ICO Rounds : Cryptocapital and The Great Governance Challenge of 2017

2017 is a pivotal year for the blockchain community and for cryptocapital. Many new and exciting world-changing projects are being funded by a wave of initial coin offerings (ICOs) and the blockchain hype continues unabated as cryptocurrencies soar to new highs.

ICOs are a global phenomenon disrupting the VC market and a major story of 2017 (“Easiest Path to Riches on the Web? An Initial Coin Offering”). Blockchain projects have shown that it’s possible to raise tens to hundreds of millions of dollars, through cryptocurrencies, in minutes for the project teams that have created them. As ICOs become a mainstream capital raising vehicle, regulators are beginning to raise concerns about ICO governance practices, and this puts the emerging global ICO market at a crossroads with a looming regulatory challenge.

This post explores the emerging features of ICOs and takes a look ahead at how ICO leaders should improve their project governance and strive to be innovators within a healthy and stable capital markets ecosystem.

What is an ICO?

ICO projects establish a big vision, mint a smart contract full of digital tokens and put them on offer to the public. With an internet connection, a digital currency wallet and no financial intermediary required, owners of cryptocurrencies such as Bitcoin or Ether send their ‘crypto’ to the smart contract and register their digital address. In minutes and for a very low transaction fee, crypto owners get a piece of the action. It’s natural that Sand Hill VC investors are getting worried they’re missing out on the next big thing.

As digital currency crosses international borders with the ease of email, it’s easy to see how blockchain innovation is disruptive to all forms of financial transactions and the capital markets. There’s no doubt that sending anything of value via blockchain technology is the next evolution of the Internet. There are plenty of signals that cryptocurrencies will disrupt and disintermediate traditional financial markets.

Since fundraising is a regulated capital markets process, there are a few obvious concerns in the ICO model. Let’s see why they matter, how to solve them, and establish a clear way forward.

First a recap of some of the higher profile ICO Rounds of the first half of 2017:

• EOS (https://eos.io/): $185M raised in 5 days.
• Bancor Network (https://www.bancor.network/): $147M raised in 2 hours.
• Blockchain Attention Token : $35M in 30 seconds
• Gnosis (https://gnosis.pm/): $12.5M raised, valuing the project at $300M
• Cosmos: Over $16M raised in 30 minutes.
• Tezos is currently on its way to a record-setting ICO round

What is an ICO Round?

I refer to the ICO raises of blockchain projects as ICO Rounds. In 2017, the standard ICO Round has the following features:

1. ICO Rounds are replacing Series A rounds.

ICO Rounds are the new Series A round. Blockchain startup projects are skipping traditional Series A Silicon Valley rounds and instead they are pitching their white papers directly to the cryptocurrency community worldwide. Through the global nature of the blockchain, the ICO Round is made available to anyone with cryptocurrency and access to the internet.

Why it Matters

Public blockchains like Bitcoin and Ethereum effectively cut out traditional financial intermediaries like banks, payment processors, investment brokers and traders. If you have a project innovative enough to raise $100M the traditional way, there are plenty of VC’s that will take a piece of the action for enough of your equity to make it worthwhile. ICO Rounds are using the public blockchains, most often Ethereum, the next-generation blockchain, to disintermediate the traditional fundraising process. Seed rounds, angel rounds and even Series A rounds are being replaced by the ICO Round.

2. ICO Rounds are inviting Contributors, not Investors.

Traditionally, anyone who funds a startup project has become either an equity investor or debt-holder with clear legal terms and conditions.

The terminology of today’s ICO Rounds is different. The Terms & Conditions often call the ICO rounds “fundraisers”. Project backers, referred to as “contributors”, exchange their cryptocurrency (such as Bitcoin or Ether) for project tokens. This is an important distinction. Owners of the tokens become “token holders”, not equity owners.

Why it Matters

ICOs are ground-breaking initiatives and we are very much in an uncertain regulatory environment since major G7 and G20 capital markets regulators have not declared their positions on this new fundraising method. ICO projects are specifically not using the term “investor” because they want to distinguish the ICO Round from a traditional investment round involving regulated securities. Most ICO projects specify their tokens are not a security since this would require a regulatory-grade effort of due diligence, disclosure, compliance cost and fiduciary responsibility.

