The rapid development of the crypto market in 2017 gave birth to a new model of investing in startups. The dynamic, young industry could have been suppressed by traditional fundraising processes, called initial public offerings (IPOs), which are slow and subject to strict regulation. The new model, initial token offering (ITO), was designed to cope with the challenges of the time.
So, in which case should a company prefer an ITO instead of the tried and true IPO, and what are the risks and benefits of taking this step?
2017: The rise of ICO
The modern history of an IPO originates from the Dutch East India Company, which was the first in the world to perform the placement of its shares in 1602. The practice of attracting funds through institutional investors has long been established, as this process attracts large amounts of money. Just look at the volumes of IPOs in the US in 2017:
The above graph shows the value of initial public offerings (the amount of money that investors brought to IPOs) in the United States in 2017, by sector (in billions of dollars).
Last year, in the United States only, the IPOs raised around $30 billion (we will return to this figure later).
Only in recent days has the technology of the blockchain allowed for us to open a new chapter in venture capital investing.
Last year was marked by an unprecedented rise in the market of crypto startups that were funded by the initial coin offering model.
Source: The State of the Token Market
It is well-known that the Ethereum ICO was one of the earliest initial coin offerings and one of the most successful crowdfunding campaigns in human history.
Inspired by the success of Ethereum and other pioneers, developers began to put their projects to the ICO one by one, and investors received tenfold profits against the background of the overall market growth, and this was just at the end of last year. But the story doesn’t end there.
In 2018, the aggressive growth of this sector did not just continue, but it increased: ICO financing for the first six months of 2018 has already exceeded the entire amount of funds that were collected in 2017 (about $6 billion). According to Richard Muirhead, the founder of Public Ventures VC fund, “We have rarely been more excited about what the ascending year promises to deliver: numeric projects intending to go live on main-network, decentralised exchanges mining traction, industry grade services including custody and accounting, identity networks and data ownership models enabling the blooming of the sovereign individual and many more.”
The “explosion” of the ICO industry in this context is not just words. You can see a perfectly executed visualization of this very process from the Elementus team. By the way, in this video, the growth of the total capitalization of all ICOs stops at $23 billion (on the 31st of March, 2018). Remember the figure from earlier? $30 billion is the amount of money that has been collected by American investors in the traditional IPO in year 2017 alone. This shows how much the funds raised under the models, both new and old, are still incommensurable, despite the assurances of crypto enthusiasts about the “death of the traditional investment scheme,” etc.
Many draw parallels between the modern crypto market and the “dot-com bubble” that took place in the late 90’s. At that time, it was enough to have a domain “.com” and enter the word “Internet” in the business plan of your company so you could have the money flow right into your pocket. According to skeptics, the same thing is happening today with blockchain technology — too many projects attract funds for naked marketing and empty promises.
Interestingly enough, the rise of the IPO system fell on the rise of the “dot-com bubble,” which is often compared with the rapid burst of the cryptocurrency market.
The state of the investing market today is, seemingly, that the traditional IPO model has been shaken, and its “blockchain disruptor,” ITO and ICO, are aggressively conquering the market.
However, it is very premature to talk about the collapse of an investment model that has existed for over 400 years. Both IPO and ITO have their advantages and their weaknesses, which we will soon discuss.
So, what did give birth to this new and powerful trend in the fintech sector? What can be given to a company by a token sale and not by an IPO?
IPO vs. ITO: The collision of investment models
Round one: The audience
Imagine that you are transported to 2004 and you’re thinking about the opportunity to buy some shares of a relatively small company called Google, which is going to have an IPO. Do you think it’s a good idea? Beyond question. By selling these shares now, you would have gotten a yield of 1850% in 10–15 years — that’s considered crazy in the world of traditional finance.
But there’s one problem: in 2004, you wouldn’t have bought those shares before bidding if you weren’t from Wall Street. This can only be done through an accredited broker, and they prefer to work with institutional investors (you can read more about IPO procedure and details here). As a retail investor, you have “Minimal to no access to IPOs,” according to Investopedia. This is just the rule of the stock market. So here we are faced with the first distinctive feature of the IPO: the initial offering of shares is intended primarily for large venture investors.
All right, now we may have a look at the audience attracted by an ICO project.
Let’s consider an example of a successful startup from the crypto sphere — let’s say, Ethereum. Any person who invested BTC in ether in 2014 could anonymously receive his coins at the rate of 2000 ETH for 1 BTC. No verification. No restriction. Just pure crowdfunding.
Such a huge difference in the approach to investor control brings us to the next important point:
Round two: The purpose of the sale
It is necessary to understand why companies go through a public sale regardless of its form. In the world of traditional finance, a company’s IPO is a serious step that involves the passage of many stages of regulation. A properly conducted public sale eventually seriously raises the authority of the company and allows it to significantly increase capitalization (as it so happened with Google). So, in the traditional market there are solid companies that want to strengthen their reputation and “grow” in the eyes of investors via completing an IPO.
In the crypto world, the situation is much more wild. As we all know, funds within an ICO are often gathered by having only a promising idea, which isn’t worth anything. This is not necessarily a bad thing — for example, one of the successful “second wave” NXT blockchain projects started out with $20,000 in Bitcoin donations from volunteers. We recently wrote about the heir to NXT — a promising blockchain called Ardor.
