The Blockchain Revolution – Will ICOs Change the Alternative Finance Game?

In December 2017, the Financial Conduct Authority issued a statement warning that Initial Coin Offerings (ICOs) should be considered as high risk and highly speculative investments, suitable only for sophisticated investors.  

To support its statement, the Authority cited a number of risk factors that should be flashing warning lights. These included the fact that the ICO market is unregulated and the companies raising funds tend to be early stage with very little in the way of track record. In addition, the financial regulator pointed to the danger of fraud, price volatility and non-standard documentation as causes for concern.

All of which was probably enough to ward off retail investors who perhaps had some spare cash and who might have been prompted by the recent publicity surrounding Bitcoin values to dig a little deeper into the blockchain phenomenon.  

Investment Cash Pours In

But experienced investors are increasingly being drawn to ICOs and this has created a new fundraising option for early stage companies, particularly in the IT and technology sector. According to research by Fabric Ventures and TokenData, ICOs raised $5.6bn for startups around the world in 2017, while figures by Coindesk suggest that so far in 2018 more than $6bn has already been raised.  

What is an ICO?

A typical Initial Coin Offering involves a company essentially selling tokens (underpinned by blockchain ledger technology) that grant the buyers access to services. For instance, a cloud computing startup offering CRM functionality might sell the tokens to investors in return for rights to use the service.Thus, the startup raises money to develop its technology, while the investors are buying access the cloud product. In that respect, the model has something in common with rewards crowdfunding, but on a bigger financial scale.

In investment terms, however, the real appeal of an ICO is that the tokens function as virtual currencies that can be traded. If and when the startup becomes successful, the theory is that the value of the tokens will also rise, providing the investor with a potential return. Not all ICOs succeed, but among those that do, the Fabric Ventures/TokenData report estimates that the average return was twelve times the original investment.  

Changing the Game

Although most of the publicity surrounding blockchain has been focused on the fluctuating fortunes of Bitcoin and other virtual currencies, the underlying technology is set to bring about a huge transformation across finance, business and even public life. If pundits are to be believed, blockchain – essentially a digital ledger system – could change the way, for example, that deals are transacted and companies audited. It might also be used to underpin digitised voting systems. So perhaps it’s hardly surprising that it may also have a major impact on the way that individuals and funds invest in startup companies. It is, of course, early days, but ICOs do seem to be opening up another front in the alternative finance universe.

Bumps in the Road

That can only be good for businesses. Perhaps the biggest lesson from the great financial crisis of the last decade is that small businesses in particular were overly reliant on banking relationships. As banks pared bank their lending, it quickly became apparent that alternative forms of funding were required. Following hard on the heels of platform lending and crowdfunding, ICOs represent yet another alternative.

Not For Everyone

That’s not to say that ICOs are for everyone. From an investor perspective, blockchain related investment remains a largely unregulated space and there is always the risk of falling victim to fraud or theft by means of a data breach. And as the FCA pointed out, investing in early stage technology startups involves a high degree of risk.

On the capital raising side of the equation, only a relatively small percentage of early stage businesses will be in a position to consider an ICO. To attract investors the business will, typically, have to be in the service sector – most probably IT/Digital technology – while also possessing sufficient growth potential to assure investors that there is also scope for the value of the ICO tokens to rise significantly. To take an example, an ICO might make sense for a startup with a viable plan to sell into the enterprise software market.  

But what the rise of the ICO does illustrate is the ongoing evolution of the alternative finance marketplace. Crowdfunding and marketplace lending have already opened up the corporate finance and provided businesses with new ways to raise capital. For many, ‘Alternative Finance’ is now the first port of call. It’s a case of horses for courses. Not every business will tick the boxes for a successful crowdfunding. Not every business will be able to raise what they need through borrowing. The ICO offers a means to raise very large sums – the average is $12.7m – from investors who fully understand the risks involved and the potential for the reward.

You could argue, then, that as a by-product of the financial crisis, we are living in a golden age of innovative corporate finance. For businesses and their advisers, the challenge and the opportunity lies in finding the right solution for the company at any given stage of its development.  

 

 

 

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