What IPOs Reveal about the ICO Market

As a former investment banker, one of the first things I noticed when I started advising blockchain companies on their token launches was that the Initial Coin Offering (ICO) investment process and launch strategy closely mimicked those of IPOs, and specifically, IPOs of Special Purpose Acquisition Companies (SPACs). A SPAC is a publicly-traded buyout company that raises collective investment funds in the form of blind pool money through an initial public offering (IPO), for the purpose of acquiring an existing private company.[1] I stayed away from blockchain and crypto for a long time because I didn’t understand it, and I hope by drawing comparisons to the more familiar concept of IPOs, I can make ICOs a bit more approachable (as always, caveat emptor).

With SPACs, investors can purchase common stock and warrants (a derivative that allows you to invest more capital at a predetermined price in order to hedge against downside or exploit an arbitrage opportunity). Crypto investors are currently experiencing the same benefits in the ICO market. By investing in a currency before the ICO, investors are able to purchase tokens at substantial discounts (20–50% depending on check size and how early) and then sell a portion off for a profit once it is listed on an exchange — and in some cases even before the tokens are listed.

The intricacies of creating leverage and exploring discount deals got me thinking about how the IPO and ICO process are related and perhaps more approachable than people new to crypto realize.

For one, consumers buy both stocks and cryptocurrencies with the expectation that they are getting some current or future value from the asset — current in the case of a utility token that can be used within a blockchain platform once purchased, and future in the case of the stock/token price increasing at a later date.

Secondly, and perhaps more importantly, companies go through a rigorous process of promotion, business development and regulatory compliance in order to make their stock/token available to the public via an ICO or an IPO. The processes by which crypto and non-crypto companies prepare to launch public offerings have much in common and analyzing the similarities can help crypto companies reflect on how best to execute their own public fundraising strategy by recognizing where each model adds value.

Before we get into the similarities, let’s first point out the many ways in which ICOs are different from IPO’s:

Differences

Late stage vs. early stage

Companies that perform IPOs are usually late stage, have already raised significant funding and established a revenue generating business. The strategy for launching an IPO is to further expand the company with funds it would otherwise not be able to get (or get on good business terms) from private investors.

ICO companies are still very early, often having only developed a white paper, prototype or MVP. These companies are looking to raise their first major funding round to jumpstart a blockchain project.

Accredited investors vs. everyone

Due to the late stage of companies launching IPOs, the best deals will have already gone to accredited investors (accredited investors are investors with a $1million net worth, or $200k in annual income). So for a company like Facebook that went through numerous fundraising rounds from private investors before going public, the vast majority of people who invested in their IPO would essentially have paid for the liquidity of the already rich investors who go in early.

Although ICOs often raise initial funding from accredited investors who get in early and therefore claim the best deals, the fundraising system as a whole is far more democratized and inclusive than an IPO. Furthermore, the companies that launch ICOs are still very early stage, meaning investors could still potentially realize significant returns even if he or she didn’t participate in the actual the ICO but purchased tokens on an exchange after launch. For example, projects like ICON, NEO or EOS all had ICO’s that many investors undoubtedly missed out on. Yet if you bought their coins as soon as they hit the exchanges, you would be up by 300% or more on your investment.

Shareholders vs. community of contributors

Most people who hold stocks are passive investors. They’re not able to directly contribute to the success of the company and are severely limited in their ability to influence corporate decision-making.

Token sales enable blockchain projects to launch a new digital currency that acts as an incentive mechanism for a global community of people to contribute to the project. If people believe the tokens hold value, they are willing to create and share content for the project, refer friends, develop supporting applications or simply provide feedback, all in exchange for those tokens.

Securities vs. utility/security

A security usually represents an ownership stake in a publicly traded corporation (via stock). Owning a security can come with certain privileges, including monthly payouts (dividends), the ability to profit from capital gains when the stock sells the securities and in some cases, voting rights.

