The Pros & Cons of Fundraising Using Blockchain for Startups
In June 2017, Kik made an unexpected announcement. The popular chatbot and messaging app platform is going to raise another funding round. And this time, the money will not come from venture capitalists. Instead, the company is announcing a public ICO (initial coin offering).
In short, anyone in possession of cryptocurrency can support Kik by trading it for the platform’s new bitcoin-like money called the Kin.
As the company’s CEO explained, they deem cryptocurrencies as a more beneficial way to monetize and sell virtual products. Typically, when building a new mobile app, developers choose either of the following monetization strategies:
- Sell their community attention to advertisers.
- Offer physical or virtual goods within the app.
Blockchain technology might be the new route towards better digital monetization. The currency will be used to reward both active community members and developers. For example, a developer can create new app stickers and sell those for Kin within the app. Game bonuses, group charts, gated content — all of these “virtual goodies” could be traded for Kin. Additionally, the company plans to incentivize app developers to build use cases (and hence the economy) around Kin by rewarding them with more Kin for their projects.
The question that bothers everyone right now is this — fundraising using blockchain is indeed a great source of startup funding or not?
In this post, we will explore how traditional crowdfunding through platforms like Kickstarter and Indiegogo has morphed into a brand new breed with the help of blockchain.
Remind Me, What is Blockchain?
Blockchain is the technology long promised to disrupt the financial world and, along with it, startup funding. It has traditionally been tied to Bitcoin, a cryptocurrency which is deemed “mysterious” for the vast majority. But it has branched out from Bitcoin as a new (and more secure) method of recording financial transactions and even funding contracts.
Think about it this way.
Blockchain is simply a different form of recording transactions. Traditionally, transactions are kept on ledgers (now digital) and held in secret by financial institutions and even typical crowdfunding administrators. The parties of a transaction have access to their own personal record (e.g. their own bank account transactions and balances) but not to any other transactions that may take place.
Blockchain, on the other hand, is an “open” ledger for all who participate in transactions. Each transaction is entered as it occurs and becomes a part of a “block” of transactions completed within a set period of time. These transactions are recorded permanently and cannot be altered once recorded. The entire history of transactions is maintained in a “chain,” and this can never be altered or modified.
What blockchain does is eliminate the intermediary in financial transactions, such as a bank and its accountant who hold the records for themselves. Can transactions be altered or modified? Yes, of course, although this is rare. Still, hackers have been known to do so.
In sum, blockchain ledgers have the following characteristics:
- They are publicly shared.
- They are “decentralized,” in that no single authority must approve and verify the transactions.
- They are secure, because records cannot be modified, and they are shared among all participants.
- They are automated, so that there is no chance of duplicating or conflicting transactions ever occurring.
So, what does all of this have to do with startup fundraising and securing investments? Read on.
When IPO Meets ICO
When a startup goes looking for funding, it has traditional methods, such as banks, venture capital, and even established crowdfunding sources. These are like mini-IPO’s, in which a founder might offer an equity position in his company or at least the promise of a return on investment. The investor then provides a certain amount of cash funding. Some of these investments have born fruit and venture capitalists have realized huge gains. Many of them, however, have not, and, especially with crowdfunding, the failure rate has been substantial.
It was inevitable that new ideas for fundraising would be generated, if only for those in developing nations who have no access to banks and other traditional sources. And these ideas came from the development of blockchain and cryptocurrencies.
At first, cryptocurrencies were established as alternatives to regular currencies and traditional financial institutions and industries. And they were initially considered little more than “fake money.” Gradually, however, they gained credibility, as Bitcoin, the first of such currencies, began to attract investors. Initially trading at $0.07 in 2010, it reached $2,500 in late June 2017.
The call for investors into cryptocurrencies came to be known as an ICO’s — Initial Coin Offerings.
Since Bitcoin, other cryptocurrencies have been developed, each funded with its own ICO. Ether, for example, the coin of the blockchain Ethereum, is now considered to be the next major currency, currently valued around $250.
ICOs work just like IPOs, although shares are in the form of the cryptocurrency tokens.
The point is this: cryptocurrencies have taken their place in the financial industry, holding real-world value and considered to be valid financial instruments — just like traditional currencies and stock. It is only natural, then, that startups might begin to look at cryptocurrencies for funding, and that is exactly what has happened.
The Case of Humaniq
To understand the value and power of crypto-funding, let’s take a quick look at Humaniq, a for-profit enterprise with a global purpose — reach those in developing countries with a banking system that uses biometrics, Blockchain, and mobile devices.
