
ICOs and venture capital: friends or foes?

Asgard this month became the first European VC firm to announce it will hold a token sale to finance its next investment vehicle. Oscar Geen explores how the rise of initial coin offerings (ICO) has changed the relationship between startups and their backers and how investors should respond
For startups looking to raise capital in 2017, three letters – ICO – have changed everything. The ability to sell access to their product, or even their equity, in tokenised crypto-form has given them the ability to raise vast amounts of cash without holding a single meeting with an investor.
The threat to the funding model of traditional venture capital firms is considerable, but some institutional investors also see great opportunity in this new, extreme form of crowdfunding.
Berlin-based Asgard announced at the start of December that it will hold an ICO at the start of 2018 to finance its next venture capital fund. It plans to invest in 20-30 technology companies that make use of artificial intelligence software and is taking minimum commitments of €200,000.
Asgard says the venture capital business model is broken and elitist. It aims to change this by opening up the market to a wider base of global investors who want to participate in the emerging digital industry.
A similar sentiment has been expressed by startups that use the fundraising mechanism. Adam Graham is CEO of listed marketing network, The Marketing Group, and has a keen interest in the business uses of cryptocurrencies. "ICOs should open up more niche businesses that have a great value to a certain type of person that may not be of interest to VCs. They may be transformative businesses that solve an important problem but don't give VCs the 10x return they need to cover all the other losses in their portfolio."
Aside from running its own ICO, there are other ways VC firms can benefit from them. Michael Jackson of Luxembourg-based Mangrove Capital explains: "We've incorporated the concept into our investment thesis. We can help founders achieve a successful and compliant ICO."
Easing the process
According to data compiled by Mangrove, startups had already raised more than $3bn from ICOs by September this year. The VC and growth equity industry as a whole invested €13.4bn in all European companies and €4.85bn of that in technology companies in the same period.
Jackson understands the allure for founders, particularly those that are naturally introverted or just do not have the time to spare on the fundraising process. "Raising funds is a complex and time-consuming business that is not very transparent; and you have to meet dozens of different people and rely on your performance in a short presentation."
An ICO process on the other hand allows founders to explain themselves in writing by issuing a "white paper" document that outlines their business plan and the terms of the offering, and in that sense they can keep investors at arm's length. This process gives the founder more control but also makes them accountable. Jackson sees the positives here but also warns of the potential for problems: "The good thing about any form of crowdfunding is that you instantly have 1,000 fans cheering you on if they buy into your project. The downside of course is the pressure to deliver, and if things go wrong those 1,000 fans quickly turn into 1,000 enemies and detractors."
Of course, failure is a risk for any startup, but some investors see the risk of failure as being exacerbated by the anonymous nature of the technology itself. A senior executive at a blockchain-enabled payment software company recently told unquote" that they see "no space or need for cryptocurrencies within regulated financial markets". They explained: "If you invest in an ICO, you are locking capital up in [a company's] technology or functionality. If they change business model, your money is locked up in the original model."
We've incorporated the concept into our investment thesis. We can help founders achieve a successful and compliant ICO" – Michael Jackson, Mangrove Capital
As with any form of crowdfunding, what exactly is being sold in an ICO is a key point of contention. Some companies have tokenised their equity, which would insulate investors from the risk of a change of business model. However, this raises questions about whether the tokens should be considered securities and therefore how they should be regulated and exchanged.
To avoid this, most ICOs consist of tokens that can be redeemed for a service. A report by Mangrove Capital found that more than 90% of ICOs have been for projects in which product innovation is reliant on blockchain technology and that large-scale ICOs (raising more than $10m) have been dominated by projects delivering services to the blockchain economy or financial services industry.
With this type of background, many of the companies running ICOs may not need VC firms, at least for the technical side of the operation. The Marketing Group's Graham thinks there could be other considerations. "Whether or not a founder should use an ICO really depends on what the business will do," he says. "When you raise money from angels, what you also get are networks, experience and contacts that should provide value over and above the money."
Mangrove's Jackson agrees and adds that the nature of the VC role leads to a more philosophical approach to challenges and potential failure. "VCs are always full of their own importance but there is a lot for a founder to benefit from by having people who have technical expertise outside of the area that the founder has," he says. "That might not necessarily be on product side, but seeing business models succeed or fail, we tend to be a bit less emotional about things. We're abstracted from the process, invested in 30 companies, and many go wrong."
However, Jackson is clear that not all the companies Mangrove invests in will be targeting ICOs. "It has to be logical rather than forced," he says. "The companies need to have a natural utility token aspect to them."
Regulating democratisation
Even companies that have this natural utility aspect could have their tokens classified as securities, as regulatory bodies scramble to keep up. The Marketing Group's Graham says: "It's inevitable that it will become more heavily regulated. UK regulators have come out and given pretty general guidance. Singapore has come out in favour of it. Everyone's establishing their positions with different territories embracing it as an opportunity or being a bit more conservative."
Jackson agrees there will be more regulation but is concerned that the democratising aspect of the ICO could be compromised if this is too stringent: "We will get more regulation, but I hope that it doesn't stop people investing in them. Obviously we don't want mis-selling but limiting participation to accredited investors will exclude a lot of people and I see no reason why ordinary people shouldn't be allowed to invest in these things."
Graham takes a similar position on this. "The potential is huge," he says. "I do think we'll look back on this like the dotcom boom. In the same way, we had people raising telephone-number-sized rounds on the back of a fag packet and the bubble burst. But nearly 10 years later the economy's transformed." Although regulators may not take much solace from the dotcom comparison, it is clear there is a lot of enthusiasm for what is a genuinely different way of raising money and distributing a product.
However not all parties share in this enthusiasm. The aforementioned anonymous senior executive says: "I personally think cryptocurrencies will collapse in the not too distant future. On the other hand, I've been saying this since January and everything's gone through the roof so we'll have to wait and see."
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