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The pros and cons of ICOs for entrepreneurs

How can an initial coin offering fund a startup? An MIT expert on the advantages and the unanswered questions.

By Betsy Vereckey  |  April 12, 2018

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Since last year, startups have raised more than $8 billion using initial coin offerings. Is that a good idea? Depends.

Why It Matters

An initial coin offering can help a startup raise capital and assess market demand. But doing it right means understanding why you’re doing it, and if you should do it at all.

It’s a challenge most entrepreneurs face at some point: access to capital.

Enter the initial coin offering, the latest trend in cryptocurrencies. Akin to crowdfunding, an ICO allows startup founders to raise money by creating and selling their own virtual currency, no venture capital required.

Despite a slow start, the industry exploded in 2017, mostly because of the fervor surrounding all things bitcoin, the largest virtual currency, with a market cap of more than $117 billion.

Initial coin offerings offer new options for entrepreneurs, said MIT Sloan assistant professor Christian Catalini, an expert in blockchain technologies and cryptocurrencies. Catalini has been watching ICOs closely and tracking data for more than a year.

For the longest time, we believed we would have to wait a long time to have enough data to write a paper,” Catalini said. “But then there was a massive explosion in activity through 2017, and our data kept doubling in size.”

The data keep growing. Catalini estimates that blockchain-based startups have raised over $8 billion through initial coin offerings since 2017, which far surpasses the $1 billion in traditional venture capital within the same sector.

Catalini, alongside Joshua S. Gans, a University of Toronto Rotman School of Management professor, set out to investigate what entrepreneurs should know when funding venture startup costs with initial coin offerings. Their new paper, “Initial Coin Offerings and the Value of Crypto Tokens,” applies economic theory to reveal how cryptotokens can even have value in the first place. It also identifies the commitments entrepreneurs must make to successfully fund their venture through an ICO and discusses how the monetary policy of a token may influence fundraising.

Here are four common questions answered in the new paper.

What are the advantages of an ICO?
For startups, an initial coin offering might seem like a golden ticket to getting a project off the ground. It may appear as a relatively quick, uncomplicated way to secure access to funding with low barriers to entry. For example, it can take less than 100 lines of code to create a token on top of blockchain-based platform Ethereum.

In an ideal scenario, ICOs also generate buyer competition for the token — they give entrepreneurs an idea of what consumers are willing to pay for their service, similar to crowdfunding. This insight on market demand revealed by Catalini and Gans’ research is valuable because it may increase entrepreneurial returns beyond what can be achieved through traditional equity financing.

“An ICO is a way to gain insight at a stage where there’s still a lot of uncertainty around what the value of a digital platform will be,” Catalini said. “By issuing a token that starts at zero value, market forces can drive the price up if people are confident about the ability of a specific team to successfully build the platform they’re promising they’ll build.”

Tokens can also help startups attract early adopters and encourage application developers to build on top of a new platform.

What are the disadvantages of ICOs?
Part of a cryptotoken’s current appeal — the lack of regulatory structure for initial coin offerings — is a downside for the successful development of this market, Catalini said. ICOs right now sit in a gray zone. The U.S. Securities and Exchange Commission and other regulatory bodies are trying to catch up with fast-moving developments. With so much uncertainty in the U.S., many entrepreneurs have chosen to set up shop in Switzerland and Singapore, where there’s more regulatory clarity.

“In the U.S., we haven’t set up the legal, technical, or normative controls yet,” Catalini said. “Entrepreneurs want regulatory clarity so they have more clarity about what they can and cannot do. Right now, I think there’s high uncertainty, and the space has attracted a high degree of opportunistic entry by lower quality teams.”

Among the issues regulators are looking at is: When is a token a security versus a commodity? “Most tokens clearly start as securities. The teams behind them have a lot of influence over their value and development when the platform is not fully developed, and most buyers are really investors hoping that the token will appreciate in value,” Catalini said. But over time, things can get more complicated: “If the codebase is open source and the token is widely distributed, it starts to look a lot more like a commodity,” he said. Shedding light on this inflection point will be important.

Regulators are also worried about ICOs being used to defraud the public. Of the approximately 2,000 tokens that have launched so far, Catalini estimated that only a few will be worth trillions of dollars five or ten years from now. But which ones will those be? It’s anyone’s guess.

“There’s a delicate balancing act between allowing the technology to flourish and allowing experimentation to take place, and on the other hand making sure that we protect investors and consumers from exposure to assets that are volatile, risky, or straight up frauds and scams,” Catalini said.

How should entrepreneurs use cryptotokens?
A token should serve a specific purpose within a digital platform, such as rewarding investors who are willing to fund a venture, Catalini said. An entrepreneur could also use a token to create incentives for multiple stakeholders. In advertising, for example, a token could allow a startup to reward all the different players (advertisers, publishers, or content producers) for their contributions to the ecosystem.

“Entrepreneurs need to ask themselves, ‘Why do I need a token in the first place?’” Catalini said. “If there’s not a real economic reason, then entrepreneurs should not just add a token or the word ‘blockchain’ to their idea just because it may secure them some funding. They may be landing on a business model that is completely inconsistent with what they’re trying to do.”

Once a startup’s founders agree that a token would add value to their digital platform and business, they must commit to using the token as the one and only medium of exchange on the platform. Catalini’s research also shows that founders must reveal upfront decisions about the token monetary supply and commit to this for the model to work.

This is where a key difference between tokens and traditional equity comes into play. “Equity gives you a right to the returns of a team of entrepreneurs on a very long time horizon, no matter what new idea that team may come up with or how the idea may evolve further,” Catalini said. “Tokens are about building shared, digital infrastructure for an ecosystem, which you can often think of as a public good. Once the platform is up and operating, everybody can use it to build products on top of it.”

What’s in the future for initial coin offerings?
Blockchain technology will continue to open up new possibilities beyond financial applications.

“I think you’ll see tokens being introduced across different industries,” Catalini said. “A variety of new business models will emerge as the market matures and becomes more sophisticated. Right now, people are focused on using tokens to raise capital, but looking at the future I think the more interesting digital platforms will be using these tokens not so much as a funding mechanism but as a way to align incentives across different types of participants.”

Depending on the circumstances, that could mean whatever the entrepreneur wants it to mean.

A token could be given to a participant tasked with a data science problem and appreciate in value when that participant comes up with a valuable prediction. A token could be sold and used to fund open-source software projects that are hard to finance with traditional structures. It could even represent a unit of utility, such as a gigabyte of storage or access to a network.

Still curious about ICOs? Delve deeper into research from Catalini and other MIT Sloan faculty members at the MIT Cryptoeconomics Lab.