Selling a security requires being registered with the SEC (securities and exchange commission) and abiding by a strict set of laws that require (among other things) disclosing the company’s financial records in order to protect citizens from being defrauded from their investment.

Currently, most blockchain companies issue tokens that can be classified as both a security and utility. For example, Filecoin issues a utility token that functions within a blockchain ecosystem to pay for file storage space. Yet it could also be considered a security because that same token is offered on public exchanges for people to acquire as a speculative investment. Regarding their legal status as a security or utility, cryptocurrencies and tokens fall into a gray area that is hard to define except when assessed on a case-by-case basis and has yet to be clearly defined by regulatory agencies. In fact, the indications for how regulatory agencies will treat cryptocurrencies changes on a weekly basis so for now this remains a significant difference between crypto markets and traditional markets.

Finally, tokens are not as highly regulated as stocks, making the barrier to entry for launching ICO’s significantly lower than IPO’s. This is made evident by the fact that 604 ICO’s have already been launched so far in 2018 compared to just 229 IPO’s in all of 2017.

Token Economic incentive models

Companies launching an ICO release tokens instead of issuing shares. Therefore, they need to place a large emphasis on token incentive models that can provide short and long term value to early adopters.

Companies launching IPOs have no such obligation to reward early adopters. If we think about a company like Uber, whether you were the 10th person to ride an Uber or the 10,000th, you would still be paying the exact same price. In other words, Uber does not have a built-in reward structure for early adopters. Conversely, ICO companies must think short and long-term about how to reward early adopters for helping build their project through various stages of development because they are typically funded by investors before reaching product-market fit or scaling a user base. For example: they could decide to ‘buyback and burn’ a small portion of their tokens every quarter as Binance does. This process works as a replacement for the traditional stock dividends model and can also be structured in a way that allows the earliest token holders to sell their tokens for the highest price (i.e a sliding scale based on the date in which you purchased your first token).

Similarities

Despite the many differences in IPOs and ICOs, both fundraising events ultimately follow a similar pattern of steps as illustrated below:

Figure 1: Image sourced from iCash AMA

In the case of a SPAC IPO or ICO, the business plan (otherwise known as a prospectus or whitepaper) is needed to give investors a clear sense of what the company’s value proposition is and how it plans to execute on this proposition

• Capital is raised on a thesis that is usually best supported by an MVP and some user validation
• The company must provide an ownership stake to investors in the form of shares or tokens
• The most important criteria for nearly every serious investor will be the quality of the company’s team. An experienced and qualified team is usually required in order to raise funds. Once funded, companies usually seek to expand their team to include more qualified and experienced people to support growth
• Companies that have successfully gone through their ICO or SPAC IPO will seek to fulfill the tasks set out in their roadmap, most of which include selling their products in the appropriate capital markets in order to generate positive returns to investors (in the form of increasing stock/token price and/or quarterly dividend payouts).

Conclusion

Despite the centralization, over-regulation and preference for accredited investors in IPO markets, blockchain startups launching ICOs can learn a lot from the IPO process. Publicly traded corporations go through significantly more regulatory hurdles to compete in a market that is older and more sophisticated when it comes to evaluating company potential, identifying fraudulent activity and setting strict performance metrics.

As the ICO market continues to mature, it’s important for companies to operate under the assumption that their investors are as experienced and sophisticated as those who invest in IPOs. This means creating a well-defined roadmap with monthly targets that are consistently met, going above and beyond the necessary requirements to achieve regulatory compliance, and perhaps most importantly, providing multiple channels to communicate their progress and update investors.

Successfully emulating the best traits of the IPO market will enable ICOs to attract larger institutional investors who will fast track their growth and ultimately help lead blockchain technology to mainstream adoption.

[1] Special Purpose Acquisition Company (SPAC) https://www.investopedia.com/terms/s/spac.asp#ixzz5LdN2W5rU