Is the ICO explosion sidling VCs?

The cryptocurrency arena is a lot of things, but a waste of time it’s not. Fluctuating prices, continual influx of new contenders, lack of regulation, vulnerability to fraud and hype climate mean that players must navigate an unpredictable path across a terrain that could be described as the wild west.

Adding to apparent chaos — and opportunity — is the explosion of initial coin offerings (ICOs). Entrepreneurs looking to raise capital to build their tech startups can raise millions by creating digital tokens and selling them in an ICO. Often the company’s unique tokens comprise the currency required to purchase and operate the products and platforms that they are developing. Investors can either pay for these tokens using other cryptocurrencies, or with US dollars. Essentially, it’s a form of crowdfunding, except investors receive cryptocurrencies instead of products.

Although ICOs have been around for almost five years, it wasn’t until April last year that the idea of using ICOs as a springboard for funding startups began trending across the blockchain space. In just three months, this trend had grown into a sweeping phenomenon that was transforming the way companies are funded. In June 2017, for the first time ever, ICOs had displaced venture capitalists (VCs) as the leading source of funding for startups.

The 2017 numbers tell of the astonishingly quick adoption of the ICO as a funding tool (according to CoinDesk figures). An inconspicuous Q1, which saw just seven ICOs, offered limited clues about the coming storm. In Q2, twenty five ICOs raised an estimated $680 million; and then Q3 saw an effective doubling of both the number of offerings and the total investment. In Q4, the numbers exploded — with ICOs raising $3.23 billion from almost 120 events ($1.4 billion in December alone). For comparison, just $200 million came from VC firms in the same period. By the end of the year, ICOs had attracted (all-time) approximately $5.7 billion in funding, with $4.9 billion of that coming in 2017.

Obviously, these newfangled fundraising events have been big successes for the startups that initiated them. Top of the pile last year was Block.one, whose ICO raised $700 million in Q4. Block.one is developing software that “that promises to handle millions of transactions per second,” and despite the lack of a product, the company raised about $4.5 billion in 2017. Protocol Labs, which raised $253 million in an ICO, is building a blockchain network with which digital storage space can be bought and sold. Other significant winners include Tezos ($230 million), Bancor ($153 million), Polkadot ($145 million) and Qash ($107 million). This year, the ICO for LeadCoin, a lead-sharing blockchain network, caused a stir by raising more than $50 million in just 30 minutes.

Participants in ICOs are essentially betting on the future of these new businesses. Unlike with an IPO, the bet is made earlier in the startup’s development, which obviously increases the risk. It’s a testament to the disruptive power of blockchain technology that VCs — once the only financial entities privileged to get an early look at tech startups — often now find themselves part of the stampede to grab a small piece of an ICO offering for the hottest new startups. While VCs are often among those invited to a discounted pre-sale of tokens before they are offered to the public, it’s fair to say that there are a new breed of startups that have found a way to circumvent their dependence on VC money.

It’s important to note that ICOs are not IPOs and the tokens are not shares. Tokens do not represent equity in the company, nor do they entitle the investor to voting rights or other shareholder privileges. Tokens have traded post-ICO in the past, but the ability to trade post-ICO is currently under regulatory scrutiny and it is unclear how tokens may trade in the future. Further, there is no guarantee either that the company will launch or that the company’s product will ever emerge.

Despite incredible success for several companies, the failure rate of the coin-offering has been also been quite high. According to Bitcoin.com’s analysis of ICO tracker Tokendata, of the 902 ICOs initiated in 2017, 142 failed at the initial funding stage and a further 276 have failed since. The report also notes that, of those companies still in business, 113 ICOs are classified as ‘semi-failed’. Added to the already deceased, that implies a failure rate of almost 60 percent.

One of the biggest concerns is that the cryptocurrency market has operated to some extent independent of existing regulatory regimens and therefore it’s susceptible to bad actors and various kinds of fraud. Regarding ICOs, the SEC has issued guidance since last July strongly suggesting that most or all tokens sales are subject to U.S. securities laws. While this ostensibly puts ICOs in the same regulatory bucket as traditional public offerings, it’s still not entirely clear how the SEC would view any particular token sale as they aren’t all the same. In fact, the SEC has issued subpoenas to a large number of players in the token sale business, so the seriousness of the SEC about regulating ICOs should not be underestimated.

Aside from the volatility of the cryptocurrency market, detractors are quick to point out that the majority of companies launching ICOs have yet to develop products and that investments are often being made solely on the basis of a white paper of intent. They also suggest that ICOs often lack properly developed teams, that their business plans are insufficient, and that some companies seem to have issued tokens simply to make a quick buck.

The safest bets, arguably, are those token sales that encourage purchasers to become future users of their tech ecosystems, and therefore actually serve a specific purpose in the context of the products and services in development. In such cases, purchases of tokens are akin to obtaining early access to discounted store credits.

It remains to be seen how the token sale phenomenon will evolve. Detractors would say that we need absolute regulatory clarity sooner rather than later. While the SEC has already made it clear that securities laws are generally applicable to token sales, it is likely that the specific nature of the regulation will be clarified in the near future, which could alter the funding landscape.

Yet at least for the foreseeable future, token sales conducted in accordance with applicable law and regulation are going to be a compelling fundraising option for technology initiatives because they are such an efficient vehicle for spreading awareness of a blockchain-oriented project within a community of people who understand its potential. In such cases, getting word out to potential users and developers is arguably as critical as raising funds, and a great token sale, conducted lawfully, can achieve all these goals simultaneously.