Crowdfunding the future

Blockchain-based crowdfunding is becoming a huge phenomenon, with tens of millions of dollars pouring into different ICOs (Initial Coin Offerings) over the course of 2016 — and 2017 is set to be an even bigger year as the technology matures.

Like all new technologies and movements, blockchain crowdfunding is prone to hype as it gathers momentum and establishes itself as the de facto means of raising the cash for cutting-edge new cryptocurrency projects. This is a technology for the grassroots — blockchain promises disintermediation of finance and much else besides — and so perhaps its to be expected that the money and development also comes from the grassroots. Big corporations are developing their own distributed ledger technology, but the real innovation is happening in pockets of activity scattered across the web.

ROI

So what drives investors to throw money at these projects? In 2016 there were multiple seven-figure crowdfunds, with some picking up many millions of dollars — or, at least, the bitcoin equivalent, since bitcoin and other cryptocurrencies are the standard means of investing in these initiatives. As a truly international currency and with no controls on its movement or deposit limits, bitcoin is the ideal way for investors all over the world to get involved.

This is a bleeding-edge sector and these are projects that wouldn’t have been possible ten or even five years ago. There’s certainly a buzz for investors about being at the forefront of that. But for many investors — or speculators — it’s simply about the potential returns. They’ve all seen bitcoin multiply in market cap by 10,000 since it first hit exchanges, and other major projects have managed 10x or 100x. Others, of course, don’t. Some fail due to lack of expertise or marketing, others are outright scams. At least one major project in 2016 suffered catastrophic failure. There’s always a risk/return trade-off, and greed can make investors blind to the pitfalls. Over the course of the coming year, it’s likely these expectations — and the returns commonly enjoyed — will approach something more in line with sanity. It’s the difference between penny stocks and multinationals; ICOs are taking a step in the direction of the mainstream.

For what it’s worth, the sector has already changed a lot in the last year or two. It’s becoming far more professional. Gone are the days when a single anonymous developer on a message board could raise dozens or hundreds of BTC (tens or hundreds of thousands of dollars). Nowadays the successful projects have a lot more information about the technology, the developers’ experience, and much better marketing. The more transparent and professional a firm and its team, the more they are likely to raise, all things being equal.

Crowdfunding vs securities
One of the major changes of the past couple of years has been the evolving regulatory framework. Lines have been drawn between what is acceptable and what is not. There is a clearer message that creating or even buying securities outside of the current regulatory structures is fraught with problems — especially for those in the US.

Crypto-tokens come in many different forms. Some clearly are securities; they pay dividends or represent a share in the company. That’s a regulatory nightmare for the issuers and they will run into problems if the SEC or similar bodies take an interest. The few who do go down this route either choose to remain anonymous (which impacts their ability to raise funds successfully), or live in a jurisdiction that has not ruled this out — yet.

So most firms are going out of their way to issue tokens that are specifically not structured as a security. For example, they give no rights to dividends, no voting rights, no rights to inspect the firm’s books, and so on. And they are integral to the operation of the project: the same token used to raise funds is used within the application. There will typically be external demand for these after the product launches, so the rewards for holders come not from dividends, but from buy pressure deriving from customers’ or users’ transactions. That makes a world of difference from a regulatory standpoint. Rather than being a security, these tokens start to look a lot more like digital products such as ebook or music downloads — albeit ones that can be traded on the open market.

Evaluating ICOs

Blockchain crowdfunding is a gold rush. Risk is always involved with any form of investing, of course, but some projects are sound, others little more than vapour. One of the changes that has happened since 2014, when the ICO craze kicked off properly, is the level of professionalism that developers and companies bring to bear on their offerings. Back in those days, it was possible to raise hundreds of thousands, even millions of dollars with little more than a few forum posts and a halfway convincing white paper.

Nowadays a solid white paper (including both technical and business case) is only a starting point. A professional website and marketing operation is key — if it doesn’t look professional, it’s probably because it’s not and investors recognise that. Some or all of the developers and team should be open about their identities — they should publish their CVs or LinkedIn profiles and ensure there’s no doubt they are who they say they are and that there’s full accountability. They should have relevant and proven experience, and ideally a strong track record in both crypto and their chosen business area: reputation counts for a lot in this world, far more than qualifications or education. They should also be prepared to engage directly with the community, on Slack (typically) and message boards, and in videos and AMAs (Ask Me Anything sessions). All of this is really entry-level stuff for 2017, and any project unwilling to do this should raise a red flag in the mind of investors.

With the growing regulation around this sector and wiser investors, there are fewer scam projects. But cryptocurrency is all about decentralisation, so solutions to this problem that involve specific parties auditing and approving a project are frequently mistrusted and unpopular — and introduce a single point of failure. One alternative is a decentralised reputation system. In one implementation, tokens are being distributed to a cryptocurrency community in proportion to how much currency they hold. They will then be able to vote on new projects based on ownership of that token, indicating whether they think the initiative is viable. It is therefore a kind of community-based KYC (Know Your Customer) process. It’s not perfect, but nothing is — and it offers a different model to the traditional regulatory one, which doesn’t work well in this sector.

We’re still only at the start of this, but 2017 promises to be a big year for blockchain-based crowdfunding.