ICOs – Neue Regeln für die Start-up Finanzierung

Es wird kaum noch bestritten, dass Initial Coin Offerings (ICOs), bei denen Crypto Tokens emittiert werden, das Potenzial bieten, sich als neue Finanzierungsform für Startup-Unternehmen zu etablieren. Nicht absehbar ist bislang allerdings, in welchem Ausmaß dies geschehen wird. Anschließend an den letzten Blogpost zur grundsätzlichen Funktionsweise eines ICOs von Adrian Haase und Julian Albrecht gehen die Autoren daher nun der Frage nach, für welchen Typ Startup ein ICO überhaupt in Frage kommt und ob (insbesondere institutionelle) Investoren diesem neuartigen Finanzierungsinstrument positiv gegenüberstehen.

Blog series ICO – Part II: Commercial relevance – who needs it?

ICOs¹ have achieved quite a significant commercial relevance within the last months: According to Smith + Crown a total of 64 ICOs with an overall volume of USD 102m have been executed in 2016. Moreover, in the second quarter of 2017, 50 closed ICOs raised a total of USD 700m according to a report by coindesk. While now being the biggest factor in the blockchain world and an important one in early stage investment, these numbers are still pretty low in comparison with the entire world wide venture capital market with a total volume of about USD 40bn invested in Q2 of 2017 (reported by KPMG), let alone traditional capital markets. However, interestingly, some voices² already suggest that ICOs have replaced traditional financing rounds in blockchain-linked companies and business models: Over the past 12 months, roughly USD 140m went into those blockchain-linked companies by way of acquisition of shares whereas USD 331m did through ICOs. Even though regulators in a number of countries (China being the most prominent and harsh example) have come up with firm regulations and/or even bans of ICOs, chances are that their overall volume will continue to grow due to the characteristics and pros exemplified in our first blog post (ICO Blog Part I). This part highlights dimensions and possible consequences with regard to the future commercial relevance of ICOs.

Relevance for startup companies

It goes without saying: ICOs in which crypto tokens are emitted have enough potential to establish themselves as a modern funding model of startup companies. However, it is currently not possible to predict the real scale, i.e., whether all sorts of companies will make use of this funding model and whether companies and business models prone to ICO will use them exclusively as their future financing instrument.

ICOs vs. financing rounds vs. debt financing

For companies, financing methods used to be a trade-off: They received liquidity in exchange for the incurring of debts (loan capital) or the loss of profit and power (equity financing – see Part I of our blog posts to ICOs). Crypto tokens issued in the course of an ICO do not have such elements. But still, the emission of tokens might cover the (potentially large³) need for liquidity. Therefore, ICOs are widely regarded as an extremely attractive instrument from the perspective of issuing institutions.

Does it mean, that companies – given they have a fitting corporate purpose – will finance themselves solely by way of ICOs? Well, let’s stay realistic here and keep a few things in mind. The funding potential generated by ICOs is always subject to the actual market situation, i.e., supply and demand. Advantages of ICOs from the founder perspective might be regarded as disadvantages by potential institutional investors. Investors will reflect those disadvantages in their public offerings and the scenario might – in the long run – result in a lower liquidity inflow compared to financing rounds.  

Suitable companies and corporate purposes

Nonetheless, the advantages of ICOs compared to equity financing will likely outweigh from the companies‘ point of view – at least as long as these companies’ business models will allow for ICO-financing. Thus, the future commercial relevance of ICOs highly depends on the assessment as to who these ICO-prone companies really are.

Blockchain-based companies

It is obvious that companies with blockchain-based business models (especially so-called protocols) are capable of successfully emitting crypto tokens. Each blockchain technology can use crypto tokens to reward, for instance, verification and consensus processes. Mining of crypto tokens may serve as an inherent purpose of the business model and provide certain service offerings (e.g., providing disk space). Where a company decides to distribute crypto tokens in exchange for money (or tokens such as BTC or ETH), it does away with services provided by miners, but obtains liquidity, without a loss of shares (and consequently, shareholder rights).

There are no fixed prerequisites as to how mature a company and its business model have to be in order to raise ICO-money. Large investors are expected – even more as is the case with equity financing rounds – to prefer ICOs in later stages. The reason is simple: Without having any shareholder rights or other possibilities to influence the daily business in the future, ICO investors really need to trust the current business model and founders team.

However, ICOs can also be conducted by way of crowdfunding (which is, up to now, the predominant form in practice). It is quite imaginable that young startup companies will be financed by their own fanbase.

Non-blockchain-based companies

But what about business models which are not based on blockchain or any network effects? So far and as far as apparent there has been no major ICO with an old-economy emitter⁴. While this does not mean that an ICO is impossible in such a scenario, the issue is raised if and why ICOs (seem to) require blockchain-based business models.

Let’s transfer our previous thoughts into our analog world and ask, for example, why it seems more likely that Deutsche Lufthansa AG will issue new shares (in the event of a capital increase) instead of Miles & More-points (as tokens) or why the German Dirk Rossmann GmbH will probably emit new shares rather than loyalty tokens even though incentive programs have been implemented in the analog word for quite some time? Loyalty points, for example, could be easily earned through mining when customers use the offered services – yet until now a tokenization of points or an ICO acquisition possibility is neither intended nor widely developed⁵. Why is that? We have identified two potential reasons:

1. There is no trading platform for establishing a secondary market of bonus points.  

Neither Lufthansa nor Rossmann and all other numerous emitters of bonus programs provide a platform for trading acquired points.⁶ ICOs are useless for many investors as long as a derivative market has not been formed. A venture capital fund is not interested in exchanging acquired tokens into services, but rather wants to profit from price increases on secondary markets.

