Initial Coin Offerings (ICOs) consist of the creation of digital tokens by small companies to investors, in exchange for fiat currency or first-generation dominant cryptocurrencies, such as Bitcoin. ICOs are enabled by the use of Distributed Ledger Technologies (DLTs), such as the Blockchain, which facilitate the exchange of value without the need for a trusted central authority or intermediary, allowing for important efficiency gains driven by such disintermediation.
ICOs are having a moment, with much media coverage and hype around their potential for profit-making. This extends to their potential to address the SME financing gap. ICOs enable value creation through the potential development of network effects and efficiency gains driven by the use of the blockchain. Although the lack of regulatory clarity currently exposes ICO participants to some risks, ICOs have the potential to offer a new way to raise capital for projects enabled by DLTs and the blockchain, benefiting from efficiencies, cost savings and speed of execution, if appropriately regulated and supervised.
Regulated ICOs can be a more inclusive financing vehicle by allowing small retail investors to participate in the financing of small businesses and start-ups. Depending on the type of rights assigned to ICO tokens, companies can raise risk capital without sharing ownership, addressing one of the main impediments to the use of public equity financing (dilution). SMEs are granted direct access to an unlimited investor pool and the liquidity of tokens issued in ICOs is one of most important benefits of ICOs when compared to conventional start-up financing mechanisms such as Venture Capital (VC) funding.
Despite these potentials, ICOs in their current shape and form carry important risks for SME issuers and investors subscribing to token offerings. These are mainly linked to the uncertainty of the applicable regulatory framework for ICOs and crypto-asset markets, coupled with the lack of financial consumer protection safeguards, limitations in the structuring of ICOs and operational risks related to DLTs, exposing investors subscribing to ICO offerings and SMEs issuing tokens to significant risks.
Issues around pre-ICOs present potential conflicts of interest arising from the pre-sale of tokens at heavy discounts that hold exactly the same risk as the ones purchased by investors at the offering stage. In addition, the absence of skin-in-the-game by issuers who do not take any personal financial risk poses another source of potential conflicts.
Most ICO offerings do not fit the standard investment paradigm, inter alia because of the ways value is created and attributed between the different participants of a network and the difficulty in quantifying that effect. Sharing and allocating the value created by tokens may not always be straightforward given the duality of the token’s function both as a means to represent the future value of the company (similar to an equity share) but also as a means to transact on the platform or get access to the platform (usage or utility). Understanding ICO structuring is a prerequisite for the valuation and pricing of tokens by SMEs and investors subscribing to ICO offerings.
The listing and active trading of a token in a crypto-exchange or crypto-trading platform is considered as a proxy for the success of the ICO and an important factor for the future viability of the business. Market returns of ICO tokens have been found to carry some systematic risk as their value is correlated with bitcoin returns.
The low cost of token issuance driven by efficiency savings from blockchain-based solutions is considered to be one of the most important benefits of financing through ICOs.
The evolution of costs related to an ICO issuance follows the evolution of a financing mechanism, as ICOs mature and move away from unregulated territory, and increasingly involve advisory fees (legal, financial, security), marketing expenses, listing fees and other post-ICO costs.
Venture capital (VC) investment in blockchain-related projects has been compared to ICO issuance, so as to depict the proliferation of ICOs as a financing vehicle for early stage financing of start-ups. VC funding can be, and has been, complementary to an ICO offering, with VCs offering non-monetary contribution such as expertise, industry knowledge, connections, as well as managerial and strategic assistance.
The most prominent limitation of ICOs at their current stage and form lies in the regulatory uncertainty and arbitrage exploited by some issuers. The absence of disclosure requirements in ICOs exacerbates information asymmetries already present in early-stage SME financing. There is also a lack of financial consumer and investor protection in ICOs that would allow investors to obtain redress and compensation, in a situation where coverage by bankruptcy laws is not assured, and the risk of fraud is high. As the uncertainty and the risks involved in ICOs at their current form are vast, ICOs cannot be considered as an appropriate investment for retail investors who do not necessarily have the financial skills required to undertake such high-risk, high-volatility investments.
