2020 Recap: Evolution of Crypto Fundraising from ICOs to STOs
Cryptocurrency was conceived as a digital alternative to traditional currency in the aftermath of the 2008 global financial crisis, when people started losing faith in traditional financial institutions. We have witnessed cryptocurrency go through ups and downs in terms of price and reputation as a result of mechanisms like crypto fundraising and how the world is responding to this phenomenon. In today’s crypto bear market which is well continuing into the pandemic-induced financial crisis, is crypto fundraising considered a thing of the past?
Before we start examining the history of Initial Coin Offerings (ICO) and understand how the structure has changed and adapted to deal with different public reactions, it would be informative to know a little history of fundraising before the era of cryptocurrency.
3 Traditional Ways of Fundraising
Equity Funding
Simply a company selling shares for cash to fund the company. A valuation is first negotiated between the investor and company, shares are then purchased at an agreed price based on the valuation. Once purchased, the investor is now a shareholder and owns a piece of the company in proportion to their holdings against the other shareholders.
This type of funding requires zero collateral, but requires accountability to investors. Through quarterly reporting or annual general meetings, companies report progress on a regular basis. Usually the shareholders have a say in the company’s direction if they have significant shares and given a board seat. The ideal exit is usually an acquisition or Initial Public Offering (IPO). Once equity is sold to an investor, further fundraising has to be done often at a higher share price to prevent the owners from selling more of their own stake and for investors to realise their share’s value is growing.
Debt funding
Loan or debt-based fundraising means borrowing money now and repaying it back later with interest, within a specific time frame. This usually involves some form of collateral offered to the lender for security, and is great for when the project owner/company needs capital quickly although the loaned amount is dependent on the value of collateral offered.
There is also the alternative of convertible debt, where the company borrows money from investors with an understanding that the loan will either be repaid or turned into equity in the company at some later point in time.
Crowdfunding
Crowdfunding exploded onto the internet a few years ago. with early platforms like Kickstarter and Indiegogo emerging into the scene, engaging the public to co-fund startup ventures through a promise of purchasing innovative products at a lower than launch or retail price.
Following USA’s JOBS Act in 2012 allowing companies to acquire funding through online portals from non-accredited investors, crowdfunding has evolved to offer and sell securities to the general public and a regulatory structure is established for raising capital through securities offerings using crowdfunding.
For entrepreneurs, rewards-based crowdfunding is preferable to raise money since you only need to pre-sell a perk or product to the donor instead of equity. The process is more efficient than traditional fundraising, and the crowdfunding platform offers a place for projects to build traction, social proof, and validation.
A large part of the above fundraising methods, in particular crowdfunding, come to shape the conception of ICO, its variations, and the treatment of this newer funding mechanism.
The ICO: Sale of Utility Tokens
Within the crypto space, the Initial Coin Offering (ICO) model came to be a primary method of raising funds for blockchain projects. In an ICO, a developer essentially collects contributions denominated in Ether or some other (crypto)currency, and issues a newly minted token in exchange. It was great because A) usually no equity is expended and so the future value of the business remains with the founders and equity investors, and B) companies do not have to pay what they raise through ICOs back to their backers as with debt. Many believed that ICOs would become a new form of fundraising that could possibly replace the more traditionally known model of Initial Public Offerings (IPOs) in the future.
In July 2013, Mastercoin, who was rebranded to Omni (OMNI), carried out a fundraising event on a Bitcointalk forum thread. Investors only needed to send bitcoins to a specific address in order to participate. It was successful but the legality of this was questioned of course.
A new foundation model was formulated to replace the older model. The Ethereum project employed this model and went on to receive approximately $18.3 million worth of ‘donations’ from its project backers. Ethereum also created the ERC-20 token standard, which made token creation comparatively easier for successive ICOs. With this path paved, other aspiring projects soon followed suit. ICOs were quickly oversubscribed and record-breaking fundraisers worth tens or hundred millions of dollars were raised in mere hours or less. ICO fundraising came to be irresistible to many who wanted to capitalize on such a lucrative opportunity, with a rising interest in blockchain technology and attractive ROIs. This run extended to 2017.
