Initial Free Offerings as an Alternative to ICOs
At the end of May, I decided to build 0xNIL in response to the ICO madness. In the following months, the more I thought about what such an experiment would mean, the more I became convinced that it indicates a new path for raising funds for token based projects. (If you missed my previous post introducing 0xNIL, you can read it here.)
What I suggest here is that it is possible to solve the many problems related to the ICOs using a different approach that can be summarized so:
If instead of selling your tokens you give them for free to your “early adopters” and reserve a certain amount for your project and team, whoever owns the coin will have the incentive of using your product and advertising it in hopes that it gains value, while you are firmly motivated to improve the product itself.
The many problems related to the ICOs
Tokens sold during an ICO are securities
In fact, they are assets sold with the promise of a future gain.
You can argue that in some cases they are utilities, but I would argue back that that is just a trick to try to avoid problems with the SEC.
Let me show an example with a hypothetical company:
During its ICO, dPark is selling 10,000 PARK tokens for any ether. In their white paper dPark says that the token is needed to pay temporary parking spots around the cities in the US, and that parking daily will cost ~10 PARK.
It is like paying in advance for a service that you think you will use. Let’s ignore the fact that, in the ordinary world, nobody would pay in advance for a service that doesn’t even exist at the moment of the payment. What would you do?
🤔 If you are an average person, you will probably buy 20 PARK just to give it a try.
🚗 If you genuinely like the idea and you are a frequent driver, you could buy 3,000 tokens to be sure that you can park for the entire year.
😻 If you are a real believer, maybe you can buy tokens for two years in advance, even if you don’t even know when the service will be operative.
👻 If you are crazy about dPark, you can send one ether and buy 10,000 PARK.
Why should you buy a million tokens in exchange for thousands of dollars in ether if the token is just a utility? Because
💰 If you want to invest, you take your risk, and buy a lot of tokens.
Unequivocally, tokens sold during an ICO are securities and, sooner or later, the SEC will take a strong position about it.
What if I am wrong and tokens can legitimately be utilities?
If your token is a utility there is a problem with taxation like Tyson Cross writes on Forbes:
The money raised in an ICO is taxable income. Unlike conventional methods of raising capital, ICOs do not qualify for tax-free treatment under the Internal Revenue Code. This means that the proceeds of your ICO will be considered taxable income by the IRS. […] It does not matter if you hold this cryptocurrency and do not convert it to fiat. In the eyes of the IRS, the receipt of valuable property is taxable income, regardless of whether it is ever sold.
Is there a need for me to explain why this is a big problem for any project?
Lack of motivation for founders
Whilst I am writing, ICO Alert lists 1028 recent (ended) ICOs.
Do you know how many projects in that list are either working or in active development? Do your research. The sad reality is that only a small fraction of them is still alive.
Is it all a big scam? I don’t think so. Sure, many scammers have taken advantage of the bubble, but many projects just die because the founders lack the strong motivation necessary to reach the goal of any startup.
In the traditional VC-funded world, a startup either bootstraps or raises a seed; if it gains traction raises a Series A, and after a couple of years a Series B. Sometimes raises a Series C, and even a Series D.
In any case, the founders have their money when the startup is either acquired or goes public. And not all the time.
This approach has been successful for many decades, because any founder is committed and very motivated to fulfill the company mission, even though it is not easy at all. Any entrepreneur out there knows very well the struggle, the stress, the courage that you need to succeed; you cross the hell because of your motivation.
In contrast, in an ICO the founders have their money when the project is often just a white paper. Why should they have a hard life for many years when they have already reached their personal financial goal? Don’t take me wrong; there are a lot of great projects founded by people that believe in what they are doing, like Aragon, District0x, Request Network among others. We cannot say the same of many more other projects that also raised millions.
