ICOs: The Rise of a Blockchain-Based Financing Instrument In 2017, we have seen rapid growth in capital raised through initial coin offerings (ICOs), which startup companies use to raise funds online via the issuance of new cryptocurrencies. In this report, we examine the use of ICOs and: 1) Explain how ICOs work, why they have grown so rapidly, what concerns are linked to them and how regulators are addressing them. 2) Provide an overview of the ICO ecosystem and some of the more popular sectors in which startups using ICOs to raise funds are focusing on. We also profile Filecoin and Tezos, the two tech firms that have launched the most successful ICOs thus far in 2017. 3) Share insights from our interview with Tezos Cofounder Kathleen Breitman on the future of the ICO as an equity financing instrument. Deborah Weinswig Managing Director FGRT deborahweinswig@fung1937.com US: 917.655.6790 HK: 852.6119.1779 CN: 86.186.1420.3016 1
In 2017, we have seen a boom in ICOs, which are used to raise funds, mainly by tech startups that are developing applications for blockchain technology. Introduction In 2017, we have seen a boom in ICOs, which are used to raise funds, mainly by tech startups developing applications for blockchain technology. This report explains what ICOs are, why they have become so popular, and their advantages and disadvantages. We also examine the outlook for ICOs as a fundraising instrument. For this report, we interviewed Kathleen Breitman, Cofounder of Tezos, a blockchain company that recently completed one of the largest ICOs by total capital raised. Breitman provided us with an overview of her company, which we profile later, and her opinion about the future of ICOs as a form of company financing. The ICO as a Fundraising Instrument An ICO is an online fundraising mechanism through which a startup company raises funds by issuing new cryptocurrencies, or tokens, to be purchased by investors. The ventures financed by ICOs are typically technology projects related to cryptocurrencies or decentralization through the blockchain. Examples include decentralized file storage network Filecoin, which allows participants to share unused storage space on their computers, and Tezos, a smart contracts platform with a formal governance mechanism that enables token holders (investors who own tokens) to make collective decisions on issues such as system upgrades. The tokens do not give investors a share in the company, as occurs with other equities. Rather, tokens are just a unit of value that investors can sell for other cryptocurrencies or for fiat (regular) money, or spend by using the issuing company s services. For example, with Filecoin, token holders can use their tokens to pay for storage space available through other parties in the decentralized storage network. With Tezos, tokens are used to reward developers who propose system upgrades that are approved collectively by the token holders. Figure 1. Glossary of Key Terms cryptocurrency/token blockchain initial coin offering (ICO) smart contract A digital or virtual currency that uses cryptography for security. Bitcoin and ether are the main cryptocurrencies by market capitalization. Token is used as a synonym for cryptocurrency. A digitized, decentralized, public ledger of all cryptocurrency transactions. An unregulated means by which funds are raised for a new cryptocurrency venture. A self-executing contract wherein the terms of the agreement between buyer and seller are directly written into lines of code. Source: Investopedia.com/FGRT 2
ICOs have become a popular form of fundraising for tech startups that develop blockchain applications. When launching an ICO, a company publishes a white paper in which it gives investors information about its business, similar to the prospectus a company would create for a conventional initial public offering (IPO). Investors purchase the tokens offered through an ICO using more established cryptocurrencies, such as bitcoin and ether. Tokens differ from regular shares issued in a conventional IPO in that they do not entitle the owner to a share in the issuing company. The ICO Ecosystem: $2.2 Billion Raised So Far in 2017 One of the first and most significant ICO-style crowdfunding initiatives was undertaken for the launch of Ethereum a blockchain platform on which smart contracts can be run in July and August of 2014, when programmer Vitalik Buterin sold ether tokens to investors in exchange for bitcoin. Source: istockphoto At the time of writing, a total of $2.2 billion had been raised by 148 ICOs since the start of 2017. Following Ethereum s launch, the ICO became a very popular instrument for blockchain startups to use to raise funds. From the start of 2017 through the time of writing, a total of $2.2 billion had been raised by 148 ICOs, up from $96.3 million raised by 46 ICOs in all of 2016, according to specialist website Coinschedule.com. In terms of categories, infrastructure made up 42.4% of total ICO-funded projects as of September 7, 2017, according to Coinschedule.com. Among the top companies by funds raised are: Smart contract platform Tezos, an open-source smart contract platform Bancor, a protocol for the creation of smart tokens, a new type of cryptocurrency that is intrinsically exchangeable directly through smart contracts Status, a mobile operating system based on the Ethereum blockchain 3
