ICO startup funding – Look before you leap!

The use of an Initial Coin Offering (ICO) as a funding mechanism for startup companies has become a hot topic in the investment community. On the surface it sounds almost too good to be true – fund your startup with little regulation while not giving up any equity in the business. While these characteristics are true of an ICO, startup companies should proceed with great caution before embarking on this funding path.

The popularity of ICOs as a means of startup funding has surged with the media attention garnered by cryptocurrencies, such as Bitcoin, and the underlying Blockchain distributed ledger technology. To understand this popularity we need to review the basic differences between ICO funding and funding from traditional sources such as venture capital.

  • Type of funds: The biggest difference with an ICO is what is being provided by the company in exchange for the funding. Traditionally, companies would be selling partial ownership of the company in the form for equity as company founders would give up some portion of future profits. With an ICO the company is providing “tokens” that have some utility that creates their value. Tokens are almost always tied to future purchases of the company’s products or services.
  • Source of funds: While traditional equity funding is provided by investors, ICO tokens are bought by prospective customers as they are ones that will be able to recognize the value from the token’s utility.
  • Regulation: Fund raising from the sale of equity is regulated by the Securities & Exchange Commission (SEC). The SEC does not regulate ICOs.
  • Documentation: Prospective ICO token purchasers are provided with a Whitepaper and Disclaimer documents versus the more formal Prospectus available for an equity investment.

With all of these apparent advantages it’s easy to understand the attractiveness of an ICO as a means of funding a startup business. However, enthusiasm for ICOs needs to be tempered by a number of mitigating factors. First, the business must be able to establish a token that can derive value from future sales of its product and services. An example of this would be an online game company that plans to introduce a new game and sell special features (e.g. extra lives, superpowers, etc.) which can only be purchased with their unique cryptocurrency. Second, the business has to convince potential token buyers that their game will be successful (no interest in owning tokens for a game that no one plays). Third, the ultimate attractiveness of a token is its potential to significantly increase in value. This only results when demand substantially exceeds supply so buyers need to believe that the business is likely to be wildly successful.

Beyond the basic requirements of a viable cryptocurrency, companies will need to generate interest in their tokens in order to execute an ICO funding round and this is becoming increasingly difficult with the surge in competing ICOs. In just over a year the number of available cryptocurrencies as grown from a few hundred to thousands. According to the website ICObench.com which tracks ICO statistics, there are currently 2,352 cryptocurrencies issued in 179 different countries and this number increases every day. In addition the number of new ICOs either available now or upcoming in the near future is growing exponentially as you can see simply by scrolling through this list on the ICOalert.com website. This explosive growth in ICOs will make it increasingly difficult for companies to be able to create awareness for their offering and differentiate it from competing cryptocurrencies. Furthermore, the demand for new cryptocurrencies may be inhibited by recent instances of ICO fraud and security breaches. These may serve to push buyers toward more established companies or away from the cryptocurrency market altogether.

For startup companies considering an ICO for funding the biggest risk maybe the potential for future regulation. At this time, the federal government does not classify a cryptocurrency token as a security. However, if this should change then the SEC regulations would be applied to the cryptocurrency markets. This would likely discourage both buyers and sellers and significantly decrease the attractiveness of ICOs as a startup funding option. It could also create a significant overhang for businesses that have already issued tokens and this could impair the company’s ability to raise additional money from traditional equity sources. For these reasons, startups are advised to proceed with caution when considering this as a viable funding option for their business.

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