When a business reaches a certain stage of development, it looks to fundraising in order to secure money and fund the next stage of development. This happens when companies need more capital to scale quickly compared with what’s available to them at present.
Crypto businesses are not immune from this but have more options at their disposal. So, if a crypto startup is planning to secure capital, it needs to look into raising funds. If the startup is either too early or too late in the developmental stage, however, it might not qualify for any of the traditional ways of fundraising like initial public offerings and securing a bank loan.
The crypto and blockchain space is presenting novel approaches to raising funds that have not been possible in the past.
So what exactly is fundraising in crypto? How can companies benefit from this fintech revolution? How does fundraising in crypto differ from traditional fundraising approaches?
Before getting into all that good stuff, let's cover the traditional approaches to fundraising: venture capital funding and angel investors. We will then look at how the initial public offering (IPO) fares against the darling of crypto fundraising and initial coin offerings (ICOs), and cover initial exchange offerings (IEOs), initial DEX offerings (IDOs) and security token offerings (STOs) as well.
Venture capital and angel investors: Raising funds in traditional ways
If a company is looking to raise capital at some point, its owners may want to look at venture capital firms. In essence, a venture capital fund involves a group of investors who pool their money and spread their bets on startups. These firms find potential investors by sending out a prospectus, which is a formal document filed with the SEC that details the benefits and risks of an investment. If investors express interest in a project, they commit their funds to the firm.
The fund's managers review many business plans to find projects that they believe will provide the best returns. In exchange for funding, what they want is equity (i.e., shares in your company) so they can exit with a quick profit.
As a company owner, it's important to understand that a venture capital fund is short term. These firms want to make a quick profit and move on by selling their equity.
The good news? If venture capitalists choose to fund a business, it means they're confident, at least on paper, that the business will quickly increase in value. The bad news is, the company might have to give up a piece of the business.
Angel investors, in contrast, are usually highly affluent individuals who invest in a business in its early stages. Their investment focus tends to be on the entrepreneurs and their vision rather than on the soundness of the business. Instead of looking for a quick exit, their motivation for funding is to make money, primarily for the equity they may or may not hold.
Various approaches to crypto fundraising
History
In 2017, fundraising blew up in the crypto space. Many analysts and participants remember it as the ICO craze. Thousands of projects went live with ICOs. Most of them, to no one's surprise, were met with catastrophic failure.
However, a handful of them ended up minting millionaires. To many analysts, the ICO craze carried all the hallmarks of the dot-com boom, when too much speculation caused a massive bubble in the late 1990s and caused numerous new online companies to fail. Experts were bracing for a similar crash in 2017, but it never came.
The ICO craze did lead to the birth of several other forms of crypto financing, though. These include STOs, IEOs, and last but not least, IDOs. Let's go over each in detail below.
Initial coin offerings
The cryptocurrency industry's equivalent of an initial public offering (IPO) is an initial coin offering (ICO). An ICO is a method of raising funding for a company wanting to build a new app, coin, or service. Let's cover what an ICO does first and then go over the differences that matter.
The most important fundraising tool for blockchain and cryptocurrency startups is the white paper, which is arguably the most important marketing document, inviting people to invest in their company.
While brochures and other marketing materials may involve blatant sales pitches, a white paper is meant to persuade and present factual and technical proof that a specific service is superior to solving a particular business problem.
The white paper offers critical details like how much funding is required, a roadmap with a quarterly timeline, the tokenomics of the business (token distribution, including the percentage of tokens that will be publicly available versus the percentage the founders intend to keep) and details of the fundraising campaign.
Steps to launching your own initial coin offering
Here’s an overview of the fundraising process to launch a successful ICO:
1. Confirm that the project actually needs an ICO, or if an ICO is the best approach to finance their business. An ICO is not suitable for every company. Even if an ICO is easier to launch than the traditional IPO, it should not be viewed as a way to bypass the stringent regulations surrounding it. The main concern for any company considering an ICO should be whether their token will have actual utility. If, however, it's only meant to facilitate the sale and that is its only purpose, then an ICO is definitely not the way to go. But, if the business token has an actual use case, then the business should proceed to Step 2.
