Startup Funding Through Initial Coin Offering - All You Need To Know
Raising funds for your startups is no easy task. In fact, most startups fail because they fail to raise the necessary funds in time.
However, in the last few years, there have been enormous innovation in fund-raising for startups. Crowdfunding has become a favorite for several bootstrapped startups. In fact, businesses dedicated to facilitating crowdfunding like Kickstarter has achieved billion-dollar valuations.
An Initial Coin Offering is one of these fund-raising methods that is growing rapidly, although, after 2017, it suffered a hit due to SEC’s regulatory actions. It is forecasted to more than double in the next six years till 2028 – from USD 826 million in 2020 to 1902.5 million in 2028 - thus signaling a year-on-year compound growth rate of 11.1%.
The growth of ICO is also supported by the fact that the global blockchain market is also growing at a rapid rate – from 12.7 billion dollars in 2022, it is forecasted to grow to 39.7 billion dollars in 2025.
Like, crowdfunding, Initial Coin Offerings, also known as ICOs, use the power of the masses to get a huge amount of funding for startups in a very short time. However, unlike crowdfunding, which are essentially, donations provided to businesses, ICOs follow an investment model, wherein the participants engaging in the ICOs actually expect a profit from the startup.
With billions of dollars being raised through ICOs every year, it’s a great opportunity that startups are using to raise money right now.
In this article, you’ll get to know all about what is Initial Coin Offering, startups that are using ICOs to raise massive amounts of capital, how you can do it too and the dangers you need to watch out for, when using this process.
So, let’s get started learning about ICOs!
What Is Initial Coin Offering?
In the simplest of terms, Initial Coin Offering, is the block-chain equivalent of an Initial Public Offer.
In an ICO, you ask the public for money in exchange of some digital tokens issued by your startup. These tokens can symbolize ownership over your startup or even a share in your business assets or even be issued as a form of guarantee for some future product or service that will be provided by your startup.
These digital tokens operate on blockchain technology and can be bought via normal currency or cryptocurrencies.
So why is an ICO so much better than an IPO?
The fact of the matter is that most startups can not go for IPOs. It is an extremely costly procedure and can cost a startup around $5 million in legal fees. You need to hire lawyers who are well versed in corporate matters, intellectual property matters, merchant bankers etc.
Plus, if your startup is not successful, there is a huge chance that your startup is going to tank and not get listed in any reputable stock exchange.
However although an ICO can use the investment model at a much lesser cost than an IPO, there’s also a second option.
Initial Coin Offerings also have the ability to unfollow the investment model and this can pretty much be initiated by any startup with around zero legal fees. However, doing that can be a little bit tricky.
To do this, you need to ensure that the ICO contributors are entitled to a product or service and not to any form of ownership in the startup or its assets. So, for example, you offer digital tokens in exchange for a future service that your startup may provide. Or, you could provide digital tokens so as to enable token holders to take part in your startup’s beta launch before anyone else!
Startups Who Have Successfully Used ICO To Fund Themselves
Startup funding through ICOs are expected to double up in the near future. At the beginning of 2017, around $300 million was the all-time total funding that had been raised by startups through ICOs. But this went up to $5.86 billion at the end of 2017. In the first quarter of 2018 alone, $6.8 billion was raised in the U.S.
NEO, a Chinese open-source blockchain project used smart contracts and decentralized tech to raise a massive ICO. Its initial token price, which was around 3 cents, went all the way up to $40 as of September 27, 2021.
An early example of raising capital via ICO’s was that of Ethereum's ICO in 2014, which raised $18 million in just 42 days! Its price per token now is at around $3128 as of September 2021.
Startups like Dragon Coin raised around $320 million in 2018 while Block.One raised around $4 billion through an Initial Coin Offering scheme that lasted for around a year. NXT, was one of the earliest ICO proponent in the world. Its token value started initially at $0.0000168 but went up to $0.01 in 2021 - a 1000x gain!
