Initial coin offerings (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, wrote the Organisation for Economic Co-operation and Development in a recent report.
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 cryptoasset 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 pre-requisite 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.
ICOs are global in nature and trade easily across borders. A more coordinated global approach is necessary to prevent
regulatory arbitrage and allow ICOs to deliver their potential for the financing of blockchain-based SMEs, while also adequately protecting investors.