Token Based Funding
Crowdfunding is an ambitious experiment in stakeholder capitalism. While the idea of a world where individuals fund projects they find important is compelling, a number of obstacles stand in the way of such a bright future. In this article, we discuss a handful of the fundraising methods implemented within the decentralized finance space and otherwise, expounding on strengths and weaknesses therein.
Equity Crowdfunding - No tokens involved
Equity crowdfunding involves the contribution of funds by investors in exchange for interest in the venture they are funding. It’s useful to consider the equity crowdfunding model when analysing the various crypto-based funding models, as they exist to serve a similar purpose. Platforms like Crowdcube and Seedrs effectively provide a platform for retail investors to participate in a seed round. The voting rights of investors are defined by the class of stock purchased.
The obvious value provided by this style of fundraising is that retail investors can be involved in early stage fundraising without status as accredited investors. From a more generalist perspective, opening the playing field for early-stage investing is clearly in order. In the United States, start-ups and small businesses accounted for 65% of net-new jobs between 1993 and 2009, almost all of which were funded by personal savings, credit card debt and the contribution of family and friends. Despite this, the venture industry is becoming more exclusive. A 2019 report showed the investment volume in dollars climbed by 46% between 2017 and 2018, eventually reaching $254 Billion, however it was distributed over a smaller number of deals than previously. Founders engaging an open style of funding benefit not only from the accessibility of their investment to a wider audience, but also the network effects that come with having a large number of investors likely to become active users. In 2018, Monzo, a Neobank based in London, raised £20m from over 36000 investors in less than three hours, almost £7m of which was raised within five minutes. It is not difficult to imagine how valuable a network of 36000 people with a vested interest in a product could be for an early-stage company, especially when that company could not implement marketing strategies on such a scale. Indeed, Monzo went on to raise hundreds of millions more over a handful of rounds, eventually engaging YCombinator as the series F lead. Perhaps Monzo’s success was inevitable and would occur independent of the crowd-sourced money they raised. It must be acknowledged however what significant utility crowdfunding can provide. As with an Initial Exchange Offering (IEO) which will be discussed later in this article, crowdfunding platforms are required to conduct substantial due diligence before listing an offering to the public. This serves as protection for vulnerable investors, as it is in the interest of the funding platform only to list projects of the highest quality and reputability.
While it is in the interest of a crowdfunding platform only to list offerings of the highest quality and merit, the risk of bad practices on behalf of the listed companies cannot be avoided altogether. In fact, the risk vector of any firm engaging in fraudulent behaviour is quite high. A 2013 paper showed that among the publicly listed U.S firms, 14% had engaged in fraud of some description, costing some 20 - 38% of the firm’s value. This is a huge limitation for the crowdfunding model, for which the theoretical basis is provided by economist, Gary Becker. His theory of crime and punishment offers that the utility of opportune behaviour is decreased by the probability and severity of punishment, as fraudulent agents are assumed to be “rational”. With this logic in mind, it makes sense that regulation could puncture the rates of fraudulent activity, although this is far easier said than done. It requires a great deal of commitment and capability to disarm a scam artist with a credible appearance. However, a report identified that fraudulent crowdfunding activity can be identified ex ante, as malicious individuals are less likely to have conducted a crowdfunding before and are less likely to engage with social media. Buy and large, investors in a crowdfunding don’t conduct the level diligence necessary to reliably prevent fraud and the loss of their deposit.
Token Based Funding
The decentralized incarnation of equity crowdfunding is the Initial Coin Offering. This method involves the issuance of utility tokens through an exchange. These tokens derive their value from the perceived value imputed by investors as signalled by the price they are willing to pay for tokens. More formally, they grant a right-of-use to a digital service. Utility tokens are scarcely intended to represent investments. In the case of traditional securities, investors make placements in a company with the expectation that in the future, that company will produce cash flow. The Howey Test is satisfied by a traditional stock, and while it is often argued that the same is not true of utility tokens, this distinction is equivocal. Utility tokens aren’t designed for any specific functionality external to the project itself, and projects utilize their native token to a far greater extent than a public company utilizes its shares, notwithstanding that utility tokens can be traded on an open market. As an example, Ethereum has a publicly traded token, but that token is also used to generate incentives within the system such that the functionality of the network can be executed. Don’t hold your breath for a large, publicly owned company to enact any similar practice using common stock.
Opening the market for utility tokens is certainly a founder-friendly way of raising funds. During the initial phase of the ICO era, companies raised exorbitant amounts of money to finance their ventures not only pre-product-market-fit and cashflow, but in some cases, before having a viable product. Block.one as an example, raised over $4 Billion in an unregistered ICO in 2016 without a live product. They paid for it in the end: in September of last year Block.one negotiated a civil settlement to the tune of $24 million with the SEC - water off a duck’s back for a company that’s just raised $4 Billion. Entrepreneurs undergoing a traditional funding round often have a very hard time convincing investors when they don’t have an exact plan of what to do with the amount they intend to raise. Angels and VC’s often show very little tolerance of founders without a definite idea of what success looks like and how they plan to achieve it. The unprofessional investor however, does not conduct such a comprehensive appraisal when considering an investment. It should be considered natural therefore that an open market for early stage investments yields undesirable outcomes. Indeed this is an important problem: a 2018 study identified 78% of all ICO’s as scams, with scam being defined (either by the community or the author of the study) by a project where the management team had no intention of delivering the utility which was advertised to investors before the fundraising. Solving this problem has been important within the Ethereum community for some time: Vitalik Buterin and other prominent researchers in the space have identified a number of superior mechanisms to raise funds in an open way. The following is a list of such mechanisms and alternatives to the ICO.
