If you are interested in learning more about the applications of blockchain technology and cryptocurrencies within capital markets, you have come to the right place. These “capital markets” are not your traditional space for raising equity and debt – rather, they are places for companies to rapidly gain capital via cryptocurrency exchange. This article will delve into:
- How cryptocurrencies form a crowdfunding-like space for incredibly efficient access to capital
- What constitutes an Initial Coin Offering (ICO)
- Monetary policy per different currencies, and the effects of supply and demand on future value
ECM. DCM. CCM?
Traditional Equity and Debt Capital Markets are markets that exist between clients and financial institutions to meet the funding needs of those clients. This brief, one-sentence summary is the essence of investment banking – raising capital for those who need it. With that said, I would recommend taking some time to familiarize yourself with the space and the typical activities that companies operate within each.
Elimination of Intermediaries
In comparison to the traditional equity and debt capital markets, cryptocurrencies have generated a new and efficient way for blockchain start-ups to gain funding on projects and other advancements. Since blockchain technology eliminates many of the regulatory and intermediary needs of traditional capital-raising processes, through secure decentralized databases, business owners now have access to capital that stretches beyond that of financial institutions and investors. Blockchain technology and cryptocurrencies have developed a capital market that acts like an accelerated crowdfunding process --“accelerated” meaning that capital (cryptocurrencies) is readily accessible and transferable from one currency holder to another.
Investors & Market Liquidity
There are several reasons why capital funding from cryptocurrencies is better than fiat currency. From the company perspective, startups may like the prospect of setting their own terms, or allowing network (those creating value) to have stakes in the project, thus incentivizing them to increase its value. This differs from a traditional capital raising environment such as an IPO where a company dishes out equity stakes to a group of people who offer the highest amounts of capital (depending on the structure of the IPO).
On the investor side, the crypto markets are extremely liquid. In contrast to traditional equity raising, there is no need to wait for an IPO or an exit opportunity to regain invested funds. Investors can pull money out of projects whenever they would like (assuming the terms of the token sale allow it). As a result, price movements are extremely volatile, but that is the very nature of cryptocurrencies – they serve as highly liquid assets.
Regulation and Taxes
When it comes to raising capital through crypto markets, the project or economy at hand is not necessarily subject to direct taxation. As I will mention later on in this article, taxes are a major incentive for companies to raise capital through initial coin offerings (ICOs), as after-tax funds are significantly heightened. In a traditional capital raising environment, companies going public on regulated stock exchanges must pay capital gains tax.
On the other hand, a downside to the crypto markets is that they have little to no proper regulation. This lack of regulation creates an environment that attracts many new ventures that would have otherwise been deterred by federal guidelines and high costs. However, these low-regulation settings may also attract people whose projects are not reputable, of inadequate quality, and extremely high-risk. We will touch on this topic later, but it is something that all investors should consider when thinking about funding ICOs – many people forget that these projects are high-risk start-ups, and that high returns are anything but guaranteed.
Initial Coin Offerings
For those of you unfamiliar with the process of capital raising via crypto markets, an initial coin offering (ICO) is an investment that gives investors crypto coins/tokens in return for investment, something that differs from the issuance of securities as in an initial public offering (IPO).
Source: FXEmpire; “What is an ICO and How Does It Work?
Above is a high-level overview of the differences between an initial coin offering (ICO) and an initial public offering (IPO). You may now be wondering how an ICO works. What is the process of raising these funds for blockchain technology companies? What does it mean to exchange digital currencies as a way of raising capital? I have outlined the process below:
- Stage 1: White Paper
At the beginning of an ICO process, marketing efforts are critical. To spread awareness of a new technology or coin, founders market their product through sites frequently used by cryptocurrency investors. In addition, creators draft a white paper, otherwise known as an investor presentation outlining the details of the project. From the founder perspective, this beginning stage of an ICO process is critical to its success, as it lays the groundwork for support from the user community. As with all investment banking/capital raising processes, marketing a product can make, or break, its outcome. The marketing process to potential investors is just as important – a white paper typically includes information on the structure, underlying technology, and key details of a currency/token and the ICO. For an example of what a white paper includes, please follow the link below:
Once a white paper has been properly circulated through the addressable market, a company will have an idea as to whether investors are interested in funding the project at hand. At this point, the company must address concerns and risks associated with the ICO process, ultimately using feedback from the community to draft a final white paper to gain the highest levels of support.
- Stage 2: Offering
The offering, otherwise known as the penultimate version of the white paper, lays the groundwork for terms surrounding the ICO, something that is critical to any serious investor. The offer outlines the project details, required capital, and project timelines. This offering indicates what financial instrument (digital asset) will be sold during the ICO – these are normally tokens. These tokens will have a value assigned to them, and investors will be told the expected period after which the company will commence returning earnings to investors (typically by way of dividends). It is important for investors to pay attention to these timelines, as one should realize that dividends may not be paid out for an extended period. Once the company’s offer has been signed, the ICO start date is announced in advance, and marketing efforts increase dramatically.