Users should also make sure that it fits with their business strategy and business model.
2. Get a team together. If the token has an actual use case, it's time to bring in the experts. There's work to be done on everything from developing the product to marketing it. The team may or may not include advisers. Regardless, advisers should have experience launching successful ICOs. There are plenty of crypto projects that launch without advisers, but it is uncommon for larger projects to not have any advisers on their board.
3. Review any regulations around running an ICO in the country in question. Some countries have stringent regulations around what classifies an investment security. Other countries like China have outright banned ICOs. Users should make sure they are in the clear for regulatory oversight. This ensures that the road ahead isn't hampered by any legal or technical hindrances.
4. Prepare a project roadmap. The project roadmap gives potential investors a timeline. This means that they get a sense of progression and what to expect as the project moves forward. As long as the team can meet the set milestones, investor confidence should remain high. Sure, this is beneficial for funding, but it also goes far in keeping the cryptocurrency community active and enthusiastic.
5. Write and release the white paper. Review the marketing collateral published by competitors. This includes going over successful—as well as less successful ICO white papers—to understand what goes into a good one.
The purpose of the white paper is to instill and build confidence in investors. That's why it should include what the project is about and what problems it solves. Users should also mention why the team is uniquely qualified to solve them. Finally, mention details that will sway a potential investor to support the project. It may be worth investing in a writer who specializes in white papers for the crypto industry.
6. Build an online presence. Having a website is essential for any self-respecting crypto project. The site is the promotional base. It's where any potential investor can learn about the project and read the white paper. Building and promoting the community will also go a long way. Users can reach out to crypto influencers to see if they'd be interested in promoting the project. Finally, it's critical to get the project listed on ICO listings. Many serious investors review these listings often to find projects they may wish to support.
7. Pick a token sale model. Several models are available from the Dutch Auction to Capped or Uncapped auctions with fixed rates. Users can even consider a hybrid model. The ICO may also be broken down into different stages. There may be a presale or a private sale even before the ICO is open to the public. Ensure that the token sale model is friendly to investors and community members. Community backlash due to perceived unfairness can wreck a project in its infancy.
8. Release a smart contract and start minting tokens. The project details should include early on which blockchain the project is to be built on. Traditionally, most projects live on the Ethereum blockchain because it was the first to deploy smart contracts. Today, though, many rivals are emerging with faster throughput and different technical architectures.
It's important for users to hire a developer who can audit their smart contract. The dev can make sure that it's not vulnerable to any exploits. This way, when the launch date comes, there are no unforeseen issues that can plague the ICO.
9. Launch ICO. This last step marks the end of the fundraising process. Upon the launch of the ICO, a lot will hinge on whether the project reaches its fundraising goals. In case it does, continue to focus on fostering the community and improving the project. Go over future plans. The rest will fall into place.
For the actual ICO campaign, any potential investor can buy tokens with fiat currency or a prespecified digital currency. Users can think of the token as a share of the company. In contrast, for an IPO campaign, a private company decides when to go public. For a company to be eligible for an IPO, however, it must meet many stringent conditions like opening its books up for public scrutiny, risk loss of control, incur an increase in reporting costs and so on. An underwriter leads the IPO via book building, which involves trying to pin down the price. The underwriter builds the book by asking investors how many shares they might want of the company, and how much they might be willing to pay.
Additionally, an IPO also requires a third-party audit to ensure that all financial activities engaged by the company are in compliance with the law. This grants investor protection, thus boosting confidence in the project's reputation.
As shown in the table, launching an ICO can be a straightforward process and because of the lower barrier of entry compared to IPOs, any crypto-savvy blockchain developer can launch one. Finally, project owners can launch an ICO fast, even within a few days' time.