The lack of any trading platform (and thus a price tag) leads to a second aspect which cannot be fulfilled:

2. The link between the market value of tokens and the company success cannot be guaranteed.

A financially strong company is capable to settle debts and, maybe, to distribute dividends. Lenders or shareholders can be sure that their profits correlate with the company’s success.  Likewise, an ICO investor does not want to invest in a blackbox, but hopes for and relies on profiting from a positive price development on derivative markets, determined by a future company success.  

Does it mean that ICOs are provided solely for blockchain-based companies for all time to come? Not necessarily: If Lufthansa finds a way to make their Miles & More points tradeable (at low transaction costs)⁷, the following consequences are imaginable: The demand in Lufthansa-operated flights increases and prices are rising (in EUR). Miles which can be redeemed for flights will also increase in value. Investors could purchase miles with the idea of never exchanging them into any flights, but rather bet on increasing flight prices (in EUR) and trade the ICO-acquired miles on trading platforms. Still up in the air (no pun intended) – but possible.

Relevance for investors

Just as ICOs build a new financing form for startup companies, they also might be a new investment form for investors. New investment objects are especially attractive to investors in times of low interests. This applies all the more when completely unknown investment forms arise as a result within the course of a new technology and leads to the effect that several ICOs have already reached their caps in a matter of seconds (one of the fastest ones yet being BAT generating USD 35m in just 30 seconds).

What results into more liquidity without any debt or emittance of corporate rights for the startup company, means payment for tokens without any of these considerations for the investors. Therefore, a huge amount of trust will be necessary on the investors’ side. Loaners are (only) threatened by the insolvency of the debtor, shareholders by little earnings. Investors of an ICO must fear that their tokens are worthless, even though the emitting cooperation is not insolvent and might even generate earnings. It is therefore going to be even more important for investors to have a clear picture about the above-shown link between company success and token market value. Corporations which can guarantee this link will find convinced investors who will invest without a direct consideration (apart from virtual tokens) and provide liquidity. Eventually, there are going to be (and maybe there even are as of today) corporations with business models so convincing that they, in order to prevent dilution of equity, won’t provide any other form of financing – which means that the ICO will be the only way for investors to participate.        

If the economic link between corporate success and crypto token price is set, there will be another advantage for investors: It is more likely than not that already emitted tokens will “suck in” the earnings of the corporation. Consequently, tokens might economically prevail over shares/dividends and all in all, the shareholders’ role might become a less important one. This way crypto tokens and ICOs will no longer be a mere financing, but also a new distribution model, and one which founders can still easily participate in by keeping a share of these crypto tokens for themselves. This is not necessarily bad for investors, because the skin in the game leads to aligned interests in a price increase for both parties.

All in all, ICOs are not an entirely negative phenomenon for investors: Crypto tokens are a product which is more tradeable in secondary markets than a reclaim of a debt or a share. Therefore, it can be expected that not only startup companies, but also investors will be intrigued by ICOs. ICOs could therefore particularly interest investors who

• have no interest in shareholder voting rights as they only invest amounts so small that they would only result in minimal rights anyhow;
• do not care about dividends as they only speculate on an increase in price for crypto tokens.

Once again it shows that indeed – from the investors point of view – there are parallels to an IPO: Whoever invests into shares (not regarding strategic investors), often does not care to appoint the board of directors or even gain a dividend. Rather, the person will be looking for a price advance, in order to profit on a secondary market (the stock market).

Death of funds

Occasionally you will get the impression that ICOs are going to revolutionise crowdfunding in a way that (startup-) companies will no longer have to rely on Venture Capital Funds (VCs) as investors, or that, inversely, investors will invest solely and directly invest into tokens rather than pay a VC-Manager for the same job adding management fees and carried interest. However we do not consider this is a probable development for one main reason: It would be based on the premise that deal flow and market access are the only reasons for an indirect investment into a fund. If this would be the case fund managers would indeed be in trouble (at least in token sales without any VC-dominant pre-ICO). It is oftentimes easily forgotten that apart from offering exclusive access to deal flow (which indeed gets massively softened by ICOs), funds fulfill another important function – asset-picking: Just because an ICO is much easier to access than a VC-financing round does not mean that people will widely rely on their technical know-how and market knowledge when it comes to investment decisions. In other parts of the financial sector fund managers have been paid for decades to pick publicly accessible assets (listed stocks which everyone can buy) at the right time and at the right amount and to subsequently sell them. Last but not least from a startup company point of view, it will be sensible to get VCs on board because their expertise and advice will prove valuable irrespective of whether or not they hold shares in the company.  Venture Capital Funds will therefore not die – it remains to be seen, however, if they can keep their present business model without being disrupted.

Conclusion

ICOs are a new way of financing and provide for a range of advantages for the emitting institute. Compared to the acquisition of shares, investors waive their influence and dividends; compared to providing a loan, they waive their right to reclaim any money. Therefore, especially speculative investors who are interested in the stock market-like fungibility of crypto tokens will be approached by ICOs. Looking from the startup company point of view, ICOs are an opportunity both for already established companies as well as, emphasizing the crowdfunding/fan case aspect to it, younger ones. The need for liquidity of companies with non-blockchain based business models who do not provide a link to success and no platform for taking action is currently unlikely to be satisfied by ICOs. However it remains to be seen if digitalisation and decentralisation will lead to an increase into fitting business models. We do expect that the economic relevance, meaning volume and frequency, of ICOs will increase unproportionally (compared to established forms of financing), without completely replacing financing rounds as a major financing opportunity for young companies. Venture capital funds and other institutional investors will not be obsolete through an increase in ICOs, but might have to look for a new role.