One of Vitalik’s responses to the dysfunction of ICO’s is the DAICO. The Ethereum creator describes a process by which developers in need of funds for their project specify some sales mechanism where individuals deposit ETH and receive tokens in exchange. This is referred to as the contribution period. Once this period ends, external investors lose the ability to contribute ETH and the token balances are set. From there, the tokens become tradeable on an open market. Additional functionality is provided by the ‘tap’ state variable, which imposes a limit on the amount of ETH that can be withdrawn every second. The tap state variable allows for improved security on the basis that both the developers and voters must be corrupted in order to cause significant damage. This is because the tap amount is set by the developers and eventually voted on by token holders. Consider a 51% attack; in this case the attacker’s ability to funnel funds out of the DAICO contract is limited to the extent that an honest developer reserves the ability to lower the tap again if they get the sense that the contract is under attack. To the contrary, in a case where developers imprudently spend the contributed ETH, voters can self-destruct the contract, liquidating its contents and distributing the pro-rata ownership among the investors. As such, DAICO’s make it more difficult for bad actors to defraud contributors and run away with the proceeds of a public token sale.
Interactive Coin Offerings (IICO)
Another model proposed by Vitalik is the Interactive Coin Offering. IICO’s exist to provide certainty to investors over valuation and participation, although certainty over each can not occur contemporaneously. In a capped sale, a fixed number of tokens are sold at a fixed price, meaning that valuation is predetermined. Notwithstanding that, there is no guarantee of participation, as frontrunners will offer higher gas prices to reach the front of the queue, effectively competing smaller players out of the opportunity. In the case of an uncapped sale, the incentives are a little more intricate. IICO’s incorporate a very interesting feature whereby investors stipulate the maximum value at which they are willing to participate in a sale. If the valuation supersedes that threshold, bids are revoked and funds returned. Conceptually, this is quite similar to a SAFE note with a valuation cap, except no negotiations are required between company and investor in order to determine valuation - investors simply impute this information voluntarily and allow market forces to determine the fate of their investment. There is great incentive in this case for investors to provide accurate estimations of value because a personal cap that is too low will force an investor out of participation. Therefore, only those who are bullish (or at least representing bullishness) participate. In effect, this layer of functionality adds a widget of diligence for each individual investor, as they are required to communicate the point at which they consider the project to be overvalued explicitly. Alternatively investors can leave the maximum value blank and guarantee participation (note that this comes at the expense of certain valuation). In this way, the token sale is interactive, as it requires individuals to make a value judgement about the project that is relative to their competitive investors. That said, investors have a large incentive to buy tokens early rather than later, as a bonus round is offered in order to compensate those who take risk. Once again this is similar in concept to a SAFE note, except this time with no valuation cap and a discount on conversion. A 20% bonus may be offered to investors in the first (full bonus) stage where deposits can be withdrawn voluntarily at no cost. In the next stage, only involuntary withdrawals are allowed to be made without penalty, and the amount that can be withdrawn linearly diminishes. Additionally, the initial bonus that was offered in the initial phase diminishes linearly. As an example, if I make a voluntary withdrawal 70% of the way through the partial withdrawals stage, I am only entitled to a refund of 30% of my investment, the rest stays locked in the contract and is subject to a bonus reduction of ⅓. This means that if I invest 100 ETH when the bonus rate is 20%, I receive 120 ETH worth of tokens. If I then withdraw my funds 70% of the way through the round, I will receive 36 ETH (30%) back, while the remaining tokens will be reduced by 28 ETH (84/3) in value, meaning that I am left with 56 ETH (56 - 56/3) worth of tokens still in the contract. The penalty mechanism punishes irrational exuberance and illegitimate frontrunning, because a bid can’t be withdrawn without a cost being imposed. In this way, IICO’s provide fairly robust incentives to act on valid information within markets - rewards and punishments are made to incentivize a greater degree of interaction with market participants.
Security Token Offerings (STO)
STO’s enable a kind of public offering where tokenized digital securities are sold on exchanges in compliance with securities law. They are qualitatively different from ICO’s, because a security token is used to trade existing financial assets like traditional equities, whereas utility tokens are merely ownership claims on a digital service. An STO is perhaps more similar to the traditional IPO because of this difference. From an investor’s perspective, the economics are identical to a traditional equity investment; the only difference between this and a traditional securities sale is the technological implementation. The same is true of the control provisions for investors - voting rights are allocated among the different classes of token holders just as they would be in a traditional equity sale.
