Initial Coin Offerings and the Digitization of Securities
What is an ICO?
Initial coin offerings (ICOs) are a way for companies to raise capital in an alternative format. ICOs are a form of crowdfunding that work by selling investors digital tokens or coins These digital tokens can store value in many ways beyond a traditional share sold in an IPO (initial public offering). Digital tokens are created based on the perceived value of the business and sold directly to the public in exchange for cryptocurrencies or fiat currencies.
Traditionally, companies looking to raise capital have done so through channels such as venture capital, banks, and grants. Given the risks financing startups, financing has typically been done in several rounds (seed, series A, B, C, etc.). This process is extremely time and energy-intensive, and may be out of reach for some startups. Fundraising through ICOs is not necessarily easier, just different.
An ICO offers the general public and retail investors an opportunity to get involved in a project, and oftentimes generates more money in a shorter period of time than traditional methods. ICOs enable startups to “presell” a project under development, allowing companies to create a community and loyal customer base around their idea before launching their product. ICOs enable startups to validate the market potential for their business model by testing customers’ willingness to pay without heavy upfront investment in R&D.
ICOs offer startups some significant benefits over traditional methods of fundraising, including:
1. No equity dilution: Tokens sold in ICOs aren’t dilutive capital and generally don’t include voting or financial rights. In the case of conventional shares, founders end up losing sizable amounts of control to investors.
2. Speed of capital raise: Through ICOs, companies can raise capital incredibly quickly. In 2017, Brave, a browser startup, raised US$35 million in under 30 seconds and paved the way for many subsequent ICOs.
3. Access to global investors: ICOs make the location of the startup irrelevant. Global participation from investors is possible without the need for crowdfunding platforms such as Kickstarter or Indiegogo. This is particularly helpful for startups in countries that do not have access to institutional investors or a lack of financial infrastructure.
4. Low cost: Costs are significantly reduced because the process is much more efficient than traditional raises. This is because much of the process can be entirely automated, and does not require third-party intermediaries that profit off the fees between transactions.
5. Access to a variety of investors and community driven: Traditional fundraising is typically reserved for institutional investors. ICOs are much more inclusive, allowing for a wider base of investors and public involvement. Low barriers to entry are made possible through fractional ownership of tokens. Digital tokens are highly divisible, meaning that it is possible to purchase a fraction of a token.
With regulations in many countries still under development, there are no binding rules on how to prepare and execute ICOs. However many successful ICOs tend to follow a sequenced, four-step approach:
- Pre-Announcement: The company defines the purpose of the token and identifies targets for its ICO campaign. Necessary materials such as the whitepaper and marketing collateral are created to support the process.
- Offer: To company creates a clear offer that defines the token price, fundraising goal, length of sale, and other information that investors looking to participate will need.
- Marketing Campaign: The success of an ICO often hinges on the effectiveness of its marketing campaign, given that many companies behind ICOs are startups and are not usually well known. Social media platforms, forums, messaging websites, and group working sites are all heavily used in marketing efforts.
- Token Sale: The ICO is triggered and the tokens are released to investors.
Most ICOs are currently based on Ethereum and use the ERC20 standard. The ERC20 standard is a blueprint for fungible tokens that are compatible with the Ethereum network. The ERC20 dictates a number of rules and actions that an Ethereum token or smart contract must follow, and is now the de-facto industry standard for issuing tokens. Using this standard makes tokens more easily interchangeable and ensures they can work with dApps (decentralized applications) adhering to the same standard.
Why invest in an ICO?
ICO investors are generally seeking speculative gains associated with the future success of the startup, while simultaneously helping to fund that success. Instead of an offer of equity, token holders are granted rights of a different nature ranging from access to services, governance rights, to contribution and block creation rights. With the ability to own fractional parts of tokens, companies can attract a much wider range of investors.
The surge of ICOs in 2017 was a new phenomenon that took the world of finance and technology by surprise. While many ICOs are honest investment opportunities, there have been instances of flawed token valuations, fraud and illegitimacy, and lack of transparency. In the early days of ICOs, a number of failed ICOs led to the “Crypto Winter” due to plummeting valuations, empty promises, and bad press. The “Crypto Winter” is in reference to when around 2,000 global cryptocurrencies saw a simultaneous collapse and lost a total of 80% of their aggregate market capitalization. The term started to be used more commonly after Bitcoin’s price dropped south of $3,000 in December 2018. This crash caused widespread investor panic and claims that the cryptocurrency “bubble” had ended. This sideways trend continued until early 2019.
Governments and regulators have treated ICOs differently around the world, with China and South Korea prohibiting ICOs and many other countries actively developing specific regulations. Many countries are treating ICOs under the umbrella of securities legislation.
