Companies always need to raise funds for various things, such as acquisitions, increasing the amount of working capital, or for global expansion. This is usually done via an Initial Public Offering (IPO), where the company can open up its shares for the public to purchase. However, cryptocurrency projects have begun raising money via another method known as an Initial Coin Offering (ICO).
Due to its success, this method has seen increasing adoption even among traditional companies, who have been choosing to go down the ICO route instead of utilizing the capital markets. Companies such as Telegram and Kakao, popular messaging apps, have taken steps towards raising funds via an ICO instead of undergoing an IPO.
Rather than opening up shares to the market, ICOs release ‘tokens’ for the public to buy. Some of these tokens can be purchased using fiat, while others only accept payment in the form of cryptocurrency.
Both are used as means to raise additional funds. However, while they may sound similar, here are several key differences that you need to know before deciding to invest in either one.
Equity vs Utility
An IPO investor has an ownership stake in the company and becomes a shareholder; he/she is given rights such as an equitable voting share at annual general meetings and/or dividend payouts. Other than legal rights, shareholders also stand to gain additional benefits at the discretion of the company. These shareholders are therefore able to grow together with the company and see their shares rise in value as the company matures.
By contrast, ICO investors are not given any ownership stake in the company because it does not grant the investor any form of equity; he/she has no decision-making power in the company. This means that the founding members of the company have full right to decide all of its affairs.
The investor does, however, gain tokens in exchange for investing into an ICO. Other than its market value, the token may also have other benefits such as subsequent airdrops (as in the case of NPXS, the native token of PundiX) or a discount in fees (as in the case of BNB token, the native token of the popular cryptocurrency exchange Binance).
In the traditional finance space, equity-holders in public companies possess a residual claim to any assets in the event of the company defaulting. In simple terms, if the company goes belly-up, an equity holder will be given a portion of whatever cash the company still holds in its bank accounts when it declares itself bankrupt (based on how many shares they own). This claim is guaranteed by law (at least in Singapore), and is just one of the many legal rights they are entitled to.
On the other hand, token holders have no legal rights. In the crypto-space, an ICO investor has little to no legal recourse against an ICO project that runs away or ends up ditching the project.
This event, termed an ‘exit scam’ has occurred multiple times throughout cryptocurrency history.
For example, Confido (ticker: CFD) raised 1235 ETH during its ICO, worth a modest $375,000 at the time, with a token price of $0.042. After the ICO, the price of each CFD token skyrocketed to $1.20, nearly 30x its ICO price. At this time, Confido began erasing its social media presence and eventually disappeared completely. (Ironically, an ICO called Block Broker, which was supposed to prevent exit scams in cryptocurrency, also pulled an exit scam).
Notable Cryptocurrency Scam: Bitconnect
LoopX Cryptocurrency Scam
Due to the lack of regulations in the crypto-space to legitimize cryptocurrency projects and penalize companies that pull off such scams, companies are more or less free to do what they wish with the funds that they have successfully raised in their ICO.
Stage of Fundraising
Companies that decide to raise funds via an IPO can only do so after their business has been in operations for a few years at the minimum. Having a strong track growth record and consistent financials reflects their credibility, which provides IPO investors assurance that they are investing into a company that has strong financials and could appreciate in value in the foreseeable future.
The funds gained from the IPO would then be used for expansion or acquisitions, which would greatly boost their revenue streams and market positioning. This in term raises their enterprise value. IPOs are therefore used as a way for an existing business to scale.
By contrast, companies that decide to ICO usually do so at a very early stage: the funds raised are for working capital, early-stage development and infrastructure. Since they usually do not have a working business for investors to evaluate, the company would create a ‘whitepaper’, where they pitch to investors about their project and what the funds would be used for.
While this may seem extremely risky (after all, it’s just a written request for money), the mega bull run in December 2017 saw ICOs raising millions of dollars without a Minimum Viable Product (MVP), poor conceptualization and without the manpower required to fulfil their whitepaper goals.
Take EOS for example: a project started by Block.one which held a year-long ICO with no MVP (at the start of the ICO), yet managed to raise over 7 million ETH in total — an estimated dollar amount of $3.5 billion. The proceeds from the ICO would then be used for working capital instead of long-term growth in the form of acquisitions or capital expenditure.
We often refer to these projects as ‘vapourware’ — a project has no tangible product or business.
However, this does highlight how fundraising for companies via an ICO can be much quicker than through the traditional capital markets. From the investor’s standpoint, it is a double-edged sword — the potential of entering the project at such an embryotic stage comes with both a significant upside as well as significant risk.
In the traditional finance world, most IPOs are only available to Accredited Investors (AI). This hurdle requirement is designed to protect retail investors from taking on too much risk unknowingly. The KYC procedures used to certify one an accredited investor also helps to prevent money laundering, and ensures that investors taking part in the IPO are doing it for legitimate reasons.
‘The “accredited investor” definition is critical for the protection of investors. At its essence, the definition attempts to identify those individuals who are expected to be able to fend for themselves and protect their interests’ — Commissioner Luis A. Aguilar of the U.S. Securities and Exchange Commission (SEC)
In the cryptocurrency world, however, anyone can participate in ICOs. This is in line with the idea that cryptocurrencies should available to the masses, rather than being at the mercy of oligopolies found in traditional financial markets.
With such complex financial opportunities so easily available, investors who are not necessarily financially-savvy have a higher likelihood of getting burned as they might not be aware of the risks involved. Adena Friedman, CEO of NASDAQ, recently commented that ICOs are “taking advantage” of retail investors because of the “lack of transparency, oversight and accountability” to investors. As such, it is understandable why ICOs like Telegram have trended towards only raising funds from AIs.
Role of VCs in ICOs
Just to provide some market colour, we shall examine the unique value add that Venture Capitals (VCs) have in the cryptocurrency space.
In the traditional finance space, VCs occupy a niche position as seed investors who often sell off their equity stake after the company has successfully completed their IPO.
As a result of the ICO boom in 2017, VCs have been forced to adapt to this new space. As funds can be obtained from retail investors, VC have had to step up and provide a stronger value-add to the project. Projects now look for VCs that can connect them with strategic partners, who can facilitate listing on exchanges, assist them in structuring their token sales or aiding in conceptualization of the project or refining their MVP. VCs may also provide community management in addition to the usual structuring and advisory services.
As such, the competition amongst VCs in the crypto-space is as tough, if not tougher, than VCs in the traditional finance setting.
From the investor’s point of view, the key difference between ICOs and IPOs lie in the level of risk that he or she takes on when choosing to fund a certain company. Due to the lack of regulations and legal protection for investors, they might not comprehend the amount of risk they are taking on in choosing to invest in an ICO. However, the amount of risk the investor takes on is compensated through the potential return on investment.
Let us know your thoughts on the ICO vs IPO debate!
28 June 2018