Round three: The economic model
Here we should start by emphasizing that ICOs and ITOs are slightly different. A token is a more general concept than a coin (but it can still be used as a means of payment). It is also more than just a share in a company.
The traditional system of shares is based on the principle of dividend payments: the shareholder buys a small part of the company and has the right to claim some of the company’s profit (proportional to the number of shares he or she holds).
In the crypto world, we can only hope that the chosen platform we invest in will remain in demand, which will directly affect the price of the token (if it is a utility). Utility tokens work as tickets, or coupons, and represent the right to access a company’s product or service. The main feature of this kind of tokens is that they are not designed as investments (this is the reason why utility tokens can avoid problems with regulators much more easily). As soon as the investor does not own any part of the blockchain startup, the success of this new economic model depends heavily on the growth and usage of the platform. Cryptocurrency is fueling numerous DApps and manages a large number of new ICOs. This is the reason why ether has already made >200,000% for its early investors — another thing to think about when looking at America’s best IPOs of 2017, which are much more modest, though still very profitable from a traditional perspective:
Dangers of ITO
The previous part doesn’t seem to be a well-balanced and dispassionate review of ITO and IPO advantages, right? It seems that this new investment model looks more interesting: it allows you to attract more funds through a wide audience, to avoid long and costly regulatory approvals, and it lets you buy tokens that are subject to smart contracts, therefore being much more flexible than traditional shares. We also know of fascinating examples of successful startups like IOTA that have brought their investors huge profits through ICOs. Such high returns are unthinkable in ”traditional” investing.
But at the same time, it is important to understand that there is no big profit without a big risk. It is no secret that in the long term, most ICOs fail. Here’s how it is presented in the remarkable report on the state of the ICO market for 2017–18, “… the current token model is still very far from solving the open source funding problem. The majority of investors are more interested in the special nature of cryptocurrencies than in the efficiency of open source development. A lot of these projects have raised massive amounts of money upfront before receiving any market validation, creating problems for long term identification of the team.”
With the growing number of cryptocurrency projects, it is becoming more difficult for developers to attract the attention of the audience. The result is the following “genius” ads:
The crypto community made a lot of fun of this picture from Kickcoin, but it does reflect the current state of affairs in the field of ICO. Unfortunately, the “dummy” money from small investors lose majorly to the smart ones who participated in the classic IPO’s for several decades before the birth of cryptocurrency.
The example of Telegram, which only collects money for its TON project from institutional investors, is illustrative (as you probably know, Telegram refused a public round of a token sale). Indeed, why would a project with such a name and reputation bother with millions of small players in the crypto market if it can close the entire hardcap by means of private funds? Telegram’s ICO has little in common with traditional ones. All the tokens have been sold under a simple agreement for future tokens (SAFT) and with a very long lock-up period. This means that investors have bought not the tokens exactly, but only the contracts that will allow them to claim their tokens at a later time. The developers of TON, as well as the other large projects that refuse to have a public round of the token sale, are afraid to withdraw their tokens to a volatile and unpredictable cryptocurrency market. This can suppress all of the fundamental growth of their assets with a single day dump of BTC.
Use case of an ITO
There are projects for which the use of an ITO is the only right choice. These include, for example, the Dominium blockchain platform for real estate management.
The creators of the platform are aimed at conquering one of the largest markets in the world — the real estate market, which is estimated to be valued at more than $200 trillion.
The DOM token is a utility. They are used to pay for all activities on the platform, such as the creation of assets, the trading of assets, the creation of support tickets, voting for charities, listing a property for sale, listing a property for rent, registering a rental agreement, registering a purchase agreement, and registering property management actions (maintenance, etc.).
Why did Dominium choose an ITO as an investment model?
- It is an early-stage project. The team doesn’t have billions of dollars behind them, so they prefer to raise their starting capital via a token sale. One of the most important features of an ITO is that it allows a company to raise the foundation from project enthusiasts to early adopters extremely easily.
- Dominium needs massive adoption of their technology. That’s why an IPO wouldn’t be a wise decision despite the fact that it might cover the financial issues. A token sale and Airdrop is much better, since it launches the organic growth of the project audience. Airdrop is a nice way to create a community around the project, while stable demand for tokens will result in the flow of new investors, which equals token purchasers.
Crowdfunding is a good way to make people recognize your brand and create potential market demand for your product, regardless of whether it exists or not.
Here is the project’s plan:
First, Dominium has already moved a large portfolio of 24 apartments in Rotterdam into the company Dominium B.V., and they will transfer further assets into Dominium during the pre ITO. This ensures that there is a future value of around €5 million in the company already when the pre ITO starts. This sum will become the pre ITO /private sale hard cap.
Next, Dominium will invest virtually all of the money raised during the pre-ITO and ITO into properties. The entire process will be audited, so everyone who participates in the ITO knows exactly where their money has gone. As soon as the rental income starts coming in, Dominium will start buying DOM back and taking them out of circulation (together with the transaction fees in DOM tokens earned on the platform), thus assuring a diminishing supply of DOM tokens.
To sum up, both an ITO and an IPO have their own advantages. Which option to choose depends on a company’s business model.
An ITO can be useful for the initial start of the project and for attracting a loyal audience to it without attracting too much attention from the regulators.
About the author:
Kirill Shilov — Founder of Geekforge.io and Howtotoken.com. Interviewing the top 10,000 worldwide experts who reveal the biggest issues on the way to technological singularity. Join my #10kqachallenge: GeekForge Formula.