarter proved there was something to this idea of raising funds directly from the crowd. But there were major flaws:
• The contributions were mere donations. You’d get nothing in return, except maybe a free mug, a T-shirt or even just a “thank you!”
• Once you contributed, there was no secondary market to buy and sell your donation. No way to value the investment or even transfer ownership.
Then came the token phase, and it completely changed the formula: If you get a token for your contribution and the project succeeds, your contribution should rise in value.
Moreover, the simple introduction of a tradable token allowed fundraising campaigns to raise millions instead of thousands. And, now the market has spoken loud and clear:
• Kickstarter has raised $3.6 billion in total since 2012.
• In contrast, ICOs have raised $17 billion just in the first half of this year.
SERIOUS problems persist.
As I said, when you buy a token, you don’t get a share in the business.
You get no shareholder rights, no recourse should things go wrong. Projects get away with raising millions of dollars with no strings attached. Most fail. And among many that succeed, some quite literally run away with other people’s money.
Heck, even many of the legitimate projects usually have to bend over backward to figure out a way to make a token fit their business model. Some end up failing precisely because they didn’t have a fit for the tokens to begin with.
Now, this is all set to change with the arrival of Security ICOs.
With an ICO that’s clearly a security (like a stock or bond), every business with a new idea can tap into the growing pool of liquidity provided by crypto markets. If you’re running a small company, you just sell a part of the company through a token offering.
That offering can come with the promise of dividends, voting rights for token-holders and, most important, accountability to investors.
Some takeaways …
Security ICOs are the next step in the evolution of crowdfunding.
They simplify the business model for a startup, helping to raise capital through crypto markets.
They align the incentives of token-holders with those of the business itself.
They also allow businesses to create entirely new governance models using smart contracts for automating their operations. For example …
1. Instead of quarterly dividends, companies can choose to share a portion of their revenues in real time. They can drop it directly into the accounts of their token-holders.
2. The entire voting mechanism can be automated; some key roles within the company can be voted on by the token-holders. This has the potential to make businesses more democratic than considered possible today. Management would retain control only as long as they maintain the backing of the community. As soon as they lose that confidence, out they go.
This is coming to the ICO space soon. And the end result could be to transform a marketplace that’s currently in the billions of dollars into one that commands hundreds of billions of dollars, if not trillions.