It’s a new, harsher environment for startups choosing to follow the ICO model in 2019, with many projects now looking to improve on the Initial Coin Offering or considering Security Token Offerings (STOs) as an alternative approach to fundraising.
After the 2017 and early-2018 bull market, September and October of this year saw ICO funding drop to its lowest levels.
There have been numerous factors speculated as to why, from regulatory uncertainty to investor distrust in the ICO model as a whole. Much like in the early days of the internet and the resulting dot-com bubble, many are now quick to declare the ICO is dead and the bubble has burst.
It’s hard to say if this is the death of the ICO, a temporary setback, or if this maturing market is beginning to develop; but whatever it is, it signals change ahead for startups.
In short, it was a speculative mess.
Just like in the “Wild West” days of the internet, fear of missing out brought a lot of investment into this new space and resulted in an obscene amount of half-baked projects or ICOs that couldn’t fulfill their commitments to investors.
This was when enthusiasm was driven by the potential of this new, disruptive blockchain technology. Ethereum in many ways led the pack, raising 31,000 bitcoin (approximately $18.3 million US) by July, 2014 when they sold their first 60 million ether.
It was a substantial amount raised for any ICO at the time, but because investors were speculating that the launch would result in a rise in asset value, U.S regulators began debates on whether or not investments in the ether token would be subject to US Securities Laws.
And while to date, ether is not viewed as a security by the U.S. Securities and Exchange Commission (SEC), this created new challenges for startups choosing the ICO route.
And there were countless ICOs that followed, all promising the next breakthrough solution or use case for tokens, with many having no live product in their ICO phase.
The years following would see enormous amounts of funding raised through ICOs, without needing to cater to institutional and venture investors. Many of these projects, however, would later turn out to be poorly designed, unfeasible, or outright scams.
All ICOs needed was a whitepaper to pitch their idea and then they could draw in funding from around the globe. Unfortunately, there was little protection for investors when projects never gained traction, failed to succeed, or in some cases when founders completely disappeared with all of their investors' money.
This has been a major factor in the resulting investor distrust of the ICO model.
It has also spurred regulators around the world into uncertain action and debate around the legality and taxation of ICOs, and how to protect investors in this new and emerging market.
Enthusiasm still remains around crypto and blockchain technology, and this is particularly true in the crypto communities where meetups and conferences are as busy as ever.
And there are still investors out there, however, it is becoming increasingly difficult for ICOs to draw them in.
For blockchain and crypto startups, ICO funding is still available.
The market now, however, is much more conservative than before, and only companies that can offer a token with real utility value (along with demand that can maintain that value) will be able to face the new challenges ahead.
ICOs remain a high-risk asset class, and this turns off many investors. Add that with the fact that cryptocurrencies and blockchain technology are still so poorly understood by people outside of the crypto communities, and it becomes clear that there are many clients who are just not ready for blockchain adoption or investment.
An ICO with a strong token and concept can help, but this market can be very intimidating to outsiders, especially due to the perceived complexity of the technology and with so many experienced investors already skeptical.
This is in part why startups have even less opportunity for fundraising through an ICO now. (It also can’t help matters when Vitalik Buterin, programmer and co-founder of Ethereum, warns against casual investing in the crypto ecosystem.)
In such a speculative market, there is real danger when investing a lot of money.
Obviously, blockchain must be integral to the solution. But startups now need to really ask themselves this crucial question: “who is the client?”
Does that specific client need blockchain technology? And, more importantly, will the target customer be likely to adopt crypto and participate in a token sale? If not, the startup will need to look for other sources of funding.
Projects in Fintech and digital solutions have more of a chance to succeed in this hostile environment, but for them the main obstacle will be proving their value and viability over other startups.
One way projects are beginning to adapt can be seen in attempts to offer investors more security and oversight, similar to what you see in traditional equity investment models.
Along these lines, you now have the Venture Capital (VC) model entering the blockchain market, providing investors stake in a company in return for investment.
This gives investors the control and involvement common with VC financing, and also a share in revenue generated by the company.
Rather than a startup receiving all of the funds for a project at once, as with the ICO, the VC model has companies actively seeking investors throughout their project.
For startups, VC financing is not easily obtained or closed, and is often a time-consuming process. Venture capitalists tend to be very cautious with their investments, making it more difficult to get a foot in the door.
For investors looking into crypto and blockchain startups, however, VC-financed projects offer more security and peace-of-mind than the ICO model. In many cases, they also produce more successful startups, with greater investor control and more motivated entrepreneurs.