Keeping these points in mind, it's understandable what came to fruition at the end of the ICO craze of 2017. It turned out that most of the thousands of projects being pushed as the “next best thing” were basically poorly planned projects or straight-up rug pulls (Rug pulls are when a project team intentionally runs a pump and dump scheme by convincing investors to buy, thereby increasing the price rapidly before the team dumps their holdings onto the market, driving prices crashing down.) Since pretty much anyone could launch an ICO, many people did. So many founders waited for a boost in their token price before vanishing with the funds.
To better protect investors and boost confidence in the token issuers (i.e., the owners) of genuine projects, what came next was the IEO.
Initial exchange offering
An IEO is like an ICO, except the entire issuance occurs via selected cryptocurrency exchanges. The project owner receives peace of mind because they know their token will be available to any investor with access to the exchange. If an exchange is reputable and well-established, exchange backings can give investors reassurance that their funds are protected.
The tradeoff is the high cost of having the exchange manage the coins directly. This includes paying a listing fee for the token, as well as giving up a percentage of the token sales. In essence, the exchange is loaning out its reputation to the project for financial gain.
This situation differs from when a cryptocurrency exchange chooses to list a project's token. Based on the exchange's own conditions, an exchange might list a token once it independently deems the project worth listing.
Security token offering
The less popular security token offering is a more cautionary approach to crypto fundraising. As the name already implies, this approach already recognizes the token as a security. This means that they comply with security regulations as necessary.
Regulations may include Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements. KYC and AML policies ensure that financial services recognize and minimize risks in accordance with government regulations.
Initial DEX offering
A DEX is a decentralized exchange. DEXs work as automated market makers. They rely on smart contracts to execute fund transfers, thereby eliminating the need for a third party. KYC and AML compliance are also not required. This may subject them to stringent regulations later on when the hammer drops, though. Instead of personal identification, all anyone needs to participate is a digital wallet address to receive the coin in question.
Regulatory risks to be aware of
As with any nascent industry, users should be aware of the increased scrutiny their projects may fall under. Because the regulatory agencies in various countries classify cryptocurrencies and crypto assets differently, it’s best that users review the legal implications of launching an ICO in their respective jurisdictions. This gives project owners, as well as investors, reassurance that their projects won’t face legal troubles later on.
Although public blockchains are transparent and allow for customer identification, there is an ever-growing number of obfuscation measures designed to safeguard crypto-asset owners' anonymity. However, no organization is responsible for collecting and verifying KYC data on customers, like their names or addresses, or monitoring transactions for suspicious activity if there is no centralized clearing hub or exchange.
A slew of new financial crime legislation has gone into effect worldwide, intending to close gaps in supervisory and regulatory frameworks and combating money laundering threats. Money laundering is the practice of converting vast sums of money earned from criminal activity, such as drug trafficking, into legitimate funds.
To prevent money laundering risks, Anti-Money Laundering legislation has been established in some nations, while more strict measures have been enacted in others. AML policies are put in place by the regulators to keep criminals out of the financial system. Variations in risk appetite provide opportunities for regulatory arbitrage for undesirable actors. This may lead to a shift toward less formalized work environments that will allow for better agility and the ability to innovate quickly. However, others may prefer more regulations to demonstrate their soundness, safety and confidence.
The road ahead
With cryptocurrencies and blockchain technology going mainstream, they've caught the eye of traditional gatekeepers. These include regulators, banks and financial institutions. As discussed, some regulations might be a good thing, as this market is rife with scams and low-quality projects. Introducing investor protections and greater stability via regulations might not be such a bad thing.
Since the advent of ICOs, crypto innovations have come a long way in such a short period. IEOs, IDOs and other, newer fundraising innovations are here, and they're quickly catching up in popularity compared with other novel approaches like ICOs. What new fundraising technologies will emerge in the future? This remains to be seen. But, the industry will be shaped by the regulatory landscape and the creativity of crypto or digital finance will shape the industry. There's no doubt about that. Hopefully, they'll also take heed to the needs of project investors and issuers alike.