To raise funds, Humaniq developed its own initial coin offering with a cryptocurrency called the “HMQ.” It has already secured $5 million in investments (investments are now closed).
The implications for founders of any business are clear. Seek funding through ICOs, by developing one’s own blockchain or by using an already established one (Ethereum is a good option, as it also offers businesses unique initial currencies and “smart contracts” between founders and investors). Thus, the startup can cut out the middlemen with their higher fees and interest rates, and get the necessary funding.
There are Pros and Cons of Fundraising with Initial Coin Offerings
While ICOs are being touted as a great way to decentralize venture capital, thus creating new sources of funding for entrepreneurs and new investment opportunities for groups and individuals, the entire phenomenon is not without its challenges.
Before a startup dives headlong into and ICO funding adventure, then, it is a good idea to look at ICO pros & cons.
The Negatives of Bitcoin Crowdfunding
These are the concerns that seem to be most identified by those who are currently involved in ICOs and appcoins. They are cons of blockchain technology in fundraising that certainly need to be considered as real and current.
Lack of understanding regarding governmental rules and regulations, regarding investing and receiving investment capital.
There are legal risks involved in an entrepreneur seeking funding via an unregistered token, even when it goes through registered blockchain platforms, like Bitcoin and Ether. In the case of the U.S. SEC, for example, just incorporating outside of the U.S. will not grant ‘immunity.” As well, the SEC has recently established rules regarding equity investments in crowdfunding activities. There is nothing to say that it may easily clamp down on ICOs, especially unregistered ones, in the near future. This may give some savvy investors pause.
Some of the amounts being raised through ICOs are staggering. Early investors in Bitcoin and Ether are eager to invest more and more in new ventures, and founders are “tempted” by the easy money to raise far more than they actually need or would get via traditional financing. This is one of the most serious disadvantages because the reputation of ICOs could ultimately crash when returns are not what investors expect and/or contract for.
Lack of Control and Protection.
This, of course, is an investor’s not a startup’s problem. But it is a weakness that, if not “fixed”, may sour investors over time. Investors have very little control over how their funding will be used, not to mention factual information. And unethical or fraudulent “startups” really have little-to-no fiduciary responsibility to their investors. Smart Contracts, such as those through Ethereum are a start, but the promoter has ways to alter those arrangements. And the verdict is still out on how legally binding such contracts are. If enough investors get “burned,” this form of funding may dry up until more detail is worked out.
It’s Too New.
As mentioned earlier in this article, the concepts of Blockchain, cryptocurrency, and ICOs are still foreign to many investors, and certainly to individuals who have money to invest but see this cryptocurrency “stuff” as somehow fake money. It will take time for the entire concept to become mainstream and for weaknesses to be eliminated. In the meantime, founders need money.
Among the Benefits and Advantages of Fundraising With Initial Coin Offerings
Some of the disadvantages listed above can actually be the pros of blockchain technology in fundraising for the startup.
Traditional Funding Comes with Strings/IOC’s with Far Less.
Yes, this is a clear advantage for the founder. Initiating an ICO with a unique currency that can later convert to Bitcoin or Ether, takes a lot of regulation out of the mix, at least right now. And, when using banks and traditional venture capitalist funding, there are tight contracts and legal responsibilities.
ICO Funding is Cheaper.
When the middleman fees and interest are cut out of the mix, getting funding is cheaper. And the founder is freer to make the “rules” regarding equity and/or returns for himself.
Flexibility for the Investor.
So far, investment returns on ICOs are more accelerated than returns with traditional funding. Investors like this. They also like the fact that they can liquidate earlier and faster than before. They can “trade in” their investment and make room for other investors who may not have gotten in at the beginning.
Flexibility for Startup Founders.
One great thing about ICO is that funding can come from a variety of currencies, both fiat and crypto. This may attract more investors than traditional funding which usually occurs in a single currency.
So, Is an IOC for You?
Most of the risks and blockchain technology problems lie with investors, not startups. And those risks generally revolve around the fact that the concept is new without much precedent or regulation. In short, these are “high-risk, high-reward” opportunities, just as some traditional investments are.
There certainly are many advantages for you as a startup, perhaps the biggest one is the flexibility you have with the funds you obtain. Still, a detailed study of blockchain technology pros and cons is in order before you dive into this new phenomenon.
If you want a more detailed explanation of the pros and cons of Blockchain fundraising and some recommendations based on your individual circumstances, contact a pro at Romexsoft. We have both the experience and expertise to steer you correctly.