by Banyamin Hakimian, Francesco Rassu
The traditional capital-raising process involves a number of players whose operations are strictly limited by a tightly regulated environment. The last three years have witnessed an increase of a new unconventional way to bypass regulatory restrictions: ICOs.
An ICO (Initial Coin Offering) is the sale of tokens in exchange for cryptocurrencies carried out in order to fundraise new projects linked with the blockchain technology. Start-uppers have the possibility to raise an amount of capital which would not be available through traditional channels such as IPO’s. Moreover, ICOs do not include giving up equity and resemble more a crowdfunding event in which motivated participants hope for a stellar return on their investment. Theoretically, investors’ interest comes from possible benefits in holding access to the service provided by the issuer and from the prospect of hefty capital gains. This new phenomenon spread due to its easy implementation: anyone can participate in a token sale accepting risk and concerns associated with the purchase of those assets.
According to CoinSchedule, ICOs raised a total of $95M in 2016, $3,8 bln in 2017, 6,1 bln in 2018, with a record of nearly $3 bln raised only in March 2018. This year, 33% of ICOs were related to Communications start-ups, 15% regarding Finance, 11.5% Trading, 8% Gaming, 5.5% Commerce and Advertising. Data Analytics, Data Storage, Privacy Security and Logistics represent each one nearly 1% of the cake, despite the disruptive impact of blockchain technology on these industries.
Venture Capital funds raised $ 8.78 bln in Q1 2018, not much more than how much ICOs have raised over the same period. But now it gets interesting. Although blockchain and blockchain-adjacent start-ups recorded a $900 mln capital raising in 2017 and $375 mln in Q1 2018 thanks to Venture Capital initiatives, ICOs have completely exceeded these numbers: at least 3.5x in 2017 and 7x in Q1 2018. The aforementioned give us a good overview of how crypto start-ups have faced the cash-raising dilemma. However, these statistics do not include the number of failed initial coin offerings. Out of 902 ICOs, 142 failed before the ending, 276 after and 113 were classified as ‘semi-failed’: a 59% failure rate is quite similar to the historical failure rate for start-ups according to Cambridge Associates, a global investment firm based in Boston which tracked the performance of venture investments in 27,259 start-ups between 1990 and 2010. Its research reveals that the percentage of venture-backed start-ups that fail—as defined by companies that provide a 1X return or less to investors—has not risen above 60% since 2001.
At this point, it should be taken into account the opportunity to approach this new phenomenon by using ICO mechanism to raise Private Equity and Venture Capital funds, eventually understanding the implications of considering this alternative channel.
To date, there has only been one PE-focused ICO: Fundcoin. The Finles Capital run ICO never took off for a wide range of fatal issues with the project and it can be useful to emphasize what went wrong and how we can improve from that point. The first and foremost point where Fundcoin really could and should have done better is the legal aspect. In the ICO’s whitepaper it states:
“Tokens may not be available to all persons in all jurisdictions as certain offering restrictions may apply. In particular, no tokens will be available in the US, Singapore or the EEA.”
And to ensure truly ensure you do not reside in any of the countries listed above you had to simply check a box. Firstly, it fails completely as far as know-your customer (KYC) and anti-money laundering (AML) practices are concerned and it is simply downright illegal. Secondly, to evade the regulatory hurdles existent for paying out dividends Finles will engage in a sort of share buyback by buying and afterwards burning a certain amount of tokens to prop up Fundcoin’s price; the proposed approach sits in a legal grey area and is an additional point of possible regulatory action.
Reputational-wise, Finles Capital is a little known Dutch asset manager with a not-so-impressive record when it comes to investing: one of its funds, the Finles Lotus Fund, invests in a selection of mainly Asian equity funds, Asian, stocks and hedge funds and it is one of the worst performers among funds of its kind; in addition, another fund run by the company, the Finles Fontain fund, an unconstrained hedge fund that returned a 7.4 % in 2010 has been slacking heavily in the last few years. One could even say that the ICO is a way of escaping the asset manager’s poor reputation when it comes to investing, not exactly the best premise to launch an initial coin offering.