ICOs became a substantial sector within the general cryptocurrency market but were not without its problems. Some of the ICOs launched during this time could be classified as securities, which meant increased scrutiny and possibly intervention by established regulators like the Security Exchange Commission (SEC). To avoid regulatory trouble, many projects started looking for ways to fundraise in a more compliant manner with existing financial regulations. As the SEC moved in, ICOs began to cool.
The STO: Introducing Asset-backed Tokens
By 2018, ICOs gained a bad reputation for being unregulated and risky, and we saw the rise of the Security Token Offering (STO) to address regulatory concerns as well as issues plaguing ICOs. STO meant the sale of a security token as opposed to a utility token, which opened up a lot of possibilities, because you could tokenize almost any asset and this brings efficiency, liquidity, transparency and accessibility to once highly inaccessible markets. Most importantly, an asset value is now tied to each Security token.
STOs started to gain attention as a counterbalance to the Wild West of unregulated token offerings. Yet because of its nature as a regulated product offering, as Lim of Taylor Vinters Via LLC insightfully points out, there is irony in that the continued survival of the digital token industry (in the form of the STO) hinged on an offering structure necessitating institutional centralization and close regulatory supervision. With the threat of draconian regulations posing as an obstacle to the offering and trading of security tokens, enterprises may struggle to see any tangible benefit provided by STOs beyond those already present under traditional corporate financing structures.
Having regulators preside over such activity was definitely a deterrent. When STOs became popular, Taiwan rushed to create the world’s first STO laws, but overly strict regulation chilled interest. Thailand was also one of the first to launch a framework for STOs, and although its local SEC approved of digital exchanges for tokens, its regulator reports that no firms have utilized the laws to raise funds. Projects were more cautious about their offerings and lie in wait for someone else to pave the road for the STO class.
Although people were initially hopeful, in the end, STOs did not catch on like they were supposed to. There are few functioning and reputable security token exchanges out there, whereas most of them are still “in development” or closed off. STO Investors still needed to conduct their own due diligence and be wary, even if an STO claims to be in compliance with securities regulations.
The IEO: Sale of Tokens through Crypto Exchanges
Another fad that arose in 2019 was the Initial Exchange Offerings (IEO), or exchange-led version of the ICO.
An IEO relies on having one or more crypto-exchange(s) to serve as a counter-party who will sell project tokens, minted by developers to the exchange, to interested individuals on the exchange platform. Conditions are subjected to the agreement between the project developers and the exchange, which is similar to the structure of an ICO.
There are several advantages of conducting an IEO. For one, exchanges and projects can tap on the user base of both parties to obtain contributions for the IEO. Furthermore, exchanges give more reliability by providing an additional vote of confidence because of its own due diligence on the project, as well as being the official site for token sale. The next natural step of listing the project token for secondary market trading will also be assured once the exchange chooses to onboard said project. Based on these grounds, the IEO model appears heartening in terms of introducing more points for due diligence/checks with the centralized exchange as a middleman.
However, according to BitMEX Research, IEOs in 2019 have lost investors up to 98% of their money, which I think pretty much sums up the subsequent failure of IEOs to change the fundraising landscape.
Takeaway
People gradually become disillusioned with the fad of making quick money through ICOs, with the concepts of STOs and IEOs being insufficient to properly address the flaws of the ICO model. Such forms of fast and unregulated fundraising also brought the industry into greater scrutiny by global regulators, which made crypto fundraising much more difficult.
If anything, there were key lessons to be learned from the evolution of crypto fundraising. Obviously there was a lack of clear and tested regulation in place specific for this sector, with no protection and project oversight offered to project investors or stakeholders, without proper accountability in the sector. Many if not most projects ended with poor delivery and investors taking loss, not to mention those with outright fraudulent activity that took advantage of careless, greedy investors looking to make a quick buck with the ICO hype. Ultimately, there is still a market for crypto fundraising evident from the size of funds injected during the last ICO high; but now, it has to be done right.