The potential of ICOs as a mainstream financing option for SMEs of any type and activity is considered to be very limited at this time, particularly given the regulatory vacuum of the crypto-asset market. Although ICOs are being hailed as the solution to SME financing gaps, ICOs are, by nature, not the right solution for every project and differentiation should be made between blockchain-enabled projects or products/services, and businesses or products/services not built on DLTs, as the former has a higher potential of benefiting from an ICO.
Policymakers have a role in creating the conditions necessary to facilitate the development of ICOs in a safe and fairway and allow for the potential benefits of ICO structures to be enjoyed in a viable and sustainable way by SMEs, while at the same time protecting SMEs and investors from risks involved in such structures. The clarity in the regulatory and supervisory framework applying to ICOs is arguably a stepping stone to the safer use of token issuance for financing purposes. Standardized disclosure requirements would be indispensable to overcome information asymmetries that are already present in the financing of SME risk. Enhanced investor protection for retail investors, coupled with efforts for greater awareness of risks by retail investors, can safeguard their informed participation in such financing. AML/CFT requirements on ICO issuances are equally important, especially given the wide range of relevant issues observed in the crypto-assets space.1
Given the global nature of ICOs issuing and trading across borders, cooperation at the international level is warranted for a coordinated global approach that will prevent regulatory arbitrage and allow ICOs to deliver their potential for the financing of blockchain-based SMEs, while also adequately protecting investors.
1. The importance of the ecosystem for ICOs: Network effects
ICOs involve, by design, a platform comprising a network of participants who purchase and hold tokens. This network and the wider ICO ecosystem are central to the success of ICO-funded ventures, enabling the creation of network effects.
Network effects allow for potential value creation by the network that is being formed automatically and by default in every ICO with the mere participation of stakeholders in the offering. Such value resides primarily with those ICO participants who subscribe with the aim of using the platform or service offered on the platform, or with investors who have a dual role as both investors and users of the platform.
Potential network effects, together with efficiency gains driven by the use of DLTs, are arguably the two most important sources of value creation of ICOs.
The ICO ecosystem is a complex environment extending beyond SMEs launching ICOs (issuers4) and individuals or institutions wishing to participate in the ICO (investors or participants). It comprises digital exchange venues; trading platform operators; digital wallet providers; increasingly emerging financial and technical advisors; participants in regulated markets where tokens are underlying or referenced assets (e.g. derivatives, exchange-traded funds); investment funds or other collective schemes investing in tokens (e.g. hedge funds – reportedly heavily involved in the ICO market); custodians and regulators.
The ICO ecosystem is tech-heavy, and building a community plays an important role in their development given the open-source nature of many of the platforms’ protocol. Computer engineers, programmers, and developers build the network infrastructure and develop the platforms’ protocol (software) and applications that run on it. The entire community of developers and programmers can contribute to such projects given the open source nature of the protocol used in most cases.5
Social media and specialised internet websites play a role in communicating the projects backed by ICOs and even marketing the issuance: platforms such as telegram, specialised sites such as Github, but also mainstream social media such as Twitter and Facebook participate in the promotion and marketing of ICOs.
The importance of the network in blockchain-based projects is such that some ICO issuers have resorted to “airdrops”, the free distribution of tokens issued through random allocation or based on specific criteria (see Box 2.1). Although such mechanisms enable the rapid creation of a network around the project, participants’ incentives may not necessarily be appropriate for the platform to fulfill its potential (e.g. speculation).
Given the tech-heaviness the ecosystem and the technological requirements underpinning ICO mechanisms, an SME wishing to issue tokens needs to have a business rationale based on DLTs and the blockchain. SMEs may be tempted to use ICOs as a way to easily raise funds given the momentum even when the use of the blockchain is not adding any value. However, if the proposed service or product does not integrate the use of blockchain, the implementation of the project and long-term sustainability of the company is questionable.
