Crowdfunding: Crypto Based Models

Advances in the blockchain technology, which we analyze in depth in

the crypto finance course have also put blockchain on the radar as

notable crowdfunding platform. In particular, in the last few years,

the blockchain quote, unquote platform enabled many companies

to raise a spectacular amount of capital, but on the other hand,

generated quite a bit of controversy. In the next two videos, we'll look at

how capital raising could be done on the blockchain, analyze performance so

far and derive some basic risk factors that investors should be aware

of before jumping into this market. Again, we're going to fit

crypto-based fundraising into our now familiar crowdfunding framework. The starting point is, again, someone

coming up with the very early stage idea for a highly uncertain projects,

that's a little ahead of his time. Now, in crypto-based funding channels,

many of these ideas, will involve blockchain to some degree,

mostly about using blockchain to quote, unquote disrupt some segments

of the real economy. For instance, say someone comes up

with the idea of letting people renting our spaces on their

hard drives for storage and using blockchain to keep

track of their usages. Or maybe a supply chain logistics solution that uses blockchain to record

the movements of actual goods. And again, instead of going to

the banks or venture capitalists, you appeal directly to the crowd and try to get small capital contributions

from individual backers online. And this time, you appeal through

the venue of the blockchain. We've already discussed the technology

in our crypto finance course and feel free to go back to that course for

a refresher. In this module,

we'll be talking about the business side. Using a public and programmable

blockchain, typically, Etherium or similar platforms like Neo,

the entrepreneur receives capital contributions, and in return,

instead of sending products or equity stakes,

sends crypto tokens to the contributors. Recall from the crypto finance course

that a token is simply a smart contract, a piece of code running

on the blockchain and anybody could generate these

tokens relatively freely. And just like in non-crypto crowdfunding,

crypto-based crowdfunding could also be classified into two types by the

kind of token that participants receive. The first type is called the initial

coin offering or ICO and a similar in some aspects to the reward-based

crowdfunding we talked about earlier. Here, the crypto tokens that the

contributors receive will essentially be accessed right to the products or services

that the entrepreneur will develop and do not confer any control right. ICO was all the rage from 2016 to 2018, with billions of new dollars raised and

then the market sort of dried up and replaced by other variants like

initial exchange offerings or IEOs, which is just like an ICO

except the exchanges themselves actively help in designing

an issue in the tokens. The second type is called the security

token offering or STO, and is essentially the crypto

equivalent of equity crowdfunding. The tokens are the same

as stock certificates and do carry residual cash flow claims and

control right claims. And just like Equity crowdfunding or an

IPO, firms doing STO need to be properly registered with the appropriate

regulatory bodies like the ICC and FINRA. In this video, we'll focus on

the first type, the ICOs and IEOs because there are a little

bit more complicated, usually not regulated and

generally much harder to value. Here's a brief description

of how ICO works. Similar to Kickstarter, an ICO is like

pre-selling your products or services. Except you're selling tokens representing

access rights to these products and services. You would generate a token smart

contract on the blockchain coding these access rights. Then you're going to hold a nice seal

event, where you sell these tokens to the public in exchange either for

other crypto currencies, like Bitcoin or Ether or

in rare cases for actual fiat money. After you receive the money,

just like on Kickstarter, the project proceeds to the development,

scaling, and fulfillment stages. That's it, but

have you noticed a key difference between an ICO campaign and

a Kickstarter campaign? If you participate in

a Kickstarter campaign, the products your promised

is not really transferable. It's very difficult for example,

to sell the Oculus VR goggle to someone else when you

haven't even received it yet. In contrast, the crypto tokens you

received in an ICO campaign can be bought and sold freely on crypto exchanges,

just like any other cryptocurrency as soon as they're listed and usually way before

the actual product is even developed. So critically,

the ICO has features from both a reward-based Kickstarter campaign and

equity IPO. Like a Kickstarter campaign, the issuer

is pre-selling its products or services. Like an IPO, the tokens conferring

the product access rights can be freely bought and sold in the secondary market, thereby enabling much faster

liquidity to the project backers. Consequently, we can see

that the ICO attracts two distinct types of participants. The first type of participants buy

the tokens because they like the product. They want to use it and therefore

need the tokens to access it later. The second type, by contrast,

buy the tokens to speculate, they don't really care whether

the product will be developed or not. As long as someone's willing to pay for

the token at a higher price, they'll happily sell it to them. So an ICO is really a unique

