Written by Csaba Hajos
There are so many newly-emerging fundraising methods in the blockchain area, that people are hardly able to follow or understand all of them. Due to the level of novelty and the dynamics of change, there are only a limited number of analyses available. From them, there are even fewer that try to compare the traditional (investor-based) funding methods with ICOs, STOs and TGEs.
What I will do in this article is to perform a comparison of the traditional investor-based funding approaches with blockchain methods from financial, legal and IT standpoints.
Before I start the analysis, let me give my view on a question that I have received many times: can the STO or TGE be used only for blockchain-based solutions? In my opinion, no. This alternate way of funding is suitable for any type of fund-raising as long as the regulatory rules are kept.
The ICO and STO “funding industry” (we can already call it “industry”) has many similarities and differences with the traditional fund-raising methods. The points I will raise will justify the existence of both.
The purpose and usage of fundraising
Before we jump into the fundraising question, let’s start with some definitions to bring every reader to the same level of understanding.
ICO – Initial Coin Offering
This method was used originally to raise money via crowdfunding for cryptocurrencies or coins. The idea has existed for some years but on a smaller scale and for other uses: Kickstarter, Indiegogo and many others. Unfortunately, this is the method, which gained negative media coverage as a result of scams and regulatory restrictions.
As a result of regulatory debates, creative people came up with the idea of “utility tokens”. In this case, the funders buy products, services (or coupons) of the start-up that can be used on the newly-created special platform or sold on an exchange to realize profit. To avoid regulatory issues, the sellers of utility tokens want to differentiate themselves from ICOs from the very first moment, therefore they name their token sales events to “Token Generation Event” (TGE).
More recently, a newer term emerged: “security token”. This is a special type of token where the value is derived from an asset which is usually external.
Some further clarification is also necessary for the traditional, non-blockchain based investment area. When it comes to funding a business, investor-based fundraising is only one possibility. There are personal investors, friends and families can also help, and last but not at least, boot-strapping (financing from own money). I think this is clear, without any further explanation, all the non-investor-based funding methods can be used in the blockchain world as well!
Within the investor-based world, three types of fundraising exist: equity, loans and convertible debt. All have different specifics that I will cover briefly if I compare the different investment-types.
Purpose and usage of funding
Let’s start with the loan-based fundraising as that is the easiest and works almost the same way as the majority of tokens do.
In this case, the start-up borrows money and pays it back later. In the traditional world, the back-payment happens in the form of cash, together with a predefined interest rate.
In the case of tokens, the investor gets the tokens that can be later sold on an exchange, with possible gains that fulfill the purpose of interest, in exchange for lending the money. It can also be used personally by the investor, but in that case we cannot really talk about investment, that is really only about purchasing a product, which can be done on Kickstarter or Indiegogo.
If someone thinks over the above, the risks of tokens become clear against the traditional investment.
Risk 1: the gain is not defined in advance – it can be huge or nothing
How do you know if the price of the token will meet your expectations against your expected interest-level? In some cases, the revenue model is very complicated, so it is almost impossible to estimate it well. Especially the platforms do not exist at the time of fundraising and this makes the estimation almost impossible: there is no pricing or trading volume information at all.
If you are unlucky, not only the interest can be lost, sometimes the token itself is not developed.
Risk 2: the whole invested amount can be lost
In the traditional corporate world, there is a well-defined process of pledging collateral to the loan: if the project fails, the collateral will be used partly or completely to cover the investors’ losses.
What secures your investment in the blockchain world if you are only a token user and the token only represents rights to use the token on the “to-be-developed” platform which does not get developed? (Don’t forget, the fund is used to complete the development, hardly anything exists at the time of fundraising.)
There is not much an investor can do, in my opinion.
The second case is the equity based funding.
Traditionally, this is ideal for borrowers who don’t have collateral or cannot self-finance (bootstrap) the idea.
In this case, the role of the collateral is fulfilled by the equity itself. Therefore investors usually expect that a running business exists with some already ensured revenue; ideas are rarely funded. Investors carefully evaluate the prospect of the companies. They prefer to fund companies that operate in an industry that has massive growth-potential or it should have a patent that ensures the long-term viability of the business.
What’s more important is that the investors get stocks which serve not only as a collateral, but also ensure rights to have an influence on the management of the company if they think the company is not on the right track.
From the above, the next risk is clear:
Risk 3: the majority of ICOs, STOs and blockchain companies, together with their products, do not exist at the time of fundraising
If a good whitepaper was created, the investor can get information about the funded “product” from it. Unfortunately, those papers are usually poorly written (however nicely designed) and hard to get any usable business information from them to estimate anything. And this is not what a professional investor prefers.
Another point to consider when someone evaluates a blockchain project is the following: a typical problem (and a clear differentiating factor when comparing with traditional fundraising) is that it is hardly ever specified what happens exactly if only a portion of the fund is raised. In many cases, it is said that the cost will be proportionally decreased among the areas. But what will cut the company exactly and can it be cut proportionally? Cut the product functionality? With all my IT experience, it is not possible, without jeopardising the viability of the end-product. Then how would an investor know that the product remains viable? Or cut the marketing cost? Then maybe the decreased campaign will not attract enough investors who are willing to push the prices up.
Again, another risk:
Risk 4: the usage of funds is not well-defined, and there is little or no definition as to what happens if only a portion is gathered.
There are various new risks for investors in this new funding industry. Investors with large amounts carefully evaluate the projects and avoid them when the outcome is hardly predictable. This is why regulators have begun to involve themselves into this space.
Don’t be afraid to ask companies for information and if you feel something is not clear, better to forget it!
This was the first article in the series. Stay tuned, the next article about “Trading of tokens and exit possibilities” will come soon!
If you think differently, you think I forgot something or you just want to agree, please comment, like or share the article.
Csaba is a seasoned IT and financial consultant who uses his blockchain knowledge to help and educate people, so they can better understand the technology and its business usability.
(credit for the picture: Storyblocks)