How ICOs will change VC
Since the beginning of 2017 I have been doing a lot of research on ICOs and crowdsales, as part of a project to analyze equity crowdfunding deals in Brazil. In this post I plan to share what I've learned and why I really believe that the blockchain technology will transform venture capital forever.
What are ICOs?
ICO mean Initial Coin Offering, an adaption of the popular IPO (initial public offer), when a company wants to become public and trade its stocks in an exchange.
ICOs or crowdsales are public fundraising efforts of projects and companies. It is a very similar process with equity crowdfunding, but instead of fundraising in dollars these projects raise money through cryptocurrencies (usually Bitcoin or Ether). And instead of using a crowdfunding platform, they use a blockchain as the platform.
In exchange for their money, the backers or investors get another digital asset, called token.
For the beginners in blockchain and tokens, I suggest reading this excellent article about tokens by Luis Otávio, founder of Catarse, the largest crowdfunding platform in Brazil or this long-form piece from Preethi Kasireddy, a blockchain engineer that is writing great stuff about blockchain on Medium.
I will borrow the token definition of Luis:
A token is a digital asset that can be transferred, and not simply copied, between two parties through the web without the consent of any other party.
Every token has an utility, they serve for a specific purpose. This way, there are two types of crowdsales that are taking place, that together raised more than US$2 billion to date.
- Crowdsales of distributed protocols and cryptocurrencies: these represent most of the ICOs being done today. These are fundraising efforts of extremely technical projects that compete to be the next standards that use blockchain technologies to create a new generation of distributed applications. In the case of Ethereum or Tezos (the latter one raised US$200 million in one of the largest ICOs) the users of the network provide computing power to verify transactions in exchange for tokens. Another case is Filecoin (another US$200+ million ICO), that is a distributed storage application, where users provide memory space in exchange of tokens. The tokens create an economic incentive for parties to collaborate in the distributed network. The investors or backers in this case get tokens that will be publicly traded and have a fluctuating price in the cryptocurrency exchanges. If the technology happens to be useful and catch as a standard, the token prices will surge and the token holders will be able to sell them for a higher price. If the project do not work or do not have adoption, the tokens will have no value.
- Crowdsales of companies: this is the second wave of ICOs and the one that draw my interest to the blockchain technology. It all started with startups that use the blockchain technology to solve a specific problem. In this case, instead of having an utility (e.g.: computing power, storage, etc.), the tokens are tradable "contracts" that represent equity or revenue share in a business. Some people are calling this cryptoequity. An example of this type of operation is Trueflip, a blockchain-based lottery that raised R$8+ million and will distribute a part of the revenues from the lottery ticket sales. Below I show a chart that compares VC investing with ICOs financing blockchain startups.
But what happens when any company is able to do a crowdsale?
I believe there is a wave coming that will change venture capital forever. Nowadays, it is very complex for a company to establish a crowdsale and create its own token. Currently, you need deep technical skills.
In the near future, ANY COMPANY will be able to do its own crowdsale.
And this is happening already. There is a movie that raised US$1.7 million. To do the crowdsale, they had to partner with a blockchain consulting company.
We are still in the dark ages of cryptofinance.
Currently, it is really hard both for entrepreneurs and investors to participate in this marketplace.
But this is changing fast.
Soon enough, there will be several worldwide platforms that will offer crowdsales as a service. Creating a project and raising money will be as easy as creating a crowdfunding campaign on Kickstarter. Early signs of this trend are Waves, a platform that allows anyone to issue their own tokens, and Funderbeam, a token-based equity crowdfunding platform in Estonia that already helped companies raised €4 million.
To show the crazy growth of the ICO market, take a look at the chart below.
There is a clear inflection point in May 2017. Then, the total funding was US$300 million. Only four months later crowdsales raised a total of R$2.2 billion.
This shows the huge demand for venture/equity investments from unaccredited investors, that is currently suppressed by regulators.
Why ICOs will change VC
When any company where able to raise money online, traditional VC will change. Here are the reasons:
Liquidity: a great thing about tokens is their liquidity. Nowadays entrepreneurs have to work with exchanges to list their tokens and then, anyone can buy and sell that token. In the future, the listing process will be seamless. This is a huge change for VC. Even with the growth of equity crowdfunding, most investors are out of the venture capital game due to the capital lock-in and very long-term 7 to 10-year returns. If you invest in tokens, you can always cash-out.
Non-dilutive investment: this one is exclusive for the crowdsales of "utility" tokens. Projects such as FileCoin raised US$200 million before launch without compromising any equity. This is crazy! Of course we are living in a bubbly environment, but this is a big change. Instead of investing in the company investors are now investing in the network created by the technology.
Global fundraising: to participate in a crowdsale, you need to transfer cryptocurrency to a wallet in the blockchain. Any investor in the world can participate. This opens up and increases the total market of available resources.
Decentralization: when crowdsales get mainstream, they will compete with traditional venture capital, debt and equity crowdfunding. This gives more power to entrepreneurs to choose their destiny and more power to investors because it democratizes the access to investment opportunities, usually restricted to larger investors.
This will eventually create a global and decentralized exchange where anyone will be able to buy and sell assets from thousands of projects and companies around the world.
What about regulation?
The SEC (Securities and Exchange Commission), authority that regulates financial markets in the United States, recently positioned that tokens are a security, when the entrepreneurs promise revenue-share or equity in return. In this case, companies have to comply with complex rules and governance, usually unaccessible to startups. But with this positioning, the SEC cleared the way for ICOs that DO NOT promise financial benefits in return.
Earlier this month, the Chinese Central Bank declared that ICOs are illegal. The authorities decided to temporarily suspend them to protect investors from scammers and will now work to create a proper regulation.
Will this make crowdsales disappear?
Most likely not. People are still eager to participate. Projects are mostly being hosted in "crypto-friendly" countries such as Singapore and Estonia. To avoid legal problems most crowdsales also do not allow US investors.
Will the US lose ground on blockchain tech because of this? Time will tell. If you look at the teams of the main cryptocurrency and blockchain projects you do not see many Americans. Russians, Ukrainians and Chinese are the majority.
I have invested in a few crowdsales, as a way to learn more about this type of funding that will be revolutionary. See you on the other side!
Important: if you are interested in investing in a crowdsale, take extra care evaluating projects because there is not protection against scammers. This is one of the disadvantages of having a decentralized economy: you have to look for yourelf. Look very close to the team's track record and spend time in due diligence.