VCs vs. ICOs: What Model Is The Future Of Startup Fundraising?

Justin Gage is an analyst at Cornerstone Venture Partners and previously a data science major at NYU’s business school. You can follow him on Twitter here.

ICOs have been the talk of the technology town for what seems like this entire summer. These new methods of crowdfunding have allowed companies to raise previously untold sums of money in the form of cryptocurrencies. Filecoin, a storage company, raised more than $250 million in a few weeks. There has been more than $1.2 billion total raised in ICOs so far in 2017, which far outpaces any previous year. It also outpaces VC investment in the blockchain space over the same period.

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Initial Coin Offerings allow companies to raise virtually unlimited amounts of money, from anyone who’s willing to join, without any significant friction. If a company at the earliest stage, usually pre-product and often even pre-team, can raise tens of millions in cryptocurrencies, why does anyone need VC investors?

The Economic Role VCs Play In An Efficient Capital Market

Traditionally, VC funds have filled an important gap in the funding chain. Their job is to act as connectors and distributors. Large pools of investor capital like endowments or corporations seek to be diversified across different asset classes, and the high-risk game of startup investing is one of them. But since the riskiest startups generally raise small amounts of money when compared to the assets under management of these institutions, it’s not realistic for money managers to invest directly in early-stage startups. Instead, they act as limited partners and delegate this task to VC funds. In exchange for a management fee and a nice chunk of profits, VCs will act as the capital distributor.

From the company side, there are also important benefits to the VC model. Instead of raising small amounts of capital from individuals, startups can pitch centralized bodies to invest relatively large amounts of capital. Logistically, it should be easier to raise a $2 million seed round from 4 investors than it is to raise from 20 individuals. Further down the company’s lifecycle, it’s also easier to keep 4 investors updated than it is to keep 20 individuals updated.

With this framework in mind, it’s easy to understand why ICOs are potentially disruptive. It’s a funding model that offers entrepreneurs a seamless process to do what they were unable to do before: raise money from masses of individuals with efficiency.

How ICOs Reduce The Importance Of The VC

Raising money from individuals is a real pain for entrepreneurs. Regulations limit who can invest in startup equity, requiring accreditation that depends on net worth and salary. Companies also are limited to raising only $1 million in equity crowdfunding every 12 months. And in addition to regulatory hurdles, startups need to find investors who are interested, negotiate and draft the proper terms, and actually get the capital. ICOs remove almost all of these roadblocks.

With an ICO, startups can raise as much cryptocurrency as they want at whatever terms they choose. No legal terms are drafted, investors are notified and acquired through the internet, and digital currencies are seamlessly sent over the web. Investors seem to be lining up for these coin offerings. So if you’re a blockchain-related startup today, it seems like you don’t really need VCs anymore. Why deal with greedy institutional investors when you can instantly raise as much as you want on a blockchain?

ICOs Are Actually Not All-Purpose

The assertion that ICO based financing will replace VCs assumes that the current trajectory of ICO volume (up and to the right) will continue (as much of the crypto community seems to project). Assuming the crypto community is correct, VCs will have to adapt by investing in ICOs or accept death. But this narrative has some serious flaws because there’s a strong chance that the trajectory won’t continue.

In fact, the premise of ICOs replacing VC funds rests on three key assumptions about the future of fundraising that are far from decided. We’ll run through all three of these assumptions and see why there’s more than one side to this story.

Assumption #1: Initial Coin Offerings Are Relevant To All Companies

Buyers in an ICO never receive shares of the company. Instead, buyers get tokens, which are like tickets to the company’s show. Tokens should have some sort of connection to a company’s core product for users to enjoy the product’s full value. For example, to make money on Numerai’s crowdsourced hedge fund platform, you need to stake their token called Numeraire. The problem is that a token-based business model just isn’t relevant to all companies.

For some companies, especially companies that involve significant use of a blockchain, tokens can be a helpful way to organize the product and drive use cases. For others, like businesses that sell to other businesses, tokens aren’t relevant to their core business model. Companies that aren’t related to blockchains at their core do not make for good token sales. In fact, we’ve already seen backlash at startups like this who go ahead and make a token anyway just so they can run an ICO.

