Traditionally, a startup seeking capital in order to help them grow and expand would look to private equity, usually from Angel Investors or Venture Capitalists. In the last few years, this has all started to change, with startups, mainly from the fintech space, deciding to go down the non-traditional route of launching an Initial Coin Offering (ICO), raising their funds in the form of cryptocurrency. According to the report State of the Token Market, created by Fabric Ventures and TokenData, startups raised $5.6 billion last year from launching ICOs.
This tremendous growth, the hype within the community about the benefits and advantages of doing an ICO, and general dissatisfaction with the VC-investment process by those who have experienced it, have all led us to this particular point. Now, experienced professionals from a variety of other industries within the business community are beginning to sit up and take notice of the waves that successful ICOs are making. Law firms, such as Collyer Bristow, understand the importance of sharing this information with their clients and their partners, and to engage in much discussion as possible. The blockchain-specific focus on collaboration now stretches even into the City – with its reputation for fierce competition.
Collyer Bristow recently hosted a panel with the intention of providing answers to the question of which form of investment, private equity or ICO, is the best way forward for a newly formed, fast-growing business in this current climate.
Private equity, the traditional route to raising capital, is well-known to anyone involved with business transactions. There is usually a division made between private equity and venture capital (VC) funding – with private equity, an investor is usually looking to take on the whole venture, taking a up to a 100 percent stake, with an eye on selling the company on or undergoing an Initial Public Offering (IPO). VC funding tends to be less concerned with high equity stakes, and will often target small companies that have the potential for rapid growth. VCs will usually appoint new directors, and provide assistance via an accelerator or industry contracts, for example.
Many people, particularly from ambitious startups, have come out with some criticisms of VC fundraising – it is a long, arduous process, which leads to startups having to satisfy many requirements and demands by the VCs along the way. For a startup that is growing quickly and that wants to get a minimum viable product (MVP) out there as quickly as possible, having to go through this process can definitely be a chore, and something that some may feel is holding them back in their earlier stages. Time that senior partners in this startup could be devoting to growing the business, is spent on pitching to various VCs and producing all kinds of documentation for them. In addition, companies that the Fintech Times has spoken to in the past have sometimes found that they were not able to find a fully on-board VC who would satisfy their terms, despite having widespread enthusiasm and demand for their product.
Furthermore, both private equity and VC investment require the relinquishing of a certain amount of equity – a portion of your business that you are not likely to ever see again. Many startups are reluctantly having to give up large portions of their company because they have no other funding route left available to them. You also have to factor in the mentality of VC investors as well – their goal is an exit, or anyway in which they can make the maximum return on the capital that they have put in. For a startup, particularly the ones that are focused on creating a game-changing product or solution that will have many real-world impacts, this can be very much at odds with their mentality, in which for them success is represented by number of users/ beneficiaries, or in the realworld impact of their idea.
For many, these potential downsides to private equity pale in comparison to its advantages, which is one of the reasons why it is so widely used as a method of raising capital. However, with the increasing prevalence of rapidly growing startups, particularly with the rise of the fintech industry, these downsides have been put more sharply into focus. In addition, if private equity was a perfect solution for all companies fundraising, then ICOs would not have grown so much as funding source. So, why is everyone so excited about ICOs?
We’ve come a long way since the first Bitcoin whitepaper was published by Satoshi. Now there are thousands of other ‘altcoins’, coupled with the increasing number of token systems being utilised by various organisations and startups. One of the more recent developments in this area is the use of ICOs. Instead of raising capital by giving away equity in the company, an ICO allows a startup to sell a certain number of personalised ‘coins’ to customers/investors.
These coins or tokens can then represent different things. They may simply be a token that has a utility within the service a company offers (to exchange for services within their platform for example) or may have certain rights attached to them, potentially allowing them to act like shares (voting rights and so forth). Much like in an IPO, these proprietary coins will then get listed on a crypto exchange. This means that their value may increase in the short and long term. Looking at how the price of Bitcoin has risen almost exponentially since the late 00s, you can understand why someone would be keen to own one of these tokens, which may potentially be worth a lot more than they originally paid for it.
The advantage of this method, that many startups see as vital, is that it allows for the rapid raising of capital from a variety of different (and often non-typical) investors, without giving away any equity in the company. In addition, at least until recently, ICOs were free of many of the regulations that one would have to adhere to if they were undertaking an IPO. Another benefit would be the fact that all the money raised during the token sale will tend to be in crypto, meaning that its value may continue to increase, with startups continuing to see returns on whatever capital they haven’t immediately used for operational costs.
Another dimension to the argument is in the nature of the investors themselves. These investors tend to be about as different as you can get from those behind VC funds, with different goals and motivations behind their decision to invest. Rather than being focussed on an ‘exit’ or thinking in terms of how they can increase the value of their share in the company, these investors may act more as if they were participating in a crowdfunding scheme – investing because they believe in the project and either want to be a part of it, or to see its long term effects on the market.
We asked Hadyn Jones from Blockchain Hub why ICOs have suddenly become so much more popular. In his opinion, the shift is driven by access to “easy crypto capital” and is something that doesn’t necessarily require an investor to be an insider or accredited. Another panelist, Mark from Illuminate Finance, weighed in as well: “Secondary market liquidity in what were previously illiquid instruments is a key benefit to investors that may also be driving some of the shift to ICOs.” He pointed out that you can see quite clearly the effect that this is having on the private equity market with other players “trying to offer this liquidity in the traditional private equity avenues, for example with seedrs crowdfunding platform, collateral backed tokens where the collateral are traditional venture equities.”
Whilst both of these panelists are heavily involved in the crypto-space, not everything they had to say about it was positive, with Hadyn drawing upon the lack of deeper understanding many of these investors have, who are just being drawn into the hype around possessing crypto-tokens, “In a smaller number of cases, it is because the need for a blockchain is an intrinsic component of the platform that is being developed, and represents a genuine innovation.” You might also find that the companies behind these ICOs are wanting to cash in on that ‘naivety’ as well.
In addition, and much like in crowdfunding, many companies fade quickly out of the limelight after conducting an ICO. Mark pointed out that a “significant number of companies funded in this way have already failed, with the incredibly small percentage that have actually created a tradable and liquid coin being a leading indicator that many of the companies that were funded via this route were companies where professional investors would not have funded them, either at all, or certainly at the price.” So, if a company was struggling to raise money via private equity, maybe there was a reason. None of this really detracts from the fact that this form of raising capital can be very successful for a small, ambitious, and rapidly growing company. However, many startups may need to think hard about whether or not they can actually deliver for their enthusiastic investors.
It’s easy to see why startups, particularly in fintech, favour the use of ICOs as a method of fundraising. The majority of concerns around ICOs focus on the disadvantages for investors and negative impact on the market as a whole. Startups do probably need to think through whether an ICO is really relevant for their business, and if they have the product to follow through once their ICO has concluded. In the future, once the hype has died down slightly, we are likely to see private equity remaining as the de facto choice for both startups and more established companies to raise capital, with ICOs being used where relevant for a blockchain-based business.