If you have an idea for a business or are trying to expand your small startup, it’s a challenge to get funding. A new trend in blockchain technology allows companies to pre-sell access to services as a way to fund the development of those services. Companies create a token that grants the holder access to products, services, or subscriptions from the new startup. The initial coin offering (ICO) allows startups to sell those tokens before the company launches, as a means of fundraising. This means startup companies can raise large amounts of seed capital from individual investors, democratizing startup funding.
An ICO can be an extremely effective way to raise capital for your business. However, it involves a fair amount of community building, technical expertise, and foresight about regulatory compliance. If you’re willing to take on these challenges, the payoff can be significant. Not just in raising funds, but also in establishing a community of supporters around your idea.
Full disclosure: draglet is a blockchain development company with expertise in building and launching ICOs for startups. We believe the ICO fundraising model is an important development in the future of early stage fundraising. However, we also believe that ICOs are not right for every business. This article will help you decide whether an ICO is right for yours.
1. The Fundraising Landscape: Crowdfunding, Venture Capital, Loans, etc.
There are many ways a business can get funding. Each method has its own pros and cons. For many businesses, traditional fundraising methods will work well. In this section we’ll look at traditional fundraising streams and evaluate their effectiveness.
a) Institutional Loan
This method is the most popular with small businesses that will generate a small but predictable return. Getting a loan from a bank or credit company is fairly straightforward. However, it requires a significant amount of paperwork and proof of previous cash flow. This is an advantage if your business has years of accounting records on file. For most startups with no previous cashflow, it’s a struggle to get approved for institutional loans. Or, you may be approved, but only for a very small loan.
Some founders take out personal loans or borrow against personal assets like their home. While there’s nothing wrong with bootstrapping a company in this way, it’s very risky. You assume personal liability for the company’s success. If you fail to pay the personal loan, your assets could be seized. This makes loans a challenge for any entrepreneur with big ideas that could fail.
b) Venture Capital, Angel Investors, & BDCs
The big companies in Silicon Valley were built on venture capital. But they’re not alone. A large proportion of companies around the world get their startup funding from some type of private investor. Getting seed capital from angel investors has become standard practice for startups. The benefit is you could receive a lot of money if you have a good idea.
The drawback is it takes a while to meet, warm up, and pitch investors. Then, investors can take a lot of time doing due diligence. Investors will investigate everything about your company: founders, idea, business model, revenue/expenses to date, and outside expert opinions. They don’t want to lose money on the investment, so you’ll need an airtight idea with little competition and everything in place to execute on the idea. Investors also usually look for equity in the company. This means you’ll have to give up some ownership and control over your company before it ever gets off the ground.
A similar alternative to venture capital are business development companies (BDCs). BDCs are publicly-traded companies that make investments in small to medium-sized private companies. A BDC is basically a managed mutual fund with many backers, and they choose businesses to back in a similar way to venture capital. BDCs tend to make many small investments, however, meaning you won’t receive a large payout. You’ll still have to give up equity in the company in exchange for a BDC’s backing.
You could try to pair up with an existing company to implement your idea. Developing a good partnership is challenging, though. You’ll spend a lot of time cultivating and pitching potential partners. Then, those potential partners will want to know a lot of details about your idea before signing a contract with you. If you give them enough detail, the potential partner could steal your idea.
Having a partner with existing infrastructure, cash flow, and capital seems like an ideal situation. However, it’s challenging to find such an opportunity. In the end, you risk losing your idea.
An exciting trend in early stage funding is crowdfunding, like Kickstarter or Indiegogo. Crowdfunding campaigns can build a great audience for your product alongside the funding that audience provides. This means you’ll have a built-in community of invested fans from day one once you launch.
The challenge with crowdfunding is managing the crowd. You’ll have to mail out perks and rewards for the funding. Crowdfunding campaigns can raise a significant amount of money, but if you’ve got a big idea they won’t help you raise tens of millions of dollars to execute it.
e) Toward a Different Type of Fundraising
Traditional business fundraising practices involve a lot of institutions and paperwork. If you’re starting a new business from scratch, chances are you’ll struggle to find early funding. The institutions that provide business funding are designed to avoid risk. That mission of avoiding risk makes sense in theory, protecting the investing institution. However, in practice it means that many new and different ideas never get funding.
Even crowdfunding, the darling of risky big ideas, has its limitations. What we need is a type of crowdfunding on steroids. A way to raise significant capital, build a community around an idea, and automate the process of rewarding backers. Enter the ICO…
2. A New Way to Get Funding: How an ICO Works
An ICO is a type of crowdsale. In an ICO, the startup creates digital tokens that it sells to participants in a crowdsale, usually in exchange for a cryptocurrency like Ethereum or Bitcoin. Once the startup hits its fundraising goal, the tokens are automatically distributed to the participants in the sale. If the company doesn’t hit its goal, however, the participants receive their funds back.
a) Ensuring Utility
The purpose of the new token varies for every startup that runs an ICO. However, the token should have some utility within the new company. This means that the crowdsale participant will be able to use the token in the future to buy products, gain access to features, or otherwise transact with the startup. The new tokens are not shares. Crowdsale participants don’t receive equity in the new company.