Looking Ahead

We should expect G7 capital markets regulators to take a position on currently unregulated ICOs in 2017.

3. ICO Rounds Transfer Risk to Token Holders.

ICO terms documents go to great lengths to cover all the potential risks associated with public blockchains and their business models. If you’re considering contributing to an ICO, I highly recommend you read them. Carefully.

The terms also spell out what they expect you to do and know before contributing your crypto. Here are just a few highlighted terms:

• “User has carefully reviewed the code”;
• “User has a sophisticated and deep understanding of the functionality, usage, storage, transmission mechanisms and intricacies associated with cryptographic tokens, like bitcoin (BTC), Ether (ETH)”;
• “The Contributor understands and accepts that he has no influence on the governance and decisions of [ICO] …”
• “The user is not a citizen or resident of a country, whose legislation conflicts with the present allocation of [ICO Token] and/or the [ICO] in general”;
• “This document does not constitute a prospectus of any sort, is not a solicitation for investment and does not pertain in any way to an offering of securities in any jurisdiction. It is a description of the functionality of a software-based fundraising campaign.”

Why it Matters

Participating in today’s ICO’s means that you should be a blockchain expert and that the offering is legal in your country. Arguably, very few people in the blockchain space are expert enough to agree to these terms.

While this post is not legal or investment advice, it’s time to ask whether the terms are in fact defensible. Everyone these days has seen the meteoric rise of the cryptocurrency space and wants to buy some “blockchain” without knowing what it is. In the investment community, this is called speculation. If you look at the Slack channels of these projects, it’s clear that many ICO buyers are speculating and not necessarily interested in the success of the project.

Looking Ahead

As more mainstream investors come on board, leaders of ICO projects need to take a greater responsibility for increasing the knowledge of their potential contributors, and being more concerned about investor protection.

4. ICOs Rely on their Tokens being Liquid Assets on Digital Exchanges

Just as Bitcoins and Ethers are tradeable on digital exchanges, the digital tokens are often traded on digital exchanges soon after the ICO Round is over. Some offerings give a pre-sale bonus to prime the pump and the early buyers/contributors have responded positively.

For example, the following digital exchanges and a selected few of the “currencies” they trade:

Kraken (https://www.kraken.com/charts): GNO, EOS, REP, XRP, ZEC

Bittrex (https://bittrex.com/home/markets): SNGLS, HMQ, ANT, SNT, BNT, BAT, MCO

Poloniex (https://poloniex.com/exchange#btc_eth): FCT, XMR, GNT, DASH, STEEM, ZEC, BTS

Note: If you are unsure about the meaning and business models of some of these “cryptocurrencies”, they do make very insightful case studies and recommending reading.

Why it Matters

ICO speculators are naturally keen to reduce their risk with the liquidity of the digital token. It happens that the short term liquidity makes speculation entirely possible. It’s important to understand that digital exchanges are not the same as stock exchanges. Digital exchanges are unregulated capital markets players and uninsured today. The financial and non-financial relationships between the large ICO projects and the digital exchanges who are making them liquid is murky and not entirely clear to contributors.

Looking Ahead

ICO projects need to consider disclosing the relationships they have with the new breed of digital exchanges. ICO project leaders should also ensure that potential investors are clear about the risks of holding digital currencies within digital exchanges.

5. ICO Rounds Deliver 100% of Funding Upfront.

Since digital currencies are like cash, ICO funded projects to date have had immediate access to the entire pool of cryptocurrency raised. The benefit to the teams is that there’s no need to wait until milestones are reached in order to see the next tranche of funding. The downside is that the project needs to diversify its cryptocurrency holdings and therefore sells off a large portion of value.

Why it Matters

Based on healthy governance practices, traditional funding models have released funds to startups in tranches as they hit their milestones — and raising $100M has not necessarily meant that the full funds are immediately available. If the team stops hitting its numbers, it might not get the next tranche — that’s just good governance. Since digital currencies are like cash, the projects have immediate access to the entire pool of cryptocurrency.

