Last summer, the news came in dribs and drabs about initial coin offerings, the crowd sales of new cryptocurrencies that give entrepreneurs access to funding. A warning here that some coins sold in ICOs could be considered securities. An alert there that celebrity endorsements of ICOs might be unlawful.
Fast forward, and the warnings are starting to come with the kind of velocity that should give founders who are contemplating ICOs some pause. In fact, suggest some in the crypto industry, these founders would be smart to start structuring their ICOs more like traditional venture rounds.
Certainly, it seems like things may need to head in that direction.
Just Monday, the SEC announced that it has obtained a court order to halt and freeze the assets of Dallas-based AriseBank, a company that used social media, a celebrity endorsement, and other wide dissemination tactics to raise what it claims to be $600 million of its $1 billion goal in just two months, according to the SEC. Just two problems with AriseBank’s plans, says the agency: its so-called offering lacked required SEC registration, and it claimed, untruthfully, that it could offer investors FDIC-insured accounts.
The SEC also spoke up last week to note that it’s monitoring companies that suddenly incorporate or market cryptocurrencies or blockchain technologies in an attempt to “capitalize on the perceived promise of distributed ledger technology . . .”
You can hardly blame Facebook for introducing a new advertising policy that prohibits ads promoting cryptocurrency, binary options and ICO.
All these actions are certain to have a chilling effect on ICOs, a slowdown of which actually began late last year, according to recent research produced by Ernst & Young. Element Group founder Stan Miroshnik, whose bank is focused on digital token crowd sales and ICOs, calls it a somewhat inevitable bifurcation between “tier one issuers and everybody else,” wherein the “big, quality offerings are drawing the majority of capital.” (Telegram, a messaging app that is planning to raise a staggering $1.2 billion in an ICO to build and support a payment system on its platform, is evidently among these.)
Now, with the SEC plainly focused on ICOs, there’s reason to think they will evolve further still — from one-time financing events that almost anyone can participate in, to the very thing they looked to displace, which is companies that receive funding over a series of rounds, often from accredited investors only.
We’re already partway there. Take Telegram, which, like a number of the “stronger” companies to stage ICOs, is also orchestrating a $20 million “pre-sale” in which numerous venture firms look poised to participate, including Sequoia Capital, Benchmark and Kleiner Perkins, according to Recode.
These private pre-sales to a group of buyers have been happening for some time, though now a growing number of companies stages a private pre-sale, then a more public pre-sale to a broader group through a newish legal framework called SAFT structures (more on these here), then, finally, a public sale.
Separating these financings as founders grow their business “meshes well with where regulators are going, which is that [by the time] you host a public sale, you should have a product that works and has true utility,” notes Miroshnik.
Paul Veradittakit, a partner with the investment firm Pantera Capital — it was among the first outfits to raise a fund focused exclusively on ICOs — is also seeing a shift, he says. Even before it became clearer that the SEC wants to bring sales of ICOs under its authority, a growing number of founders was growing “more receptive to the token-fundraising model,” and smartly so, he adds. “If you’re going to [sell] a token, you may as well be raising token rounds and having investors come in and build up the value of these tokens.”
Besides, he adds, as the “space matures and we gain more clarity on the regulator side, more and more of these institutional investors are not going to be receptive to these [ICOs] where there are no boards or protective provisions or liquidation preferences or caps.”
The rounds won’t look exactly like venture rounds. They’ll likely look more like layered seed rounds, says Veradittakit.
“Right now,” he says, “a team will say it’s going to sell 30 million tokens and [as a result] give away 30 percent of the company, which establishes the company at roughly $100 million. But is it worth it at the white paper stage, which is often when ICOs are taking place? Probably not.” He instead sees teams raise “a bit of capital” to get themselves going, then price rounds at more traditional valuations, then ultimately stage their ICOs.
He says founders themselves would prefer their fundings shake out this way, in large part because seasoned entrepreneurs are increasingly gravitating toward the model versus the “early crypto guys who were fundraising last year and who understood the model and who’ve been in this space.”
These days, he continues, “more experienced entrepreneurs who’ve worked with VCs in the past are starting token project projects, and they’re telling me they want this — they want people who will help them build companies for the long term. They don’t want to go through that quick flip and for the price [of their cryptocurrency] to tank.”
Some of them may have in mind Tezos, a little-known Zug, Switzerland- based project that said it wanted to create a “new decentralized blockchain that governs itself by establishing a true digital commonwealth.” Tezos managed to raise $232 million via a token sale last summer, but its plans were promptly thwarted by fighting between its cofounders, delaying the development of even the digital tokens — Tezzies — that its ICO contributors expected to receive.
The company is at the center of several public lawsuits as a result.
Even without infighting, one could imagine a young company being drowned by so much capital. Indeed, on stage in Lisbon in November, investor Tim Draper, an early investor in Tezos, suggested that ICO rounds would make far more sense.
Said Draper at the time: “I do think that an ICO should be just the first of many offerings, so that people can raise the money as they need it rather than raise it all at once, because there’s not a good use of capital there [otherwise]. If I raise the $240 millions that Tezos raised and it sits in this weird, convoluted legal structure in Switzerland, what do you do with that? How do you manage that money when you really only need $2 million or $3 million a year?”
Asked about his comments last week, Draper reiterated the point, saying that “ICO issuers should think ahead to make sure they have enough tokens to make subsequent issues in order to better manage the cash flows of the token offering.
At the end of the day, says Veradittakit, it’s tough for private companies to go public so early in their life cycles. The pros of an ICO include building community from the start. The big negative is that everything is driven by price, which can force founders to make irrational decisions and can have ripple effects on everything down to hiring.
Veradittakit isn’t worried about ICOs going away. “They are here to say,” he says enthusiastically. But it’s time for them to grow up, he suggests.
The SEC seems prepared to ensure as much.
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