STO’s provide a substantial technological improvement for implementation in traditional company sales. Fundamentally, blockchain offers the ability to migrate from centralized stock exchanges and financial clearinghouses to a distributed repository of ownership. This migration offers much in the way of efficiency, as currently brokerage fees can be high and the processes within financial clearing houses can be slow and vulnerable to attacks. On this basis, tokenized securities with a shared ledger of ownership would represent a vast improvement on the legacy approach to the sale of securities. On the issue of regulation, cryptocurrencies are divorced from any country’s political jurisdiction and as such, the facilitation of criminal activity is a pain point of the traditional ICO model. Security tokens are tied to real, registered assets, regulated by a specific jurisdiction and as such, they are not subject to the same legal risk as an ICO. The obvious value proposition of security tokens is to allow increased participation in traditional financial markets. That said, there are some clear challenges ahead before the true potential of the technology is realised. A fundamental challenge is liquidity: there are only very few licensed trading platforms that are accommodating STO’s. This is perhaps an obvious eventuality - it would be unreasonable to expect the same level of accessibility an ICO offers whilst also involving a rigorous KYC/AML process to determine the status of each investor. A higher cost is imposed on the issuers of security tokens for this reason, eventually meaning that there is less incentive to engage such an offering.
Initial Exchange Offering (IEO)
Initial exchange offerings allow tokens to be sold by exchanges on behalf of companies. This is valuable for companies looking to make an offering as the exchange to which they list their token has an incentive to promote the sale of that token. The economics and control rights of token holders remain the same for an investor as in a traditional ICO. Overall, IEO’s may represent an improvement to the coin offering model from the perspective of a conservative investor. In theory, exchanges listing speculative tokens are required to conduct reasonably scrutinous due diligence. This would remove a large degree of the uncertainty involved for the retail investor in theory, as they would enjoy the potential upside while the risk of downside is mitigated. While it is not in the interest of an exchange to facilitate fraudulent token sales, it is not clear that exchanges do conduct diligence on projects, rather they charge for listings on their platform. As such, this solution is not complete. Notwithstanding, listing fees on exchanges could be viewed as something of a filter for dishonest projects. Further, an important question lies in the issue of centralization, and whether due-diligence should come at the price of greater centralized risk. An additional convenience for retail investors is less compliance checks, as they have already been identity checked by their nominated exchange. Initial Decentralized Exchange offerings (IDEO) are functionally similar with IEO’s except for the fact that DEX’s will have a more limited capacity to conduct diligence. As such, the value proposition of an IEO is undermined if it is to be migrated on to a decentralized exchange.
Cash Flow Tokens
Cash flow token sales create a market for the revenue performance of a company without granting ownership of that company. Fairmint has introduced their Continual Securities Offering (CSO) model whereby a company engaging a CSO pledges to allocate a percentage of its realized revenues to a reserve, perhaps 10% distributed quarterly for 5 years. This percentage can be increased, but can never be reduced. The reserve is a smart contract which continually calculates the price at which investors can redeem their securities: if the revenues increase and the reserve grows in size, investors can redeem their tokens against the reserve pool at a higher price than what they paid initially. In this way, external investors can participate in the success of a company simply by speculating on the future cash flows of that company. Entrepreneurs can control the size of the reserve pool in order to achieve certain things; for instance if a goal of the company was to attract new investment, the reserve pool could be increased. However, the contrary is not possible, as it would necessarily mean that every current token holder would have their stake in the reserve pool reduced relative to their initial investment. From an entrepreneur’s perspective, a CSO functions much like an interest free loan: investors provide capital over a fixed period with the ability to redeem their tokens in cash from the reserve pool at the closing of a CSO. The potential uses here are immense; from the removal of credit ratings agencies for decentralized commercial bond markets to the issuance of employee stock options through a CSO over traditional stock options, tokenizing cash flows offers much in the way of efficiency.
Decentralized Autonomous Organizations are vehicles for a group to make decisions, monetary or otherwise, in a secure and decentralized way. The very first DAO was launched in 2016, designed to function as a stateless venture capital fund. By design, DAO’s are fairly robust against censorship, but face a pressing legal question: what constitutes a financial security? The SEC’s opinion on this matter was made perfectly clear in July of 2017: a 21A report announced the following: “The federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization,” OpenLaw’s response to this issue is The LAO - a for-profit venture DAO wrapped in an LLC. Thus far, legal usage of DAO’s have been limited to the coordination of digital asset grants and the funding of ventures where there can be no expectation of profit on behalf of the investor (see Howey Test). OpenLaw can facilitate the usage of DAO’s for the funding of projects where there is an expectation of profit, as DAO’s themselves can be set-up as legal entities. The LAO launch may prove to be an historic moment in time, but for now it certainly represents the first entity of its kind.
It’s clear that much can be gained from opening the playing field for early-stage investment. Something not discussed thus far is the issue of accessibility - while much can be gained from each model included in this paper, it could be considered unlikely that a small business or start-up founder would be willing to implement any such model. This is especially true when one considers how an angel investor or venture capitalist might respond to the prospect of incorporating cryptocurrencies into their investment model - reluctantly. Ultimately, all of these schemes face trial in the court of public opinion. Only proven credibility and insurmountable security will demonstrate that crypto-based fundraising really is worthwhile.