hybrid form of fundraising. It attracts both consumers who drawn

by the products consumer utility and it attracts speculators who

just want to make a profit. In order to analyze

the ICO process in detail, let's first review the process

of its big brother, the stock IPO, and

derive some important differences. Suppose you have a company

that wants to go public. Ideally, you should be in a relatively

mature stage with good funding in place, develop your product and

establish your cash flow. Now, how would you go about the IPO? Well, first,

you need to hire an investment banker. They act essentially like a financial

advisor that look through your company's operations numbers to try to come up with

an accurate valuation for your company. Then they'll prepare the paperwork

to essentially generate your stock certificate. Which is a legal contract specifying

that the holders of this stock certificate is entitled to a percentage

of the ownership of the company. It can vote on corporate matters and also gets a claim on the residual

cash flow just like other owners. In fact, if you have a bigger company,

you'll probably want to talk to a bunch of investment banks and

they will get together and form the so called underwriting syndicate for

your IPO. Now, the next step is also crucial,

once the homework is done, it needs to be examined by

the regulators for approval. In the US, this is done by the ICC. The firm needs to file a so-called

prospectus or form S-1, which is a really detailed

document describing the company, the IPO itself and offer a considerable

amount of detail on the operations and financial conditions of the company. This document is usually

hundreds of pages long. The SEC will examine

the offering in detail and approve or deny the IPO based on its

assessment of the risk to investors. And the IPO can only start

once the SEC approves it. This starts the so-called primary market

and it's where serious marketing begins. You, the CEO of the company,

will go with the investment bankers to be paraded in front of a host

of institutional investors, like Big Pension funds,

Mutual and Hedge funds etc. This is called the roadshow and the goal is to get the investors to buy

your stocks at the highest price possible. And of course, the final pricing of

the deal is not really up to you, it's up to the investor demand. The investment bankers will carefully

negotiate with the IPO investors to arrive at a final IPO price,

which could be higher or lower than your initial

valuation in the first step. Once everyone agrees on a price, then the stocks are transferred to

the investors and the primary market ends. Shortly after though,

the secondary market begins, the stock will be listed on one of

the stock exchanges and begins trading. And this is the familiar scene where

you see CEOs at the NYSE ringing the opening bell. Other investors,

both retail and institutional, will come here to trade the stock. And there are usually other mechanism in

place to prevent the key stakeholders like the founders or key management personnel

from selling their stocks too soon. Now, with this structure in mind,

let's transition to the ICO market, the beginning and

the end are similar to the IPO. We have a firm, this time, a much earlier stage startup with

possibly just an idea or white paper. And at the end, we have a large number

of secondary market participants who either want the company's

eventual product or wants to speculate on

the company's tokens. But there's some interesting

tweaks in the middle. First, the underwriting syndicate is

going to be replaced by the blockchain. You don't actually need to hire anybody. As long as you have access to

a programmable blockchain, which everyone does,

to say Etherium or Neo, then you can coat your token as

a smart contract on the blockchain. And specifically, the token is going

to be called an utility token. And as its name suggests, it does not grant any control rights or

cash flow claims. Instead, it grants the holder

of that token usage or access rights to the company's product or

service. For example, if the proposed product

is an encrypted messaging service, you could specify that once

the messenger is developed. Each message could consume say,

one token to be sent and received. So in contrast to an IPO,

instead of owning the actual company, the utility token gives

you the right to quote, unquote open the eventual

product of the company. And this right is coded as

a token smart contract and recorded on the ethereum blockchain,

for example. Once the token is generated, well,

there's no SEC registration here, the deal proceeds directly

to the offering stage. There will still be marketing, but instead

of roadshow to institutional investors, the company will directly market to the

public instead, using all the channels at its disposal, particularly social media

channels, like Twitter and Telegram as well as other channels like celebrity

endorsements and viral marketing. Moreover, since there's

no pricing negotiation, the company is free to set

whatever ICO price it wants. The initial sale will then happen,

usually automatically on the blockchain, where the buyers will send Bitcoin or

Ether to the company's respective blockchain addresses and a smart contract

will usually be in place to send the utility tokens to the investors

once they're fund is received. Finally, the secondary market begins on

one or more of the hundreds of crypto exchanges, where the utility tokens will

be traded just like a cryptocurrency with much more flexible lockup options for

the key stakeholders. As of early 2020, for instance,

out of the 5,000 or so cryptocurrencies tracked by coin market

cap, about 1500 of them are tokens.