- Stage 3: Marketing Process
As I had written earlier, the marketing process is one of the most critical steps in any investment banking/capital raising process. Without proper marketing, a company will not generate a large enough following to gain access to sufficient capital – it’s as simple as that. For those of you familiar with the investment banking space and its marketing materials such as pitchbooks and CIMs, a capital raising situation with ICOs is not much different: marketing materials drive interest. With interest, comes demand, and with demand comes capital. While an ICO process does not include the construction of pitchbooks and CIMs as in investment banking processes, it does include the creation of various presentations. In fact, many companies hire marketing agencies to make this material, as they are unknown to much of the market and have trouble making a name for themselves. Hopefully this lends perspective as to how important marketing is during the ICO process…
The marketing campaign typically lasts a month on average, but may go longer, depending on the traction a project gains in the market early on. Companies will tend to target institutional investors with a lighter focus on smaller investors for the sake of strictly capital gains. The primary focus, however, tends to be on those who are participants of crowdfunding programs – people whose involvement in the project has a “double-positive” effect through (1) providing capital and (2) backing the underlying technology of the project.
- Token Exchange
Once a company’s marketing campaign has come to an end, tokens may be bought and sold as they are released to investors. During this process, companies usually distribute tokens in one of two ways: direct distribution or via cryptocurrency exchanges. Direct distribution refers to the process of a company collecting the specific capital outlined in the offering, and then distributing tokens based on each investor’s provided capital. On the other hand, tokens may be sold on a cryptocurrency exchange, meaning that they must be released on a number of exchanges before the launch date for the sake of trading.
The actual capital raising process is done through the exchange on future crypto coins (those of the company) for cryptocurrencies of immediate, liquid value. The process would involve the investor giving the ICO bitcoin or ether, and in return they receive a certain number of the company’s token. Companies do this to create a capital structure that can support the project at hand. (Tip: This is an important concept to grasp, as it is a main reason for why ICOs were established as a capital-raising process in the first place).
If a company were to use its own created currency to fund itself, it’d be like someone laying a brick wall but using bricks they’ve already laid as a source – eventually the foundation below will collapse because there are no bricks, no established foundation, to hold the structure. Already-established currencies like bitcoin and ether can be thought of as the “extra bricks” needed to lay the wall or, rather, establish a new currency.
Current State of the ICO Market
For those of you who have been following crypto markets and, more specifically, ICO activity, you may have realized that 2017 has brought about a significant uptick in funding for technology startups. Some believe that this year’s ICO mania is due to early Ethereum adopters making serious returns after its bull runs. Investors are subsequently more willing to place their capital in positions that could yield potentially ludicrous returns. As more investors enter the crypto market, and traders begin to reap the profits from highly-popular tokens such as Ether, we will likely see continued growth in ICOs. Initial coin offerings are, after all, a hit or miss – they usually turn out to yield extremely high or extremely negative returns – and with investors finding success across already established digital currencies, they are now willing to put capital into these riskier investments.
Source: tokendata.io
As displayed in the graphic above, the noticeable increase in cryptocurrency market capitalization (excluding Bitcoin) is almost directly correlated with this year’s increase in ICO funding. One could argue that a majority of this market capitalization increase is due to the spike in (1) demand for ether and (2) subsequent bull runs (as I had written above). Another noteworthy point in this graph would be that despite a heavy dip in demand and price performance of mainstream cryptocurrencies during July, ICO funding still increased. Perhaps this shouldn’t come as a surprise – investors could have still been looking for a place to put their money, and ICOs have potential to be a fresh source of high returns.
SEC Regulation: Cracking Down on ICOs
In July 2017, the U.S. Securities and Exchange Commission (SEC) indicated that it could have the authority to apply federal securities law to ICOs. Although the SEC did not claim this the case for all blockchain tokens, it deemed the denomination to be made on a case-by-case basis. Is this necessarily a terrible thing for cryptocurrencies? In terms of growing crypto markets, perhaps not. Part of me believes that SEC jurisdiction may encourage more institutional investors to fund ICOs, given the elimination of certain regulatory risks. With that said, the lower-risk environment created by the SEC may also be accompanied by lower returns in the coming years. Were the SEC to fully regulate crypto markets in the future, their landscape could alter significantly through imposition of taxes and regulation that makes business development all the more difficult for technology startups.
Outlook for Capital Raising in Crypto Markets
At the moment, it would be wise to keep an eye on the SEC for (1) when they will decide to officially regulate crypto markets and (2) how intense that regulation will be. There could come a time within the next year or two that digital currencies come under the ambit of securities law, however, the SEC is still trying to wrap its head around how to do so. With this new asset class now in play, it will likely be much more difficult to relate blockchain technology to any other existing economy. Now, I am not saying this will stop regulation from every being enforced, because I do believe the SEC will interfere more frequently in the near future. However, I do think that the crypto markets will continue to grow and evolve as they have throughout the past year. Given the widespread interest shown by investors in ICOs, I’d hope that regulators choose to uphold them with the addition of some checks and balances.
As always, we appreciate comments/suggestions, and would be glad to answer any questions.
-Andrew Fox
Source Material:
Comments
Post a Comment