You could state that the mortality is very high even with traditional startups, but in that case those who lose their money are professional investors who know how to manage the risk. With ICOs it is quite different 😧
So many scams
I believe that bubbles are very important because they create the condition to accelerate the innovation in ways that would be unthinkable otherwise. But bubbles bring many negative issues, starting from the abundance of scams.
The worst aspect with ICO scams is that, except that in very few cases, the fraud isn’t visible. In fact, there are so many projects that fail at the first difficulty, that it’s almost impossible to understand if that failure is accidental or premeditated. If you consider that people are ingenuously taking out mortgages to invest in cryptocurrencies, you see how dramatic the problem is.
Introducing Initial Free Offerings (IFO) as a better alternative to ICOs
The use case
dPark (see above) presents its white paper and prepares an initial free distribution of its token, offering it to the public. Those who want to participate must verify their identity with, for example, Civic (to avoid spam) and send 0 ether to the IFO contract to receive a fixed amount of PARK tokens. (Those users can be seen as the early adopters of a traditional startup.)
The IFO ends, and dPark distributes, let’s say, a million tokens. Another million is minted and allocated to the startup itself (35%), the team (13%), and the advisors (2%).
Later, dPark develops its product and uses the token to operate. Setting the cost for parking in some amount of PARK, the company is suggesting an initial price of the token and a market cap.
At that point, the early adopters have the tokens they requested during the IFO, any new user can buy the tokens either on dPark, or on any exchange that list it. This action will set a price for the token. In the future, the more dPark is successful, the more its token will gain value.
The advantages of such approach
No regulatory problems
The token can’t be considered a security because dPark is not selling anything, and any later selling of the token would be reasonably done in small quantities, like selling a subscription in the centralized world.
Whether dPark has raised funds before starting the free distribution, it’s expectable that a certain amount of tokens is allocated for the investors. If so, that specific part would be a security, but it would involve accredited investors and could be solved, for example, with a SAFT.
No initial taxation
Since the initial value of the token is zero, dPark does not have to pay any tax because it’s not selling anything. Only when they will sell some of those tokens, there will be a capital gain, and taxes to be paid.
Strong motivation for the founders
Like in the traditional VC-funded model, the founders have a good return for their efforts when the token has a good value. Since the token’s price will reasonably rise when the product grows, the founders are motivated to do their best because the more value the token has, the richer they will be.
No scams
Obvious: with a IFO there is no easy money to be stolen.
No initial costs for the community
The early adopters of the product are not paying to have their tokens. Sure, they cannot have all the tokens they could maybe want, but the ones that they have are free, and in such a quantity that would allow them to sell most of them in the future to new users. Basically, the startup is rewarding the early adopters to use the product and spread the word.
The cons
The company does not collect a crazy amount of money during the process. But the company can still raise funds the old way, or sell future tokens to investors adopting, for example, a SAFT.
Malicious users could very likely spam every free distribution hoping for a random future success. This can be solved implementing identity verifications, like, for example, 0x Protocol did during its ICO.
(BTW, I think that identity is the next big thing in the decentralized world, and there will be soon many solutions to address this issue.)
If the token gains value too slowly, the company could be forced to use its reserves and to inflate the market to sustain itself. That would cause a devaluation of the token with the risk of starting a mortal loop which could bring the token price close to zero.
Conclusions
While an ICO is an effective fundraising tool, an IFO is a robust marketing strategy, a win-win for all the participants if the product succeed.
The use case above describes one of the possible scenarios; it does not exclude other approaches based on free, or mixed, distributions.
When 0xNIL — which is a pure experiment and hasn’t any product behind it — will do its IFO (likely in the beginning of the 2018), it could generate a significant precedent that would open the road to a new trend in fundraising for decentralized projects. Regardless, it’s clear that the “conventional” ICO process is broken, and we need to think about feasible alternatives.
Thanks to Francesco Mosconi, Umayah Abdennabi, Gael Kanievsky, Andrew J. Chapin and Salvatore Gallo for reading drafts on this.
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