Is it possible that every single company in the future will be in the blockchain space and will utilize a token-based business model? Yes. But I’m a believer in a balanced future where blockchain and non-blockchain companies live in harmony without insulting each other on Twitter. The vast majority of companies for whom tokens are irrelevant will not be able to ICO. An ICO is likely not a form of funding that’s relevant to every company out there, and its effectiveness must be judged accordingly.

Assumption #2: Initial Coin Offerings Will Steer Clear Of Regulatory Hurdles

Perhaps the biggest reason why ICOs have been so effective is the cloudiness of regulation in the space. Regulators have significantly hindered the growth of equity crowdfunding by capping rounds at $1 million per year, and passing stringent requirements for investors and reporting (although stunning new regulation may change this going forward). This is for good reason: without the proper balance of regulation, investors can and will be swindled by unscrupulous entrepreneurs. ICOs have experienced little such regulation yet (aside from China, see below), and with the added benefit of the immediacy of cryptocurrency transfers, they’ve truly taken advantage.

It’s exceedingly unlikely that this trend continues. As my friend Rick Schlesinger noted to me recently, regulators are generally reactionary; that means you can’t confuse inaction in the past with safety in the future. The SEC, which is the government body responsible for regulating securities law, has made it very clear that entities in this vertical fall into the purview of regulation. In late July, the commission released a report investigating the DAO, an ethereum project gone wrong that did a $150 million ICO. The SEC classified the DAO tokens as bonafide securities, and it warned that ICOs with a similar form may also be subject to securities regulation. In the SEC’s words: “Depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold may be securities. If they are securities, the offer and sale of these virtual coins or tokens in an ICO are subject to the federal securities laws.”

In addition to that memorandum, the SEC later released a bulletin warning about fraudulent ICOs and how to avoid them, which might reveal a bit about how they’re thinking about this.

China has already stepped forward on this issue, banning all ICOs in the country among other cryptocurrency related regulations.

How buyers react and whether they can avoid detection by legal bodies will set the stage for how attractive the uncapped upside of this funding model remains.

Assumption #3: It Will Continue To Be Easy To Raise Exorbitant Amounts Of Funding

One of the most striking elements of the ICO craze has been the sheer amount of capital being raised. So far, more than $200 million has gone into just two startups alone: Tezos and Filecoin. But with large amounts of capital come expectations of returns, and returns take time to materialize. As with any other risky asset class, many, if not most, of these ICOs will fail to return capital to their investors – such are the mechanics of early-stage investing. Headlines and regulatory bodies herald some ICOs as “scams,” but this misses the point; VCs know that startups can fail for any number of totally legitimate and honest reasons. That’s why VC investors diversify and understand that chances are a small portion of a portfolio will return the bulk of fund capital invested.

As with any initial “boom,” there’s a period of inflated expectations. How else can you explain a team without a finished product, such as Tezos, raising more than $200 million? But many of these high-flying ICOs can and will fail. At that point, when a significant raise like Tezos ends up not returning capital, it’s possible we’ll see a correction, Casual investors will pull out of the market, or institutional investors will adjust their allocations to account for the volatility in crypto investments.

Eventually, as the market begins to better understand the lifecycle of a blockchain company and the associated development risks, ICOs will likely shift towards more balanced sums and requirements. More seasoned investors will demand teams to demonstrate effectiveness (beta product, initial traction, etc.) before raising significant money. Another idea that a friend and I have been working on is milestone-based ICO fundraising – releasing funds in escrow when the business meets voted-on traction milestones.

VCs And ICOs Can Work Together

The future of ICOs is anything but decided – both market and regulatory factors are still up in the air. But what seems like the more likely outcome is not that ICO’s replace VCs, but rather that ICO’s work in conjunction with VCs to make up a more robust funding environment. There are a number of different funding mechanisms out there for startups: VC, debt, private equity, revenue-based financing, and more. As the dust settles, I think ICOs will establish themselves as a legitimate pillar of startup financing, albeit for specific types of companies.

We may see VCs invest early and companies raise ICOs once they have traction, or alternatively ICO early and raise VC funding when they have traction. It’s anyone’s guess how this plays out, but with the uncertainty surrounding ICOs firm conclusions in either direction are probably best avoided.

The more you research crypto the less you know. If you think I’m dead wrong, feel free to hit me up on Twitter.

iStockPhoto / Aleutie