Another effort being made to relieve investor distrust is the development of the security token.
Any token that matches all 4 criteria laid out in the Howey Test is deemed a security. The Howey Test is used to determine if a transaction is an “investment contract”.
When a person invests money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it is considered a security, and thus subject to specific requirements related to disclosure and registration.
Following this model, security tokens could potentially eliminate some of the riskiest aspects of ICOs for investors: the lack of regulation and the lack of protection. What is more, ICOs who do not comply with regulations could face penalties, giving more credibility to startups and offering more certainty to investors.
It could also lead the way for tokenized traditional and alternative assets, like Private Equity (PE), Other Funds, Real Estate, Stocks, Bonds, and more. In this case, these tokens will not be cryptocurrencies, despite being cryptographically secured, meaning investors will need to manage their tokens based on the underlying assets they represent.
The utilization of smart contracts could potentially replace intermediaries and all the associated fees and paperwork that come with them, while likewise establishing the legal foundation of traditional investing in the crypto space.
There is a lot of hype around STOs, and perhaps rightly so, as they could be considered the safer bet for investors. The market, however, is still largely untested when it comes to security tokens, and there is still further development needed for these tokens to become the workable financial tools envisioned.
Launching a security token is going to be more expensive and more time-consuming, and adhering to all of the regulatory framework necessary will be a challenge for any startup. This is why for now, investors need to wait and see what this model might bring.
One more way ICOs could prove successful in this new environment is improving on the existing utility token.
Utility tokens provide holders with access to finished goods and services on the blockchain. And now, more than ever, the utility value of the token is crucial.
If an ICO intends to launch a utility token, their token will need to generate enough demand to firstly establish value and to secondly maintain that value.
Tokens will only increase in value if the service on offer generates sufficient demand. This means the concept and the usefulness of the token should be the ICO’s top priority.
Further, ICOs will need to know their client, as utility tokens require investor participation in a token offering, and this has now become an unrealistic approach in many target markets.
In order for startups to succeed in the ICO 2.0 era, they will really need to redouble their efforts.
A strong whitepaper and an extensive marketing campaign won’t be enough anymore.
Startups now need to prove not only their value but also their trustworthiness. They need to ease investor fears in a hostile market.
Projects will also need to provide a comprehensive set of clear and consistent documentation, along with a strong legal foundation. The key here will be transparency.
Startups must make technical information readily available to investors, including: token code, minimum value products (MVPs), working prototypes as well as business models, marketing materials, revenue stream, and more. Consistent documentation will be the first step forward to regaining investor trust.
As you can already see happening, more blockchain projects will begin adopting practices seen in traditional equity funding. This is evident in the VC financing that has entered the market, as well as the development of the security token and the STO.
There is still enthusiasm for blockchain technology, but investors will need some protections to ease their fears and bring more money into this evolving system. Traditional investment models might provide that.
The security token and STOs might bridge the gap to this security and protection for investors, but this has yet to be tested by the market. Where this takes investment will be seen.
One thing that is definite is that startups will need to work harder as they face greater levels of scrutiny from investors and regulatory authorities.
In such a harsh investment climate, increased competition will lead to a new generation of more valuable and more viable companies. It will also potentially see more transparency and secure financing overall.
In the meanwhile, investors should still exercise caution when including ICOs as an asset for their portfolio. They remain a high-risk, hyper-volatile asset for now, and even the STO still needs time to mature in the market before it can be said if it’s the way to the ICO 2.0 or not.
Is it the end for ICOs? Is the STO the way forward? We’d like you know your thoughts!
And in case you missed it, this post is the conclusion of a 3-part series on ICOs. Be sure you're all caught up before the next installment in our Crypto 101 articles, diving into tokenized assets and Security Token Offerings.
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The articles provided by IT Alpha d/b/a Intelligent Trading Foundation (“ITF”) are provided for informational purposes only. This post does not constitute investment advice, financial advice, or trading advice. ITF does not recommend that any specific cryptocurrency should be bought, sold, or held. Digital assets exist in a volatile and high-risk market, and their value can change frequently and without notice. ITF takes no liability for any decision(s) made or action(s) taken by any of our readers. Our articles are not meant to replace independent financial advice, and ITF strongly recommends any purchaser of digital assets, even if such user is experienced and affluent, seek independent financial advice in the content of their own unique circumstances.
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