Data storage is the second-largest project category in terms of ICO financing, accounting for 12.9% of total projects as of September 7, 2017, according to Coinschedule.com. This category includes a decentralized network for digital storage called Filecoin. Other significant categories are trading and investing (12.3%), payments (8.3%), finance (6.6%), gaming and virtual reality (4.7%), gaming and betting (2.1%), and commerce and advertising (2.1%). The graph below shows the top 10 ICOs thus far in 2017. Figure 2. Top 10 ICOs, by Total Funds Raised, 2017* (USD Mil.) Filecoin Tezos EOS Stage 1 Bancor Status TenX MobileGO Sonm Aeternity Monetha 64.0 53.1 42.0 37.0 36.6 90.0 153.0 185.0 232.3 257.0 *As of September 7, 2017 Source: Coinschedule.com Filecoin and Tezos were the two largest ICOs this year, as of September 7. Filecoin provides a decentralized network for digital storage that enables users to share with other parties in the network their spare capacity and to be paid in filecoin (the project s tokens). Filecoin s ICO began on August 10 and ended on September 7, 2017. It raised a total of $257 million, a record for ICO funding. The funds were raised through CoinList, a joint project between Protocol Labs (the developer of Filecoin) and startup investment platform AngelList. Investors include venture capital (VC) firms Sequoia Capital, Andreessen Horowitz and Union Square Ventures. On the day of the launch, Filecoin announced that it had raised $252 million in just 30 minutes (including $52 million raised via presale). Source: Filecoin.io 4
Tezos, with total funding of $232 million, held the second-largest ICO in 2017 (as of September 7). Tezos was founded by computer scientist Arthur Breitman and his wife, Kathleen Breitman. We interviewed Kathleen Breitman for this report, and she gave us an overview of the company. Tezos, with total funding of $232 million, held the second-largest ICO in 2017. Tezos is a smart contract platform based on a blockchain with an embedded governance mechanism that enables collective decision making, Breitman told us. Developers can propose an upgrade of the blockchain without the need to fork (split into a new blockchain with the upgraded characteristics). This is possible thanks to the structure of the platform that allows developers to make changes by simply replacing a part of the blockchain with a new part, without compromising the whole system. Source: Tezos.com Changes are approved through consensus decision making among the token holders. Developers who propose an upgrade submit it with a proposed invoice. Token holders then vote on the proposed change and, if it is approved, the developer receives tezzies (Tezos s tokens) as payment. The project started in 2014, and the ICO ran from July 1 through July 13, 2017. On that date, Tezos s ICO was the largest in 2017 by funds raised (it was later surpassed by Filecoin s ICO). Advantages: ICOs Enable Straightforward Fundraising The impressive growth of funds raised via ICOs in 2017 shows how attractive this option has become for startups seeking investment. ICOs enable startups to raise funds in a straightforward and fast way that is cheaper than traditional funding mechanisms, thanks to five main factors: Lack of regulations: Because ICOs are largely unregulated, companies do not need to spend time and resources ensuring they comply with legal restrictions, making ICO fundraising faster and cheaper than traditional fundraising mechanisms. Larger pool of investors: ICOs attract a wider pool of investors than do other forms of financing, such as VC investments, which are mainly reserved for institutional investors. Investors in ICOs do not need to meet any requirements, as the sector is largely unregulated. ICOs appeal to individual investors who have looked at the historical 5
performance of more established cryptocurrencies, such as bitcoin, and are attracted by the potential of enjoying fast returns on ICO investments. ICOs are global: ICOs have no geographical boundaries, as they are held via the Internet and the blockchain in an unregulated environment. Investors from all over the world can put their money in an ICO, no matter where the company raising funds is located. More flexibility for investors: Investors in an ICO have more flexibility in deciding how much to invest and when to exit the investment. Most ICOs have low minimum contribution requirements. For example, the minimum investment for Tezos s ICO was 0.1 bitcoin (US$251 on July 1, 2017, the starting date of the ICO). The low minimum stake makes ICO investments accessible to many. Moreover, investors can sell their tokens at any time, enabling them to quickly and easily exit an investment. By comparison, the average exit time for a VC investment is seven years, according to specialist website AngelBlog. More funds raised: Because ICOs have a global reach and are open to a larger pool of investors, they hold the potential to raise more funds than other forms of fundraising. An early-stage open-source firm such as Protocol Labs might expect to raise $10 million from a first round of traditional VC funding, according to the Financial Times. But through the sale of tokens, startups can attract both investors who believe in the company s business model and others who simply enjoy the speculative nature of token trading. This wide pool of potential investors can lead to extremely high levels of fundraising, as in the case of Filecoin, which raised $257 million through its ICO. In June 2017, funds raised through ICOs surpassed those raised through VC investments for the first time. In June 2017, funds raised through ICOs surpassed those raised through VC investments for the first time, according to investment bank Goldman Sachs. In that month, ICOs raised more than $500 million, while angel and early VC funding totaled just under $300 million, according to the bank. Criticisms: Lack of Investor Protection Is a Main Concern ICOs are largely unregulated, and many see that as key to their recent popularity. Companies that hold ICOs have no need to comply with the kind of burdensome regulations that cover other forms of fundraising. But critics say the lack of regulations brings risks for investors, as fundraisers are not compelled to make accurate statements in their documentation. There have been cases of ICO white papers that exaggerate benefits, fail to identify risks and generate unsubstantiated hype. Some critics argue that most ICOs are just scams to get investors to trade bitcoin or ether for tokens linked to worthless or low-value business plans that will eventually result in zero value. These critics raise concerns over the complete lack of legal protection for investors in ICOs compared with investors in IPOs and VC funding rounds. Moreover, many are skeptical about the creation of ad hoc tokens for ICOs in cases in which the new cryptocurrency has no real application in the business model of the company. In these cases, the tokens are created only 6
