The Initial Coin Offerings Market (Part 2)

Notes from the Vault
Larry D. Wall
April 2018

The sale of tokens in initial coin offerings (ICOs) has emerged as an important source of funding for technology start-ups. For example, CNBC technology correspondent Arjun Kharpal reported that ICO fundraising exceeded angel and seed stage venture capital (VC) funding in June and July of 2017. Indeed, a provocative Wall Street Journal headline for an article by reporter Yuliya Chernova (2017) asks, "Who Needs Venture Capitalists When You Have Initial Coin Offerings?"

In an earlier post, I discussed some of the issues related to the economics of ICOs. This post extends that analysis to compare the potential economic contributions of ICOs relative to other methods of funding new technology companies, especially in their early stages. The analysis begins with an overview of the issues related to funding new companies that specialize in technology and how existing funding methods address those issues. The post then discusses how these issues have been addressed by most ICOs.

Challenges in profitably financing new technology ventures
Some new technology ventures have the potential to provide valuable new services to their customers and high returns to their investors. However, such ventures are typically high risk even in the best of circumstances. In order for a new technology firm to succeed, and hence provide a return to its investors, the entrepreneur has to navigate a number of challenges successfully. The entrepreneur must start with a technologically feasible idea and have both the ability and resolve to develop that idea into a marketable product. The potential market for that product must be large enough to allow the firm to become profitable. Even given a marketable product and strong demand, the entrepreneur must still develop a management team that can and will take the many steps needed to turn a product idea into a successful firm.

The people who have the ideas for new technology ventures and the skills to build a firm often lack the financial resources to bring their ideas to reality. In contrast, those with the financial resources often know they lack the requisite ideas, technical ability, or managerial skills to build a firm. The problem is how best to bring those who have the ideas and skills together with those with financial resources on terms acceptable to both sides.

The people with the ideas for new ventures (hereafter, entrepreneurs) not only provide the key intellectual property, but also typically spend long hours helping to develop the product and manage the firm. Given the essential contributions by entrepreneurs, they would typically like to retain control of their firm and as large a fraction of the profits from a successful venture as possible. Many entrepreneurs would also appreciate help from investors in developing the product, market, and firm. But those with the financial resources (hereafter, investors) will only invest if their expected rate of return provides adequate compensation for the risk they are taking.

This discussion suggests there are at least three ways an entrepreneur can encourage investors to provide funding on favorable terms. First, the entrepreneur can provide more information about the underlying technology, product, planned market, and management team to reassure investors about the firm's probability of success. Second, given the critical importance of the management team to the success of the venture, the entrepreneur can give the investor greater governance power over management. Third, the entrepreneur can give investors a larger share of the value created if the venture is successful.

Although providing investors with greater governance power helps to reassure them, it comes with some risk to the entrepreneur. The investors' primary interest in the venture is their own returns, not the interests of the entrepreneur. That raises the possibility investors may use their governance powers opportunistically to benefit themselves at the expense of the entrepreneur. For example, a paper by University of California at Berkeley professor Jesse M. Fried and JSD candidate Mira Ganor points out that venture capitalists may prefer lower-risk strategies that allow them to cash out earlier rather than higher-risk strategies with higher expected returns.

The potentially conflicting interests of an entrepreneur and investors create the difficult problem of how to allow investors to intervene when needed but limit investors' ability to abuse their power at the expense of the entrepreneur. In practice, the problem of potential conflicts of interest between entrepreneurs and investors is rarely completely solved, but various measures are taken to mitigate them. One way is to restrict the investors' governance power so long as the firm is meeting the two parties' original expectations, according to University of Chicago professors Steven N. Kaplan and Per Strömberg (2003). Another way of reducing the risk is to take advantage of investors' concern about their individual reputations. Most investors care about their reputation among entrepreneurs because they plan to invest in other new ventures in the future. Investors' ability to gain access to the best ventures in the future may be significantly impaired to the extent that an investor is perceived to have abused his or her governance power in prior dealings with entrepreneurs.1

Alternatives to ICOs for financing new ventures
The Security and Exchange Commission's (SEC) general approach to investor protection is to mandate minimum disclosure standards for registered security issuers that allow investors to make informed decisions. Still, however reasonable these standards are for large corporations, they can impose costs that may be economically burdensome to new technology firms with little or no revenue. To facilitate the financing of smaller firms, the SEC has implemented several exemptions that come with significant conditions on the firm and the investor.