Network effects: an important value creator in ICOs
Network effects describe the positive externalities observed in networks when the value of a product/service to a user increases as the number of users increases, and the potential links between participants grow for every new participant joining the network (Hendler and Golbeck, 2008)6. Existing theory on network effects suggests that “embeddedness” of network systems provides participants with unique opportunities and benefits derived from each other’s participation, and firms organised through networks have higher survival chances than firms that are not (Uzzi, 1996).
In other words, the benefits a user enjoys from joining a network increase with the total number of users who are part of the network. This value proposition has first been quantified by Metcalfe’s law (the value of a network is proportional to the square of the number of users of the network) and Zipf’s law (the value of a network is proportional to n
log n, where n is the number of users of the network) (Briscoe et al., 2007). Irrespective of how its value is measured, the existence of network effects is widely acknowledged.
ICOs enable value creation by design: through the formation of platforms based on distributed ledger technologies; the attraction of participants and users (effectively all subscribers/tokenholders) and their possible interactions; and ultimately the inducement of positive network externalities on those platforms. These potential network effects increase the economic value of the platform itself and can have wider economic and social benefits.
In practical terms, the imposition of hard caps, which effectively create a tentative sale of tokens that will not be effectuated unless the cap is reached, ensures that a critical mass of users needs to be gathered before the project is launched. Positive network externalities are also evidenced by the strong positive correlation of ICO market values with the number of Twitter followers of ICO issuing companies (Benedetti and Kostovetsky, 2018), indicative of the value created when a platform reaches a critical mass of users.
Recent academic research suggests that ICOs solve a coordination failure inherent in many platforms which allow for network effects (Li and Mann, 2018). This failure relates to the complementarity among participants in the network, whereby initial participants do not know whether the network will attract a sufficient number of users for the network effects to materialize, and have a lower incentive to join. ICOs can address such failure through escalating price schedules, where the minimum price investors pay increases as more investors join the network, subsidising first movers. While such sequencing can be beneficial to resolve coordination issues, several rounds/stages of a tokensale can create the risk of becoming like a pyramid/Ponzi scheme fraud, with each round paying the previous round’s investors by pumping up the price of the token enough for previous tokenholders to exit.
Trading of tokens has demonstrated7 to create a feedback loop between token valuation and platform adoption (Cong et al., 2018). In other words, the appreciation of token value leads more investors to buy tokens and join the platform, which in turn increases and accelerates user adoption of the platform. In that model, token price appreciation is in itself driven by investors’ expectations about the value of the platform and by capitalising on the growth of the user base.
Value creation by network effects could not be created in case of pure capital formation,
i.e. when tokens are only used as a financing channel for a non-blockchain business model which is not based on the creation of a community around the product/service. Tokens which have a hybrid use, both as instruments for capital raising and a medium of exchange, lead to accelerated platform adoption. It could be argued that such value will not be equally created in case an investor is a pure capital provider with no interest whatsoever in using the platform.
The fact that there is no value creation due to network effects in the case of ICOs for pure financing of non-blockchain based services or products is perhaps the main argument against the “mainstreaming” of ICOs for SMEs. Cost efficiencies of blockchain-enabled structures and disintermediation remain important benefits of ICOs, however, in balance,these may not prove sufficient to allow for the expansion of the ICO financing model to non-blockchain-based SMEs
Academic research also argues that launching an ICO could potentially harness the “wisdom of crowds” by aggregating dispersed information about platform quality and allow for informed decision-making by participants in the network (Lee et. Al, 2018; Li and Mann, 2018). Prospective participants need to be heterogeneously informed for the wisdom of crowds effect to be exploited. Academics further suggest that the wisdom of crowds could effectively substitute the intermediary role played by traditional underwriters in the financing of blockchain-based start-ups. Given the limited quality and quantity of information disclosed about ICOs; the limited due diligence by participants; and speculators’ herding behavior, the above potential benefit is yet to be seen in ICOs.