However, startup funding through Initial Coin Offering is tapering down to more moderate levels than the historic highs of 2017 and 2018 because of SEC tightening its regulations and fraudulent companies scamming investors off their money, which we are going to examine in the next section –
Dangers In Using Initial Coin Offering To Raise Capital
Raising capital through initial coin offering favored by startups because of its easy access to public funds, making it very similar to an Initial Public Offering, while not having to go through the excruciating regulatory compliances mandated by the SEC for going public.
So, technically, a startup was getting access to public funds without going public!
However as startups were able to bypass private equity financing and instead of going public, were able to get access to billions of dollars via ICOs, the SEC stepped in!
One of the most high-profile SEC case, involved the Telegram app company, which raised around $1.7 billion via ICO. The SEC stepped in and got a temporary restraining order against Telegram, which was converted, into a preliminary injunction. Telegram was finally compelled to return $1.2 billion of the money that it had raised from investors via ICOs.
If you are raising money from individuals as investments and the number of investors cross a certain threshold, it means your company is going public. It’s one of the most fundamental legality that any company in the US is affected by!
Now, when you are going public, you need to register with the SEC and fill out several regulatory compliances. Not doing that can invite massive legal penalties against your startup!
Most startups when raising ICO funding seeks to avoid SEC oversight. To do that you need to ensure that the way in which you raise capital through ICO does not get classified as an investment contract.
But since raising money via ICOs are a legal grey zone, it becomes much difficult for startups to accurately assess how they should go forward. While registering with the SEC can be done and the entire process can cost you around $500,000, keep in mind, that you can avoid the underwriter fee, which goes up to $7 million in an IPO.
But still, to be on the safe side, you need to consider a test, which is famously known as the Howey Test.
According to the Howey test, if your funding process involves the following four steps, it will be classified as an investment contract and then the SEC can intervene –
1. It is an investment of money,
2. Individuals who are funding you expect profits,
3. The money is being funded into a common enterprise,
4. Any profits that the individuals funding the project gets, come from the efforts of third parties which includes the startup promoter or startup as a whole.
If the money that you raised hits all these four criteria, you should register with the SEC to be on the safer side. But, if it doesn’t – for example, you are using your tokens to get funder access to your product or service and not ownership of your business capital, then you are good to go!
How You Can Use ICO For Your Startup
In order to raise ICO funding for your startup, you should follow some of these best practices.
First, create a whitepaper in which you outline the function of the digital token, that is, whether it gives the token holder some right over company's ownership, assets or whether it is a future utility token, that is, it entitles the token holder for futures services provided by the business.
Also, mention details about how many tokens will be created and how it shall be distributed. Also provide a detailed description regarding the project which you want to fund using your digital tokens. Divide the project into key steps and development stages and mention the funding that you are going to seek at each stage of the project.
Make sure your token is priced in a clear and logical manner. The pricing can be either static or dynamic.
However, you should take care that it is fairly priced, that is, you should mention the maximum number of tokens that are going to be sold. Also, ensure that the pricing mechanism does not increase over time.
If you are decentralizing the project, make sure you set aside a fixed number of tokens for the development team. However, this does not apply to most startups, so you can safely skip this one, if the project that you are venturing into, is being developed by you and your team.
Now, how do you ensure your project remains free from the technical oversight of SEC?
While this is still a legal grey zone, some legal experts believe providing digital tokens for future services instead of company ownership or capital is the best way forward in order to avoid getting classified as an investment contract.
This also seems to be the case followed by the industry when raising funds via ICOs. But, most importantly do not advertise the funding process as an investment!
That said, raising money via ICOs are quite easy and is literally the biggest funding hype right now. Because of the easy nature of this funding procedure, you can get it done in a fraction of cost and time when compared to private equity or public funding!
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Adhip Ray is a startup consultant, the founder of a startup consultancy WinSavvy.com and an advisor at PatentPC.com. Although he hails from a finance and legal background with twin specializations on intellectual property rights and corporate law, he has been a marketing geek since 2015. He is also an author at HubSpot, Investing.com, Addicted2Success, StartupNation and several other business publications.