Perhaps the most important dividing line among the exemptions is whether it is limited to "accredited investors." An SEC staff report explains that an accredited investor includes "those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act's registration process unnecessary." Accredited investors may invest in securities where the firm or private fund does not make the same disclosure required for unaccredited investors (everyone else). According to an SEC Investor Bulletin, the current requirements for being an accredited investor is that the person have earned income of at least $200,000 (or $300,000 with a spouse) and a net worth of over $1 million (exclusive of the person's primary residence).

If a firm wishes to market its securities to unaccredited investors, it has three options: Regulation A—Tier 1, Regulation A—Tier 2, and Regulation CF—Crowdfunding. These are each summarized in a chart at the bottom of a blog post by SeedInvest, an equity crowdfunding platform.2 The three options for unaccredited investors listed in this chart all contain limitations that reduce investor risk at the cost of making it more difficult for the firm to raise funds. All three options limit the maximum offering size (limits ranging from $1 million to $50 million), require some documents be filed with the SEC, and include penalties for making false statements or omitting a material fact. Two of the three alternatives limit the amount of money invested by any one individual. Furthermore, Regulation CF requires the use of a funding portal or broker-dealer and imposes various requirements on the portal.

The requirements for offering securities to accredited investors are not nearly so stringent, given that these investors are presumed to be more financially sophisticated and better able to sustain losses. Nevertheless, even here the firm issuing the securities is liable for false statements and material omissions in its disclosures.

Accredited investors who invest their own money in a new venture are often called angel investors.3 A more narrow definition that better matches our purposes is the one provided by University of Tennessee professor Ramon DeGennaro and University of Carlos III professor Gerald Dwyer (2014). They define an angel investor as "a person who provides funds to a private business which does not have publicly traded stock and who is not a relative or personal friend of the owner or operator of the firm." Angel investors are often successful entrepreneurs who want to help build new firms and/or have significant industry experience that allows them to evaluate new ventures and mentor their founders. Additionally, angel investors sometimes work with other angels as a part of a group, which allows them to benefit from one another's expertise and provides them with greater portfolio diversification. Angel investors typically provide funding relatively early in a new venture's life.

Angel investing is risky. DeGennaro and Dwyer (2014) examine the performance of a sample of angel investor groups. The average return on their sample of 419 investments between 1972 and 2007 is 29 percent. However, the median return was minus 2 percent, suggesting that over one-half of the projects failed in the sense of losing part of their investors' funds. Moreover, this high failure rate occurred even though the investors in their sample tended to have a variety of characteristics associated with successful projects, including advanced degrees, many years of experience investing, and regular contact with the firm.

The amount angels can provide is limited by their personal wealth. An alternative is professionally managed venture capital funds, which provide financing across almost the full range of needs, from seed capital to start a company through to late stages where a company may be approaching the point of undertaking an initial public offering (IPO). Venture capitalists (VCs) provide some of their own money, but obtain the bulk of their funding from institutional investors and very wealthy individuals. Professional managers who specialize in investing in risky ventures run venture capital funds. A paper by University of Chicago professor Steven Kaplan and Harvard University professor Josh Lerner observes that VCs typically engage in three activities to boost their probability of success: (a) VCs spend considerable time screening and selecting deals, (b) they engage in sophisticated contracting and structuring of their investments, and (c) they improve outcomes by monitoring and aiding companies after they invest.

Even though VCs have professional managers and go to considerable lengths to increase their success rate, a high proportion of their investments fail. A paper by Harvard professors Paul Gompers and Josh Lerner with Federal Reserve Bank of New York economist Anna Kovner (2009) analyzed a large sample of venture capital investments from 1975 to 2003. They find only about one-half of investments are successful in the sense the firm went public with an IPO, was in registration for an IPO, or was acquired. Interestingly, the authors found that VCs specializing in one industry and VC firms with more experience tended to have higher success rates.

Thus, entrepreneurs with new technology ventures can use one of a number of funding mechanisms to obtain outside funds under current SEC regulations. The alternatives for raising funds from unaccredited investors come with more strict disclosure requirements. However, accredited investors can, and often do, require not only information disclosure but also some control over the firm's governance in some situations. Nevertheless, projects backed by angel investors and VCs have high failure rates even though these investors typically have some expertise in evaluating new technology projects, and often provide advice to help make the entrepreneur successful.