Notable Token Raises
The first ICOs started in 2013, but took the world by storm in 2017. One of the first examples of an ICO was Mastercoin (now Omni) which raised around US$600,000. In 2015, Ethereum received a total investment of over US$15 million from its ICO.
There are a number of notable token raises that are interesting examples of the speed of which capital can be raised using this method:
- Brave - $35M in 30 seconds
- EOS - $4B over a year
- Bancor - $153M in 3 hours
- Aragon - $25M in 15 minutes
- Tezos - $160M in 32 hours
- Filecoin - $250M in 2 months
There is now an overall market acceptance and recognition that ICOs are here to stay. We will likely see startups using a mix of traditional financing and ICOs to finance their projects in the years to come.
Digital securities have emerged from the ashes of ICOs and are now on the brink of overtaking traditional means of selling, trading, and managing asset-backed securities. With many investors losing money in ICO Ponzi schemes such as Bitconnect, companies needed a way to differentiate themselves from fraudulent actors and traditional investment firms needed a way to use blockchain technology in a regulated manner.
Digital securities are digitized upgrades of traditional securities that exist on a distributed ledger using blockchain technology. A security is a financial instrument that holds value and can be traded (stocks, bonds, real estate, etc.). For example, a digital security would simply replace your paper stock certificate with a digital version. Investing in a digital security is an investment in the underlying asset and you receive digital proof of ownership. Digitization of securities makes for faster, cheaper, and more secure markets. This enables investors, for example, to sell shares of private securities on compliant exchanges on-demand and benefit from liquidity that is not possible in traditional securities.
This digitization is made possible through tokenization and smart contracts on blockchain networks. What makes digital securities different from ICOs is their compliance; since digital securities are representations of securities, they are all subject to traditional security laws.
Digital securities can come in many forms representing investment contracts, shares of a corporation, a portion of a note, debt security, or even fractionalized interest. Some of the key benefits of digital securities are:
1. Divisibility: Through tokenization, we have the ability to dramatically increase access to investors who may otherwise not be able to invest. Art, real estate, and other high value assets can be tokenized into many pieces and distributed across many owners.
2. Liquidity and uptime: Digitization of securities allows for on-demand trading and fungibility (interchangeability with other assets). Existing financial markets are limited in their uptime and face bottlenecks when transferring assets. Digital markets are operating around the clock with no down time.
3. Effective and efficient governance: Voting rights are exercised on the blockchain and there is an immediate distribution of dividends and profits to investors. This makes the speed and efficiency of the system much more attractive than traditional systems.
4. Traceability and transferability: The use of blockchain creates the ability to conduct peer-to-peer trading and produces an immutable audit trail, allowing ownership to be verified. This makes it extremely difficult—if not impossible—to launder securities or act fraudulently, and is a more secure alternative to traditional methods.
As with the entire blockchain industry, digital securities are still relatively new in the public landscape. However, the industry is rapidly changing and growing. This means we could witness rapid, mainstream adoption of the technology in the near future. This will likely come in parallel with widespread use of cryptocurrencies and DeFi (decentralized finance).
Novel Examples of Digitization of Assets
We are beginning to see many novel and exciting new use cases for the digitization and tokenization of assets. Here we highlight some recent examples in the world of sport and art.
In early 2020, Spencer Dinwiddie, a Brooklyn Nets basketball player made headlines for tokenizing his $34 million contract. Shares were priced at $150,000 and capital raised through the token sale acted as a business loan for Dinwiddie. In exchange, his shareholders (token holders) would receive payouts as the season progressed. Although he did not reach his $13.5 million sale target, Diwiddie forward thinking has laid the groundwork for other athletes to tokenize contracts.
Opportunities in the sport industry have also arisen in professional franchise ownership. There are a number of teams who are currently owned by parent companies who are publicly traded including the Toronto Maple Leafs (NHL), Toronto Raptors (NBA), and the Toronto Blue Jays (MLB). Tokenization of these franchises are non-so-distant possibilities, and would drive loyalty by giving fans an opportunity to further engage and invest in teams.
In early 2021, 255-year-old art auction house, Christies, sold a digital piece of artwork for a record-breaking $69.3 million. Created by a digital artist known as Beeple, the JPG file named “Everydays” was made in February as an NFT (non-fungible token). NFTs give buyers proof of authenticity and ownership. “Everydays” was the first purely digital NFT sold by Christies. This record breaking auction took place when the digital art and collectibles world is exploding. Art and NFTs are the current major push we are seeing in digitization of assets. Digital scarcity is a new reality!