ICOs: A promising innovation, but pitfalls abound. Photo courtesy of Christopher Michel.
Partly because of Burkland’s roots in Silicon Valley and partly because we tend to focus on newer, venture-backed companies, many of the questions we’re asked by founders and CEOs have to do with new ways of doing things. Over the past few years, nothing has captured the imagination of the startup business sector quite like bitcoin and blockchain as a whole. Entrepreneurs want to know how they can take advantage of this technology for their companies and their products. As strategic CFOs of these companies, we’re being asked frequently about cryptocurrency in general and initial coin offerings (ICOs) in particular.
Blockchain in two paragraphs
In very simple terms, blockchain originated as a massively distributed online system that validates, clears, settles and records bitcoin transactions. Since inception in 2009, blockchain has evolved to include both private and public systems that can simultaneously secure, chronologically verify, validate and record the movement of any asset from one party to another.
Why the term “blockchain”? Transactions in the system are pooled together into a group, or block, from which alphanumeric information is gathered and combined with data from the immediately preceding group to form a complex and unique math problem. This problem is then presented to the respective blockchain’s distributed network, which uses its collective computer power to find a solution. Once the math is solved, all the transactions in the block are verified, the block in question is “sealed,” data is taken from it to form the basis of the next block, and the process starts over again – thus creating a linked “chain” of blocks.
Blockchain’s role in money
At first, bitcoin and its blockchain were focused on the use of cryptocurrency as a digital medium of exchange and thus the potential to replace or compete alongside traditional currencies and the legacy banking networks that support them. But over the past few years, attention has pivoted to the practical applications of blockchain technology. This is because blockchains can securely and permanently record any transaction without the use of third parties. This disintermediation of middlemen adds up to very low transaction costs when clearing and settling transactions, and the technology underpinning digital ledger technology provides the ability to program “smart” contracts that can programmatically execute without the need for either side to trust the other. At scale, these capabilities are going to be particularly useful in a very wide range of industries – finance, real estate, retailing, banking, insurance, logistics, healthcare, etc.. Indeed, it is very possible that every major corporation in the world will be using this technology (even if their customers don’t know it) in some part of their business within five years.
A common denominator in any blockchain is a token, or coin, that can act as an incentive for the network’s participants to solve for the blocks that keep the whole system humming along. A blockchain’s tokens are the fuel that establishes, verifies and records a chain’s transactions, so no token = no chain. This is where Initial Coin Offerings – ICOs for short – come in.
Blockchain role in raising capital for your startup
Blockchain startups quickly seized that the sale of these tokens – or coins – was a unique way to raise capital. Typically, an ICO involves the online sale of a pre-determined number of tokens for use or utility inside a blockchain ecosystem, usually before it is built. The startup thus raises capital without technically selling equity or incurring debt, and can fund the highly technical work necessary to build, test and deploy their system. These offerings have proven immensely popular, with the post-ICO value of some tokens quickly skyrocketing thousands of percent in secondary trading.
However, there is a catch. ICOs don’t click neatly into legacy securities laws and have blossomed primarily because they have operated outside the bright regulatory lines designed to protect investors, such as registration with the SEC and regulations against general solicitation. ICOs have been pumped mercilessly on social media, and since one can take part in an ICO with the mere swipe of a mobile phone screen, hype has quickly gotten far ahead of substance. Unsurprisingly, regulatory agencies worldwide are now catching up, taking a very close look at whether these tokens are actually securities in the issuing company, and whether their sale to a random unaccredited investor via a social media post is actually an unregistered offering of those securities. For its part, the blockchain community has argued vociferously that most ICOs aren’t equity at all, but just the pre-sale of digital usage rights that can be redeemed later for some level of utility within a blockchain. Both sides have a point.
The incredible appreciation of these tokens in secondary markets on crypto exchanges has heightened the SEC’s interest, as has the colossal amounts of capital being raised via ICO. ICOs have already brought in more than $13 billion YTD across 537 ICOs globally, according to Reuters, nearly double last year’s $7 billion and a far cry from the $1.3 billion in early-stage and seed-round funding from VCs so far this year. As far as capital formation goes, this clearly a whole new ball game.
Blockchain ICOs: A blessing and a curse
From our perch as on-demand CFOs, ICOs remain problematic because they are still in the regulatory grey zone. Beyond blocking access from US-based IP addresses, ICO issuers typically do little or no AML/KYC vetting, and don’t require anything close to accredited investor attestation. Investors in ICOs, meanwhile, have few rights and are typically not provided any company financial information prior or subsequent to the ICO. To top it off, marketing of ICOs remains wholly unregulated, and although the legal community has rapidly adopted capital structures from the Regulation D and crowdfunding worlds, concerns remain that these offerings will ultimately run afoul of SEC regulations concerning how one attracts investors.
And while more mundane, the accounting of successful ICOs remains murky, since the jury is still out on whether the proceeds from an ICO should be taken onto a company’s financial statements as equity, debt, or even deferred revenue from sale of a product. All have thorny issues; equity is out if the SEC deems the token a security, debt is a reach given the way tokens and blockchains work, and booking ICO proceeds as deferred revenue – potentially the most apt description from an accounting point of view – is problematic because secondary appreciation of the tokens could result a tremendous hit to the balance sheet when the future performance obligation created by the tokens is valued at its cash redemption value.
Hold your horses
We’re excited by the innovation in capital formation that ICOs represent. For the moment, though, they come with major implications for companies (and their management teams) not only tactically, i.e. the SEC might want to talk to you, but also strategically should a future round of financing be complicated by the consequences of using a structure few outside of the crypto world fully understand. Tread carefully and thoughtfully when considering an ICO, and don’t hesitate to contact us at Burkland for an unvarnished analysis of the pros and cons of this type of financing for your startup.