ICO funding versus the alternatives
The tokens sold in ICOs could represent almost anything, but most to date are utility tokens that offer access to the product being developed by the entrepreneur. As I discussed in last month's post, a utility token is often a sort of presale of the product that helps build demand for it. The sale of utility tokens to boost demand can be especially valuable for products with network effects where the value of the product to users is an increasing function of the number of other users.4

However, arguably the biggest advantage of utility tokens is many issuers believe these are not treated as "securities" for the purposes of U.S. securities law and are therefore not subject to the SEC's requirements. In particular, this means the tokens can be sold without limit to anyone without being subject to regulatory disclosure requirements. Along with potentially reducing the cost of raising funds, the ability to sell any amount to any investor provides at least two other potential benefits. First, given that utility tokens are not an equity claim in the firm, the entrepreneur could retain more (potentially, all) of the profits from a successful venture. Second, to the extent the needed funds could be raised without angel investors and venture capitalists, utility tokens reduce the pressure on the entrepreneur to provide investors with any control rights.

On the other hand, the sale of utility tokens comes with some significant limitations from the investor's perspective. The funding of new technology ventures is inherently risky, as the studies referenced earlier report failure rates around 50 percent for angel investors and VCs. This high failure rate occurs even though angel investors and VCs typically have more experience evaluating entrepreneurs and their proposed new products. In almost all respects, the minimum requirements to seek funding through an ICO have been weaker than for its alternatives. The entrepreneur may not know or even meet with investors. ICOs have no minimum disclosure requirements, and it is not even clear that token buyers have any rights if the disclosures contain material errors or omissions.5 Moreover, angel investors and VCs often have some control rights over the firm that allow these investors to reduce their losses if the project is failing, whereas utility token holders typically have little or no say in the governance of the firm.

Another potential problem with ICO utility token sales is that the SEC is taking the position many utility token sales constitute the sale of securities under U.S. securities law.6 As a result, some observers argue that the sale of securities tokens that satisfy SEC exemptions in ICOs are likely to replace the sale of utility tokens intended to avoid SEC regulation (for example, see here, here, here, and here). This raises the question, what is the benefit of selling securities through an ICO rather than through existing channels? One possible answer is it may be lower cost to trade securities tokens issued than existing securities because tokens will be on a blockchain. To the extent that the cost of trading security tokens is lower than trading securities through other channels (that is, the tokens are more liquid), the entrepreneur may be able to sell the securities at a higher price. This advantage of the blockchain, however, comes with two limitations. First, the SEC requires any trading of registered securities occur on an SEC approved platform. Second, the value of an increase in liquidity is likely to be significantly smaller to investors who are providing valuable mentoring services to the entrepreneur and/or who are involved in the firm's governance.

Conclusion
ICO token sales became a popular way of raising funds in large part because of some of the advantages they convey to entrepreneurs relative to the major alternatives. However, some of the very factors that make ICO utility token sales more attractive to entrepreneurs may reduce their expected returns and increase the risks to investors. This increase in risk is especially notable given the high failure rates of start-ups financed by angel investors and VCs.

References
Atanasov, Vladimir, Vladimir Ivanov, and Kate Litvak (2012). "Does Reputation Limit Opportunistic Behavior in the VC Industry? Evidence from Litigation against VCs." The Journal of Finance 67, no. 6: 2215–2246.

Catalini, Christian, and Joshua S. Gans (2018). "Initial Coin Offerings and the Value of Crypto Tokens." No. w24418. National Bureau of Economic Research (March).

Chernova, Yuliya (2017). "Who Needs Venture Capitalists When You Have Initial Coin Offerings?" Wall Street Journal, September 14 available behind a paywall at https://www.wsj.com/articles/coin-mania-forces-vcs-to-sidelines-on-cryptocurrency-1505388633.

Kaplan, Steven N., and Per Strömberg (2003). "Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts." The Review of Economic Studies 70, no. 2: 281–315.

Larry D. Wall is executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Scott Frame, Brian Robertson, and Warren Weber for helpful comments. The view expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email atl.nftv.mailbox@atl.frb.org.

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1 Atanasov, Ivanov, and Litvak (2012) provide evidence that such a reputational factor is a deterrent to abuse.

2 An alternative that allows participation by an unaccredited investor and avoids the registration requirement is Rule 504 of Regulation D, albeit this requires the firm to file a notice with the SEC. This alternative comes with a variety of restrictions including a prohibition on general solicitation or advertising. See the SEC's "Rule 504 of Regulation D: A Small Entity Compliance Guide for Issuers."

3 See the OECD book Financing High-Growth Firms: The Role of Angel Investors for an international perspective on angel financing.

4 A paper by MIT professor Christian Catalini and University of Toronto professor Joshua S. Gans (2018) also show the sale of tokens can provide valuable information about the demand for the firm's product.

5 Federal securities law would provide such rights if the ICO is ultimately found to be a securities offering. However, such rights are not guaranteed ex ante because most ICOs are structured with the goal of avoiding securities regulation.

6 See the SEC web page on ICOs and my prior post.