In terms of the impact to the emerging cryptocurrency market, we’ve witnessed the large projects de-risking their holdings by selling off some of their crypto fund for another crypto (e.g. Ether for Bitcoin) or for fiat (Ether for USD). These sell-offs have recently driven the “value” of Ether down and have impacted the volatility of cryptocurrencies.

Looking Ahead

ICO project leaders should enhance their governance practices by incorporating milestone-based funding models in their structures. They should also consider returning funds if milestones aren’t met. Financial reporting disclosure already exist for public companies: ICO projects should start offering more disclosure and publish independent financial audits of their project operations.

6. ICO Rounds Don’t Know their Contributor

ICOs don’t follow the traditional “Know Your Customer” practices of the regulated capital markets and investment management space. ICO Rounds also don’t have “Know Your Contributor” processes in place, except to the extent that they know their contributors’ blockchain account numbers and the digital address doesn’t reveal anything about where you live. Although many ICO projects prohibit U.S. residents from getting involved, ICOs rely on your declaring that your participation is legal in your jurisdiction.

Why it Matters

ICO projects don’t know who is funding them. They can’t know if they don’t ask, and they’re not asking. Knowing your customer is part of the regulatory compliance and fiduciary duty of today’s regulated financial services players. The issue for the ICO project leaders and advisors is that they may very well already be at personal risk with the SEC for having led and personally profited from these vehicles. When ICO projects take your cash but don’t ask enough about your financial situation or risk tolerance, that could be a red flag.

Looking Ahead

In order to move into the mainstream and maintain healthy capital markets, ICO projects will need to solve the KYC challenge in order to provide their funders/contributors with new levels of protection.

7. ICO Rounds rely on Regulatory Arbitrage

Most ICO Projects are being set up outside of the regulated capital markets jurisdications. Most often ICOs are starting in Switzerland, a cryptocurrency-friendly jurisdiction, with the Swiss town of Zug leading the way as the European blockchain epicentre. While not in the G20, Switzerland has traditionally had a strong privacy model and aligns well with the perceived anonymity offered by digital currencies.

Why it Matters

Through ICOs, Switzerland has become a major player in the emerging cryptocapital markets space. Switzerland may indeed have helped innovate the capital markets space. Allowing blockchain innovation to flourish has given many projects, including the Ethereum Foundation (which was started in Canada but moved to Switzerland for largely regulatory reasons) the opportunity to demonstrate “the art of the possible”.

Looking Ahead

The challenge for Switzerland and a few other countries shepherding ICOs, is that they’re being perceived as the place to go in order to step aside traditional capital markets regulations in relatively stable and healthy jurisdictions. With the ICO euphoria, there will likely come a time soon that ICO contributors / investors believe that a project has treated its funders unfairly. At that point Capital markets regulators will step in and this may impact the ICOs which have called Switzerland their home.

Conclusions: Looking Ahead to Improved ICO Governance

We are only half-way through 2017 and it’s clear that cryptocapital has no borders. ICOs are a rapidly emerging financing innovation which has already financially benefited many projects and their entrepreneurial leaders. Unless a black swan event happens to cryptocurrencies, they will undoubtedly continue to raise large sums of cryptocurrency for the foreseeable future. ICO leaders have a looming regulatory challenge and have an opportunity to proactively raise the bar on their projects’ governance practices to make them a healthy capital markets vehicle. This includes increased voluntary disclosures and embracing the financial reporting standards that already exist in the public capital markets.

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About Alan Wunsche

Alan Wunsche is CEO of Token Funder Inc. (www.tokenfunder.io | @TokenFunder) which is building a cryptofinance fundraising platform for businesses in regulated jurisdictions. Alan is also Chair and Co-founder, Blockchain Canada. Alan is a cryptofinance technologist passionate about the disruptive impact of blockchain on capital markets and wealth distribution. He has extensive financial and hands-on technology experience as a finance and risk transformation executive at a global bank (Scotiabank), management consulting (Deloitte, PwC), and previous startups.

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Originally published at medium.com on July 4, 2017.