Nikkei Business Daily November 14, 2017

ICOs: An Emerging Perspective

Joanna Drake
General Parner, Core Ventures Group

Initial coin offerings (ICO) have become a popular topic.  So much so that several of our Limited Partners have recently requested our point of view on this fundraising vehicle and whether it will eventually disintermediate venture capitalists.

Before we share our perspective, let’s first establish a basic definition.

In an initial coin offering (ICO), buyers exchange legal tender (like yen) or existing cryptocurrencies (e.g.,  bitcoin, ethereum) for a share of a company’s branded cryptocurrency coins, or tokens. The issued tokens can be used in exchange for future products or services that are offered by the issuing company.  For example, a mobile game company might leverage an ICO to sell tokens for use in future games, presumably at a discount to the future value of the product/service.  Alternatively, an ICO can be used as an alternative to traditional financing vehicles in which case the company promises token holders a future payment or ownership in the company itself.

This summer in the United States the Securities and Exchange Commission (SEC) issued a ruling with regard to an ICO conducted by a German company called Decentralized Autonomous Organization (DAO) stating that certain ICOs are subject to SEC regulations governing securities.  The agency determined that any token representing a promise of company ownership or future payments is a financial security and as such is subject to relevant SEC regulations.  While the SEC did not file any charges in this case, they were clearly warning the market that the digital cryptocurrency nature of the tokens offered for sale does not exempt the seller from SEC regulations.

While ICOs have been banned in China and South Korea, at least for the near future, it appears that companies can conduct ICOs in the U.S. as long as the tokens sold are not tied to compensation that might be considered a security interest.  For example, an ICO in which a robotics company promises to use the proceeds to develop a new drone and entitles the token holder to receive a product unit when it is completed would probably not be regulated by the SEC. And, in fact, we believe that ICOs for financing product development will likely turn out to be a positive opportunity for startups, especially consumer startups. Because of the speed and frictionless nature of cryptocurrency exchanges, ICOs can serve as a more efficient Kickstarter crowdfunding campaign platform.

We believe that ICOs for developing products with natural network effect are particularly intriguing.  Consumers may react quite positively toward buying tokens with the hope that their participation will not only help fund development of a product but also enhance the product’s value.  The development of Minecraft or Linden Lab’s Second Life, for example, might have been significantly accelerated by users buying tokens and inviting their friends to join their networks earlier.

Business-to-Busines (B2B) companies will be less likely to systematically leverage ICOs since corporate customer’s product evaluation and buying processes are carefully guarded for competitive reasons and because substantive pre-purchases typical to consumer demand campaigns are not normally part of a corporate buying process.

We are less optimistic about the role of ICOs is as a financing vehicle for start-ups, for two reasons. First, selling a security interest in a young private company should require a much higher level of knowing who the investors are, their objectives and their provenance than a semi-anonymous ICO allows. It is not inconceivable that following a poorly planned ICO, a holder of a large position could turn out to be a narco trafficker.  Subsequent board of directors meeting would certainly be stressful!

Second, as experienced entrepreneurs, we believe that every investment dollar is not the same. Venture investment requires diligence competency, market knowledge and company building knowledge on the part of the investors. For founders, especially those in early stage start-ups whose key challenge is company building, as important as the capital is the non-financial resources such as business advice, recruiting and networking assistance that can be provided by an aligned investor.

We are clearly in the infancy of the cryptocurrency development, probably not unlike the 1940s and 1950s when the Charge-It and Diners Club Cards were first issued in the U.S.  It took nearly 50 more years before Paypal emerged.  As a result we can expect more regulation, changing risk analysis and tales of both lucky winners and defrauded. One thing we can count on is our own evolving views as we contemplate the market maturation.

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