for the purpose of raising capital during the ICO but bitcoin or ether could be used instead. A new cryptocurrency could become worthless once the hype for the ICO fades, posing the risk that investors will lose all the value of their investment. The rising popularity of ICOs has attracted the attention of financial authorities. ICOs are likely to become a recognized form of financing that is accepted and regulated by authorities. Financial Authorities Have Started to Look at ICOs The rising popularity of ICOs has attracted attention from financial authorities in a number of countries, and some regulatory bodies have started to intervene to address the concerns highlighted above: In the US, the Securities and Exchange Commission (SEC) ruled on July 25, 2017, that the virtual coins or tokens offered or sold via an ICO may be deemed securities, depending on the facts and circumstances related to the ICO. If the tokens are deemed to be securities, they are subject to federal securities laws. In China, financial regulators including the People s Bank of China issued a statement on September 4, 2017, that banned ICO activities. The authorities declared that the large number of ICOs occurring in China risk disrupting the economic and financial order by encouraging speculation and illegal financial activities. In the UK, the Financial Conduct Authority issued a statement on September 12, 2017, that warned investors of the possible risks of investing in ICOs, including a lack of investment protection, high price volatility of tokens and the potential of fraud. Despite regulators intervention, it seems unlikely that governments will try to prohibit ICOs permanently. Even the ban introduced in China is likely to be temporary, as it is intended to give Chinese regulators time to introduce regulatory frameworks and policies for both ICO investors and projects, specialist news website The Cointelegraph reported, citing sources close to Chinese regulators. In fact, regulatory authorities intervention in particular, the SEC s ruling in the US can be considered a recognition of ICOs as a fundraising instrument that needs to be regulated rather than as one that should be banned. The Future of ICOs: A Possible Alternative to Equity Financing ICOs are likely to become a recognized form of financing that is accepted and regulated by authorities, according to Tezos Cofounder Kathleen Breitman. In the future, they will likely be an established and legitimate funding mechanism that is an acceptable alternative to equity financing, Breitman said. In essence, the ICO is a significant financial innovation that applies the blockchain technology to fundraising, according to Breitman. The application of blockchain technology provides added security for investors, as investors payments are recorded on a public ledger in a transparent, immutable way. ICOs also make it possible for companies to attract investment from all over the world and from a variety of investors, thanks to the cross-border and decentralized nature of the blockchain. 7
Breitman said that compliance directives can be directly inserted in the blockchain used for an ICO, ensuring that future legal requirements will be met automatically. Conditions set by regulators will be programmed into the blockchain in the same way that the rules set between the parties of a legal agreement are programmed into a smart contract. The ICO as a fundraising mechanism is likely to remain confined to startups operating in the blockchain. However, ICOs are likely to remain confined to startups operating in the blockchain, according to Breitman. Source: Tezos.com She sees a problem with the scalability of the ICO fundraising system, which makes it unsuitable for larger companies. Breitman also said that more traditional fundraising forms, such as VC financing, provide advantages for companies that in most cases ICOs do not provide. For example, institutional investors, thanks to their expertise, can act as advisors for a company raising capital through VC financing, rather than as just as a source of funds, while investors in ICOs in most cases do not engage with the company to the extent of dispensing advice. Investors are starting to demand more transparency than they did in the past from companies issuing tokens for ICOs, Breitman said. This makes it increasingly harder for companies with dubious business models to appeal to potential ICO investors. She offered two recommendations for investors who are considering putting money into an ICO: Investors should ask themselves whether the project financed really benefits from the use of the blockchain or if the technology is being used just to jump on the ICO bandwagon. Similarly, investors should question whether the cryptocurrency released for the ICO has a real use within the application the ICO is funding or if it is just a means to raise capital by luring investors to buy the tokens in the hope that the cryptocurrency s value will rise. 8
Deborah Weinswig, CPA Managing Director FGRT New York: 917.655.6790 Hong Kong: 852.6119.1779 China: 86.186.1420.3016 deborahweinswig@fung1937.com Filippo Battaini Research Associate Hong Kong: 2nd Floor, Hong Kong Spinners Industrial Building Phase 1&2 800 Cheung Sha Wan Road, Kowloon Hong Kong Tel: 852 2300 4406 London: 242-246 Marylebone Road London, NW1 6JQ United Kingdom Tel: 44 (0)20 7616 8988 New York: 1359 Broadway, 18th Floor New York, NY 10018 Tel: 646 839 7017 FungGlobalRetailTech.com 9