ICOs run on the blockchain. They use blockchain technology to secure the digital tokens, preventing forgery and double spending. While still relatively new, ICOs have become wildly popular. In 2017, ICOs generated more funding for startups than early and seed venture capital. Startups have earned hundreds of millions of dollars in a matter of hours through ICOs. The new fundraising mechanism has become so effective that Indiegogo is now getting involved in ICO creation.
b) Exchanging Tokens
After the ICO, most companies choose to list their newly created tokens on any number of cryptocurrency exchanges. This allows more people to buy and trade the token, creating a demand for the product you’re building.
If your ICO included a reserve of tokens set aside for development, listing your token on exchanges could make your token more valuable, increasing the value of your development fund.
3. Criticism of ICOs
ICOs have the potential to raise your company tens or hundreds of millions of dollars. They also include a community of enthusiastic token holders after your ICO who are excited for the growth of your company. However, the ICO is not without its drawbacks.
a) Technical Expertise
Executing an ICO requires significant technical expertise. Developers need to set up the blockchain for your new token. They’ll also have to program the rules for accepting Bitcoin or Ethereum, counting up the total funds received, and distributing the new token once the fundraising goal is met. Keeping all those funds secure and separate requires specific knowledge of creating an ICO. That knowledge is still fairly limited in the number of developers who can properly execute a safe ICO.
b) Perception of ICOs as Risky
Another challenge is investors are contributing funds to a product that doesn’t actually exist yet. Until you build a platform where the token can be used, the token is virtually worthless. Venture capitalists are comfortable with the idea that an investment may go to zero, and they do extensive due diligence on the team, idea, and overall market as a result. However, ICO participants tend to feel less secure. Many do little due diligence before backing a project. As a result, there are lots of scams in the ICO space. On top of the scams, anecdotal evidence suggests that, in the majority of cases, companies aren’t actually building the products they promised after an ICO
If you’re looking for institutional legitimacy for your company, this can be a big drawback. There’s a perception problem for ICOs, since they’ve established a reputation of harboring a fair number of fraudulent tokens. Of course, good companies with great intentions can execute an ICO. Many have. However, most companies looking for legitimacy choose to stay away from ICOs for now
c) The ICO Bubble
ICOs generally are also facing an economic challenge. They’re currently in a bubble. It seems most ICOs, regardless of idea or team behind them, raise money and appreciate in value after the launch. While this may seem like great news for your startup, since it’s likely to get funded, the challenge comes from the volatility of a bubble driven market. The value of your token can fluctuate wildly, and it will often change for seemingly no reason. Bull runs and bear panics are common, and tokens can take wild swings in value over the course of just a few hours.
4. What About Regulation?
If you’ve heard anything about ICOs before reading this article, chances are you’ve encountered the ICO regulation debate. With so many scam tokens and such a volatile market, it’s likely that securities regulators around the world will step in to crack down on ICOs. At draglet, we believe smart regulation could be a good thing for the ICO ecosystem. It would make the market less volatile. It would also decrease the number of scam ICOs and increase the legitimacy of ICOs as a fundraising mechanism.
The key distinction, according to US and EU regulators, is whether the token you sell is an asset that participants hope will go up in value. If so, then you’re selling a security, and you’re subject to all the laws and regulations that govern the stock markets. However, if you’re selling a utility token that customers can use to interact with your company, then your ICO is simply a crowd presale of those tokens.
In order for your ICO to be compliant, you’ll need a compelling use case for digital tokens within your company.
5. Getting Started with Your ICO
Launching an ICO requires foresight. You’ll need to plan out your timeline and roadmap for your company. Then, you’ll need to clarify the details of your company and its products and services. These details will go into a white paper for the participants in your crowdsale to review. Generating buzz around your ICO also takes work. You’ll need to think about PR and advertising to get your name out there in the crowded ICO marketplace.
You’ll also need to engage a developer who has experience building ICOs. The best developers will have experience helping with the whole ICO process, including getting your new token listed on cryptocurrency exchanges. draglet has extensive experience setting up ICOs and managing the technical aspects of a crowdsale, if you need help with this.
ICOs have incredible potential for launching bold new ideas. Some projects have raised hundreds of millions of dollars in 2017, building a strong foundation for future growth. Along with the funding comes an active community of individual investors. They’ll share your product after launch and generate buzz around your company. Not every company needs an ICO. But for those companies where it makes sense, an ICO is one of the most effective ways to get funding for your new business or startup.