Welcome to the second installment of our fall series exploring blockchain technology, Internet of Things (IoT), and security tokens. In this month’s edition, we’ll examine two ‘decentralized’ investment techniques that partially run on blockchain: initial coin offerings and equity token offerings.
Going public is often seen as the holy grail for successful startups– the big payoff after years, sometimes decades, of hard work.
Not every debut on Wall Street can be a success story, though. Just ask Facebook, whose IPO was troubled by an array of technical trading errors. Ask Blue Apron, who failed to deliver to investors what they promised prior to the IPO. Or ask other tech unicorns such as Airbnb and Uber, who still did not manage to go public (or simply do not want to).
For successful startups, raising capital through an initial public offering (IPO), can be risky. Companies that wish to conduct an IPO, have to survive a dreadful process of bureaucratic steps and regulatory measures before actually raising any money. Going through that process requires consideration and care, prior to investment.
However, new means of fundraising emerged with the technical guidance of the ERC-20 token standard; the idea of raising large amounts of capital in a short amount of time without a regulatory framework sparked the emergence of initial coin offerings (ICO).
Digital tulips? Initial coin offerings as decentralised fundraising strategy
In 2016, traditional methods of capital raising were fundamentally challenged with the emergence of ICOs. The scene changed as project initiators created a pool of tokens available to the crowd. With ICOs, the crowd i.e. retail investors, can purchase those tokens and assess their value based on a given project’s ambition. The price of the token is determined by the issuer as the token sale closes. This means investors heavily rely upon their own due diligence requirement.
Token holders (i.e. supporters of the ICO) hope the token will perform well in the future, giving a stellar return on investment when traded back to fiat currency. Unlike traditional strategies of raising funds, ICOs deal with supporters instead of investors, the latter always expecting an immediate return on investment. Here, the fundamental difference is that the funds raised during an ICO are comparable to donations, which is a reason why ICOs are often referred to as crowdsales. Supporters of the ICO, mostly receive a return on investment when selling their tokens in the future.
Generally, ICOs prove successful as the 2018 Boston College report shows: looking at 4003 executed and planned ICOs, on average they generated a buy-and-hold return of 48% in the first 30 trading days.
For companies, the adoration of ICOs is two-fold:
The structure of ICOs is decentralized and largely unregulated, leading to the assumption that they are much freer in terms of institutional structure than IPOs. An ICO structure allows companies to ‘bypass’ the regulated capital raising process required by venture capitalists and banks.
ICOs allow companies to raise a large amount of capital in a short amount of time. Take the example of the Brave project by former Mozilla Firefox CEO Brendan Eich. When launched, it raised $35 million from its ICO in less than 30 second.
Fending off FOMO
While ICOs appear to be a profitable model for companies seeking to raise capital, they also can be used as a tool to con investors. Initial coin offerings are often backed by huge marketing campaigns that aim at building hype to promote the token and attract investors.
In a FOMO, or ‘fear of missing out’, investors will be more likely to invest into what might be a fake company. Other prevailing schemes of ICOs are Ponzi schemes; the lending and exchange platform Bitconnect is an example of such. Repeatedly, investors were scammed because of a lack in knowledge of initial coin offerings.
In a response to the aforementioned scheming stratagems, securities and exchange commissions have issued governmental warnings to investors. In the European Union, the European Securities and Markets Authority (ESMA) has issued warnings to both investors and firms (2017), describing the risks and threats of investing in ICOs.
In their statements, ESMA has taken a conservative stance (similarly to the position of the SEC in the United States) to protect investors and the investment market alike: “ESMA stresses that ICOs are extremely risky and highly speculative investments. Investors should realise that they are exposed to the following risks when investing in ICOs:
- Unregulated space, vulnerable to fraud or illicit activities
- High risk of losing all of the invested capital
- Lack of exit options and extreme price volatility
- Inadequate information
- Flaws in the technology”.
In response to the cryptocurrency boom of December 2017, and the multitude of fraudulent cases related to ICO investment, lawmakers are exerting increased pressure on the institutional freedom of initial coin offerings. All in all, initial coin offerings became a less popular fundraising technique due to stricter regulatory measures in conjunction with a generally low rate of success; note that 46% of ICO projects died in 2017.
Equity Token Offerings: ICOs v2.0?
Although scams have plagued the initial coin offering ecosystem, and the investor community may elicit scepticism, the entrance of equity (or security) token offerings onto the market of fundraising appears to be a novel and more secure approach. Equity token offering’s (ETO) are basically initial coin offerings 2.0 – yet scam free.
Here too, companies (blockchain and non-blockchain based) can issue equity tokens on blockchain in a private or public statement. The token functions like a security: the fundamental difference to ICOs is that the asset is a technologically enhanced quasi-share, easy to purchase and trade, that also gives the investors and issuers legal protection* similar to classical forms of stock investment.
In Germany, equity tokens fall under the legislation of the Wertpapierhandelsgesetz as defined by the Federal Financial Supervisory Authority (BaFin). In keeping with Germany’s thorough and at times, bureaucratic reputation, the legislations explicitly states that “it is sufficient that transactions can be documented using the […] Blockchain technology, so that the token’s embodied rights“ and identity are identifiable. Furthermore, in accordance with §2 of the German bond-market jurisdiction, “the following criteria must be met simultaneously, in order for a token to be considered securities […]:
- Transferability of the token
- Trading of the tokens of its type on the financial markets
- The embodiment of membership equity or debt assets right in the token
- No classification of the token as a pure payment instrument.”
Criteria c) is of most significant importance as it defines the rights to ownership in the token. In theory (money versus rights), equity token offerings are nothing new. However, they do represent a technical innovation that promises transparency, accountability and increased liquidity: tokenization. In the context of a public ETO, equity tokens are (mostly) considered to be securities, and thus are guarded under the German legal framework. Companies seeking to raise capital in that process need to comply to the regulations of the German market once their token is categorized as a security.
As with anything, there are trade-offs: while ETOs allow individuals to securely make complicated transactions without having to trust anyone, the conservative stance taken by the government makes equity token offerings safe, but also more bureaucratic. We hope this essay helps decipher some of the terminology surrounding the evolution of investment, encouraging more players to take part and shape its future.
* Legal protection for investors can only be guaranteed in certain countries. It is advisable to be cautious and well informed of the specific legal framework.
You can catch our previous series installment on Medium. To learn more, make sure to subscribe to the NBT Thing Tank. See you soon on Medium for our third and final installment about breaking the investment status quo: how high tech investment will enable smart industries and a sustainable economy.