Finles’ monetization strategy is quite standard in the fund industry, the white paper states that:
“A total of 3% of the proceeds have been allocated to cover ICO administration costs. Management fees are set at 2% of assets under management (AUM) and 20% of realised profits”.
That said, in the crypto world the classic 2-20 fee structure may not be as well receipted and in addition a 3% flat fee on the proceeds is a significant amount of the total of funds raised; Finles planned to deploy the capital raised in its “Lowestoft Private Equity Fund”, which will do things like “corporate lending, mezzanine finance (loans and equity), p2p lending platforms and other specialist instruments” as well as investing in venture capital funds who focus on blockchain and, by doing so, it will aim to achieve an annual return of 20%. However, it is immediately clear there is no defined strategy and the white paper fails to highlight in which firms the fund will invest and instead names some of the most known venture capital firms on a purely for information only” and “not indicative of final portfolio allocations” basis.
If Finles Capital ICO is a good example of everything that can be done wrong in a PE initial coin offering, it also provides us with potential guidelines for an ideal ICO focused on private equity and venture capital.
On the legal side of things, it must be clear whether or not a token should be treated as a security subjected to regulation. The Howey Test was created by US Supreme Court following a case concerning the definition of a leaseback agreement as an investment contract, i.e. security. According to the test, a transaction is to be considered as an investment contract if the token is being sold as an investment with the expectation of profits by a third party. Whether or not this asset meets the requisites of the test, it is differentiated in two classes: utility token and asset token. That being said, our focus will be on ICOs done following regulation in place in Switzerland; therefore, the potential token would be most likely considered to be an asset token. But firstly, what is an asset token and why does it matter? FINMA, the Swiss equivalent of the SEC, regards asset tokens as securities, which means that there are securities law requirements for trading in such tokens, as well as civil law requirements under the Swiss Code of Obligations. Therefore, those willing to take part in a PE/VC-focused ICO should be accredited investors and the issuer of the token should have strong know-your customer (KYC) and anti-money laundering (AML) practices in place.
Technologically speaking, the architecture of the token is, as always, of fundamental importance. However, in the case of a PE/VC initial coin offering, an ERC-20 token, a common standard used for tokens issued on the Ethereum platform, will provide all the functionalities the issuer may need.
Reputational-wise, to achieve a strong performance with your ICO you need to an extremely competent and reputable team. For example, in the case of a private equity initial coin offering, your team should be composed of well-known professionals in the PE industry; a few popular cryptocurrency advisors, who are of fundamental importance to gain momentum with the community but of little practical use; and finally, it would be desirable to have a technical team that has already work on an ICO beforehand.
All of these factors taken into consideration, without an efficient and reliable way to monetize your initial coin offering your project, on the issuer side of things, and to guarantee financial reward for investors, you will not be able to have a viable product.
In general, the are numerous advantages for an ICO as opposed to a more traditional way of raising funds: firstly, a potential ICO would be advantageous due to the newly-found liquidity of the capital invested since you are able to sell your token on the secondary market; secondly, your target audience will be far broader and you will be able to find more enthusiastic and tech-savvy investors when it comes to VC-focused ICOs; in addition, you will not have to do a roadshow or similar activities to sponsor your fund and thus it will be far cheaper to raise capital.
In conclusion, initial coin offering can be an extremely effective tool to raise a private equity or venture capital fund and present an opportunity too good to miss for most investment firms.
Authors: Banyamin Hakimian, Francesco Rassu
Editor Responsible: Edoardo Cogliati
 The ERC20 token standard contains the basic modalities of what a token should implement for it to start trading after launch. Such modalities include token transfer, balance inquiry for specified addresses, and finding out total token supply