The Funding Gap — How do ICOs fit in the early stage financing world?
By Lukasz Musialski
ICOs are taking the world by storm and entrepreneurs from around the world are using them as the financing method for their business. But how do the token sales (for the purpose of the article used interchangeably with ICOs) compare to other ESF(“Early stage financing”) methods in terms of the project stage and funding possibilities?
The market has developed several methods for early-stage financing, which usage depends on the size as well as the stage of the development of the company. The primary methods of ESF consist of 3F(family, friends, and fools), accelerators, angels, Seed VC, Early and Late stage VC. No clear definition exists as to what amount of revenue or product stage development is required for which financing stage since it varies from deal to deal, but an overall order of financing stages can be established. The earliest method of external equity financing is usually business accelerators. The later stages are often financed by either seed stage VC funds or business angels. The following rounds at more established positions are funded by early and late stage VC funds.
In order to understand where the ICOs fit in the market, it’s worth looking at the current business models of the typical ESF providers.
· Accelerators– Is an early stage financing method that is represented by a significantly different business model than the others. The accelerators offer a unique value proposition in terms of financing since they focus on the earliest stages of development of the companies and often the firms funded have no minimum viable product. The accelerator business model revolves around offering a bundle of services and resources to a large number of start-ups in exchange for a small percentage of equity typically 4 to 8 percent. The accelerators organize one to three months’ boot camps where entrepreneurs can develop their business and pitch it to angel and VC investors at the end of the program. The accelerators are based on competitive selection and revolve around the fast validation of ideas. The accelerator business model is all about acquiring a lot of minority stakes in a big amount of startups that are in the earliest stages of development.
· Business Angels- Business angels are widely considered to create a bridge between the earliest financing possibilities such as accelerators, friends and family, bank loans and between venture capital. The capital for angel investing often comes from high net worth individuals who decide to invest in early-stage ventures. The bracket that they fill consists of early-stage businesses that have not yet reached the stage of being able to apply for venture funding. The angels fill the gap of investments that are typically below 2 million USD. Angels and venture capital firms act in complementary roles to create an environment for early-stage ventures funding. Angels similarly to other ESF methods provide value-add services to the entrepreneurs. These services may include advisory and business counseling since the investors are usually successful business founders themselves and have experience in the type of ventures they invest in. The value-added services themselves will usually be not as sophisticated as the services provided by venture firms. Business angels have been known to create syndicates — groups sharing knowledge, experience, and investments.
· Venture Capital — The venture capital goes a step beyond the angel financing and although it is also a part of ESF methods it invests in significantly larger projects typically between 2 and 10 million USD. The VC firm’s capital usually comes from investment banks, high net worth individuals, and corporates. The VCs offer to fund the businesses in exchange for equity stakes. The firms themselves are usually focused on very specific areas and prepared to support the entrepreneur in the efforts to increase the value of the business. This type of funding usually comes as a package in terms of support and services that the entrepreneur gets together with the funding. The funds have established facilities to help their portfolio companies develop. The capital is not the only value added that the entrepreneur receives in the VC financing. The other perks include monitoring, skills, expertise, reputation, and help. Even so, the strict financing terms in VC contracts can lead to potential conflicts.
This ESF market structure puts token offerings in an interesting position, as they allow entrepreneurs to raise money for interesting projects that require a significant amount of funds to develop the product without necessarily having revenues or a functioning product (which are typically VC funding requirements). Very much resembling crowdfunding in that regard. Given the current booming fundraising environment and the amount of dry powder in the market, the transition to funding more high-risk projects should not be a surprise. The proposition gets even more attractive for entrepreneurs when considering the equity stake that early stage investors usually require that has not to be given up in the crypto funding space. In addition to that, a (relatively) liquid market exists for these tokens where the ICO participants can exchange their tokens if they do not like where the project is heading.
All these unique factors regarding the ICO funding can make old-school investors on wall street grab their head in confusion. The concept of equity free funding is surely an innovative concept brought on by the developments in the blockchain technology, and given the right product and structuring in certain cases, it can actually, make more sense to both the token buyer and seller than an equity investment. There are many possibilities how tokens can return value to the ICO participants and these can range anywhere from utility, services, access, profit sharing or other smart contract applications. Depending on the needs of the start-ups, token models will differ from case to case. Thanks to the new financing methods the entrepreneurs would no longer need to stage their financing but rather, given the interest from backers, finance the project immediately.
Token sales find themselves in a unique position as unlike other ESF methods, they allow for financing projects across the entire spectrum of early-stage financing. There have been examples of both small-scale fundraisings as well as some going for funding of $100 million + that would be equivalent to some of the larger VC deals. The method works for both projects with and without revenues, developed and not developed products. We have seen both large established companies going for ICOs to fund projects as well as tech teams that are attempting to raise funding to pursue development of an idea full time.
A very important point to consider is that the traditional financing methods do not differentiate the funding strategy by business model. The same business can be financed by accelerators, angels, and VCs on different stages. However, for an ICO to be not only successful but also to provide a benefit to the customer the tokenization must be an integral part of the business. There are many great ideas out there that simply don’t fit the token model but there are also projects that could benefit enormously from the tokenization of their services, where blockchain technology can help in eliminating third parties, providing trust, transparency, and security to the business. Let us take on an example from a real-world problem. Selling tokens for an ice-cream store does not make much sense as it only introduces additional complexity, however when applying the tokenization model to an insurance or a logistics platform or even a financial information system, the tokenization of these services could prove invaluable to the business, through the application of the blockchain technology and integrating the token model in the business.
So how do the ICOs fit in the financing world? The answer is really not about the development stage but the business model. ICOs are simply better for certain businesses than for others. When looking at the financing graph below it is clearly visible that the start-ups in the blockchain space have fully embraced the ICO funding method and have passed the VC funding dedicated to the space.
Source: CB Insights
With time as the crypto space becomes more and more accessible to regular people and as the access to blockchain applications are extended through the ease of use layer (similarly to what we saw happen to the internet — nobody writes their own email servers now but people still write their smart contracts), we would expect that more and more businesses from different fields will be able to enter the ICO space as tokenization of services becomes more and more of a common occurrence. We are only in the earliest stages of the development of the blockchain technology and many of the service layers are still being developed. With the pace at which this infrastructure is being created, we remain confident that soon many more kinds of businesses will embrace the token sale financing model and that we will see tokenization possibilities for companies from all sectors.
We are very much looking forward to that future but in the meantime, the ICO financing method should be applied to companies that can clearly benefit from it through having tokenization as an integral part of their business model and can create real value through their token.