If ICOs Can’t Change, They’re Doomed to Fail

Last month, TechCrunch reported that the cumulative volume of initial coin offering (ICO) financing by startups totaled $3.8 billion, most of which was raised in 2017. While this is only about 10% of the amount raised just in 2017 through Venture Capital (VC) financing, it is still a substantial amount considering that ICOs hadn’t even really existed before the last few years. ICO financing volume is also estimated to have surpassed early stage angel and seed funding — clearly, ICOs are gaining popularity as a means for entrepreneurs to raise capital for their young companies. What does this mean for the startup community in Silicon Valley, which has traditionally obtained capital overwhelmingly from limited partnership VC firms?

The current VC funding model aligns incentives much more effectively. Think about financing as a transaction involving two parties, investor and founder. Each party has something the other wants: the founder has a promising business that the investor wants a share of, and the investor has capital that the founder needs. Under the VC model, the founder obtains the capital that he needs, and “pays” for it by giving up some equity ownership in the company.

But, how does the investor ensure that his investment is being used efficiently by the founder? This is an valid concern when investing in early-stage firms, which are naturally very risky. Here lies the key difference between the VC model and the ICO model. Under the VC model, the investor receives governance rights, typically in the form of board seats. This gives the investor direct input in firm decisions and allows him/her to take active measures to protect and grow the investment. Additionally, it diversifies leadership within the firm, fostering different viewpoints and ways of thinking, promoting innovation.

This is where ICOs fall short. When an investor buys into an ICO, he/she receives no governance rights whatsoever. Again, early-stage investments are extremely risky (VC firms expect a lot of their investments to fail completely) — taking on this risk without compensation in the form of governance is dangerous, especially for a retail investor without a lot of capital.

ICOs aren’t just a problem for investors. While preventing overbearing VC investors from obtaining board seats might seem attractive to founders, oftentimes this intimate interaction with VC firms is just as valuable as the capital that they provide. Martin Kenney of UC Davis notes that, alongside capital, VC firms encourage new firms’ growth through the provision of “services and advice.” By deciding to finance through an ICO rather than a VC firm, startups are eliminating these other growth inducers; in other words, they’re taking capital without the advice.

For founders that want to avoid governance, the TechCrunch’s Danny Crichton says that:

“the ideal scenario is an ICO, but coupled with a concerted search for the best board member(s) available to help drive the vision of the company. That keeps the CEO and founders in charge, but also forces them to ask what kinds of skills might be helpful for the company, and also show some level of humility that they might not always know the answers.”

This sounds nice in theory, but can founders (which in Silicon Valley tend to be pretty young) be trusted to autonomously select board members who are most aligned with the interests of investors? It seems more likely that founders would lean towards those who share their beliefs and biases, rather than those who offer diverse viewpoints and might challenge the founder in the future. As a result, boards of startups that follow this “ideal scenario” would likely become more homogenous, more susceptible to groupthink, and less experienced. And, of course, less likely to be held accountable by investors.

ICOs sound good conceptually, and they do indeed offer benefits, such as increasing developer awareness of the startup and its plan. Additionally, they avoid the fees and transaction costs typically associated with financial intermediaries. However, regulatory and corporate governance are weak in the ICO universe (see also how institutional investors can potentially exploit the system). Unless those in the ICO community can successfully align the incentives of all stakeholders and provide an adequate regulatory framework, they are ultimately doomed to fail. For the time being, VC firms will continue to be the go-to investors for startups.