Are ICOs the future of startup funding? An analysis to decide between launching an ICO and raising from VCs.

Martell Ultimate Startup Space by Walter Lim via flickr, CC BY 2.0 https://www.flickr.com/photos/coolinsights/6052509217 License https://creativecommons.org/licenses/by/2.0/

Do Initial Coin Offerings (ICOs) lead to quicker and easier funds for startups or are they yet another hype that is not going to last? Fact is that the startup funding landscape has changed significantly and within the last few years startups have been raising money via ICOs at impeccable speed. In June 2017, ICO funding had actually reached more than 550 million USD, being the first month ever surpassing business angel and VC funding. But every funding possibility has its pros and cons. This article aims at analyzing startup funding via ICOs and comparing them with raising capital from VCs and business angels. ICOs appear to be the fastest way to finance a startup but is it true and is it for you? We discuss the main criteria to take into consideration when deciding, as well as whether this is a black-and-white story.

ICOs surpass VC Funding for blockchain-projects

In 2013 the ICO (Initial Coin Offering) or ITO (Initial Token Offering) started with Mastercoin’s first ICO. Since then this new model for raising funds has been spreading across the US and by that changing the funding landscape of startups.

Early-stage startups typically used to raise funds from business angels or VCs. 92 ICOs collectively raised 1.25 billion USD within the timeframe of January to July 2017. In June, ICO funding had actually reached more than 550 million USD, being the first month ever surpassing business angel and VC funding. With ICOs now spreading across Europe, the first Austrian ICO has been launched mid-September, The Token Regulation Summit in Vienna as well as the conference “the rise of the ICO” held in Linz, even experts are still in disagreement on the long-term benefits of ICOs.

There is a lot of money in ICOs, but how does it actually work? With ICO a startup raises funds by creating their own cryptocurrencies and offering discounted rates on digital assets. The investors can then opt to cash out to a cryptocurrency such as Bitcoin or Ethereum or wait for the currency to rise. There are different types of tokens used, either representing some type of security-rights or usage-rights for the underlying service. Sounds easy? Well creating an ICO is but there are still a lot of things to consider before rushing in.

Criteria to decide between ICOs and venture capital financing

With this big hype on ICOs, startups might feel the attraction to fund their startup by an ICO, but it is okay to go the traditional way of seeking investment from VCs or business angels, especially if a startup does not rely on a token-based business model. With the following criteria we guide you through the process of deciding which track to choose.

Speed of raising money

Let’s start with the most obvious argument, that can also be kind of misleading: speed. A criterion that at a first glance seems to favor ICOs as they can be set up in weeks. However, well-designed tokens and well-prepared ICOs respecting legal and regulatory environments also need their 6 months of preparation if you include the road shows to the ICO investor pools in different countries, warned Richard Kastelein at the Rise of ICO summit in Linz in October 2017. This timeframe was confirmed by Stephan Karpischek, who is currently preparing an ICO himself. Attracting good Business Angels or VCs also takes about this time (6–9 months on average). So in both cases, funding is intensive and diverts the entrepreneur’s time to the funding process, though we know, they should focus on customers and the product. Regarding the criterion speed it actually seems the VC and ICO-track are equal.

Smart versus dumb money

The advantage of getting Business Angels and VCs on board is that you get smart money. They also contribute their established networks, their support with additional financing and proven good expertise on strategy and HR-management. You do not get from ICO coin-holders. However, you might get higher funds you can spend on this kind of advice. Still, an investor, whose capital is at stake, is a lot more motivated to contribute with network and strategic input than a consultant you pay for.

Visibility and network effect

If you get a renowned VC on board, you send a signal to the market, that your product can be trusted and that the VC will help you get additional financing. Having managed a successful ICO, similar to a good crowdfunding campaign, can, however dramatically increase your visibility.

A difference is further that with VCs you have a few investors, who supply you with capital, whereas with ICOs a broad range of people from the public can invest in your startup by buying tokens. It depends on your token structure, which motives people have to invest. It can be users, enthusiasts up to pure investors. The beauty of an ICO associated with a usage token is the network effect created when the usage token is actually used in the ecosystem of the startup. The process does not end with raising money, it even pushes usage. In this respect, ICOs are definitely more attractive, if you can link the ICO to your service or even your industry.

Token-holder rights

At the moment, ICOs can be done without any typical VC protection rights (liquidation preference, board seats) or shareholder agreements. This might reduce the burden on the ICO issuing company, but will it hold long-term? From a startup’s perspective, ICOs are definitely more attractive with this criterion.

Funding potential

Another criterion that has to be taken into consideration is the funding size. With ICOs there is no “typical” seed-round amount, like 250.000–500.000 Euro. In VC-world there are some rules on the amount that everybody sticks to. There might be a reason for it, as overfunding might kill the product. If there is no milestone and escrow-mechanism included in the ICO process, too much money makes less eager entrepreneurs and the outcome might be worse. Still, if well done, ICOs are more flexible in funding size. While news is crowded by high token-sale outcomes, on average, ICOs have attracted 2 million USD Still, single projects are able to raise “5x to 10x the amount” they could have raised at their startup-stage from Business Angels or VCs, remarks Travis Scher from Digital Currency Group.

Your vision

As it also came up during the Rise of the ICO summit, it is worth to mention: Not every decision is money-driven and the blockchain community with its decentralized approach is very happy to enable many people with smaller amounts to invest in startups as opposed to typical VC-processes where larger ticket sizes are in the game and where many potential investors are excluded from the process. Still, there is no much difference from launching a crowdfunding campaign to cover for that.

Business model and underlying technology

The right funding process for your startup also depends on your business model. ICOs that create a sustainable long-term value, are the ones that can trigger a network-effect via its token-holders combined with a blockchain business model. Token sales have emerged as the funding route of choice for early stage blockchain projects. “The first ICOs were the ones that wouldn’t get VCs.” As Brock Pierce mentioned during Rise of ICO in Linz. Recently, however, ICOs of non-blockchain projects have emerged, where a token-functionality is combined with a traditional business model. Some network effect, however, needs to be ingrained in the business model.

Associated regulatory risk

The most dramatic case that we are all looking at is China, where ICOs have been banned for the moment and companies who had done ICOs needed to pay back token-holders. South Korea followed some weeks later. In the US, ICOs need to pass the “Howey test” to prove that they are no securities-based-ICOs. Markets, however, such as Switzerland and Singapore have been quite attractive countries to issue an ICO as their regulation is ICO-friendly and has been stable so far. As the industry and regulators are adapting to the new developments, there is the risk that new regulations are to come but also it needs to be carefully analyzed whether existing regulations are adhered to.

There is room for combinations

Whichever funding option you choose for your start-up, keep in mind that VCs and ICOs are not mutually exclusive, in fact entrepreneurs may combine both sources to fund their companies. Traditional non-blockchain business models have started to raise funds with tokens. They offer a share of their tokens to investors during the pre-ICO phase and traditional investors and token-holders peacefully co-exist. And if you do not have a blockchain based or token based business model VCs and Business Angels are and have been for a while a solid way to finance your start-up.

About the author: Petra Wolkenstein is a seasoned M&A professional managing the Vienna boutique consultancy for business development konsultori and provides startups with key2investors a platform to professionalize their preparation and negotiation with potential investors to get funded.