Disrupting the IPO

After relying on venture capital to kick-start their initial growth, start-ups seeking to further expand operations have traditionally been forced to either seek an M&A partner or go public via an initial public offering (IPO). When being acquired isn’t an option or desirable, the IPO has long been seen as the best way forward.

An IPO, of course, isn’t simple to conduct. The process is heavily regulated, involving investment banks, law firms, and a stock exchange on which a company publicly issues and sells shares that any investor can buy and sell. Nevertheless, this is how Facebook raised US$16 billion in 2012, when it became publicly listed on the Nasdaq Stock Market.

But that was so yesterday. After all, recent developments in distributed ledger technology have created a new digital avenue for fundraising that has already started to disrupt demand for IPOs, at least in the fintech world.

Over the past year, five blockchain-based organizations have bypassed traditional avenues for raising cash (e.g., IPOs), choosing instead to rely on initial coin offerings (ICOs)—whereby investors buy cryptocurrency (or cryptographic tokens) issued by the organization onto a blockchain. In each case, the organizations in question raised more than US$150 million to fund their growth in sectors such as decentralized cloud storage (Filecoin) or distributed ledger technology (Tezos).

Because the process is less regulated and bypasses traditional intermediaries such as investment banks, ICOs represent a faster and cheaper way to raise money. Furthermore, an ICO can be a way for the issuer to build a user base and create word-of-mouth among prospective customers before products are even launched. For individual investors, ICOs provide an opportunity to invest across national borders in ventures with high-growth potential.

As things stand, ICOs are riskier than IPOs, because the ventures and their management teams are not vetted by regulators. Like all investments, these investments can be subject to governance failures. For example, at Tezos (a decentralized ledger named after the ancient Greek term for “smart contract,” which is powered by a blockchain designed to evolve and allows participants to directly control the rules of the network) operations were disrupted last year by a bonus dispute that led to a falling out between project founders and the head of a foundation created to manage the funds raised. But as the PlexCoin scam made clear, in the absence of robust regulation there is currently a great temptation for scammers to ride the cryptocurrency wave and con individuals into buying bitcoin to acquire worthless tokens that power imaginary software.

“Imagine Facebook without the fake accounts, the click farms, and the fake “likes.” Imagine dating apps without the predators, the bots, and the scammers.”

However, these are early days and regrettable events should not lead us to throw away the baby with the bathwater. Simply put, when implemented honestly and properly, ICOs can be a great way to grow ventures in today’s digital economy. That said, like any traditional private placement investments, ICOs require investors to do their own due diligence. And if you come across a company that is taking the ICO route simply to substantially cut the costs of raising money, then you might think about sniffing for a rat.

Removing intermediaries and fast-tracking the money-raising process is clearly appealing. But unless the token itself plays a role in the company’s long-term business model, the downsides of conducting ICOs probably outweigh their advantages. Put differently, if the token merely acts as an ersatz for traditional equity, thereby allowing the founders to bypass securities regulation, then I would recommend looking the other way. As they say in the community, just “hodl” on to your bitcoins until you find a better use for them.

To understand why, one needs to delve deeper into cryptoeconomics, which is about designing mechanisms and incentives to obtain desired properties in a decentralized network wherein digital or digitized goods are produced, distributed, and consumed. It lies at the crossroads of cryptography, economics, and game theory.

Imagine, for a minute, that you want to create a digital currency that people will trust. For that to happen, among other things, it must be verifiably scarce—that is, users must be able to check that no one in the network has the power to “copy-paste” the digital files that represent units of currency to enrich themselves at the expense of others. To obtain this outcome, you will want to release open-source software that users can freely audit, to rely on strong cryptography to prevent theft of mobile wallets, and to design mechanisms to ensure that users cannot spend forged units of currency.

Thus, after reverse-engineering the problem starting from the desired outcome, it becomes possible to decide which initial features should be core to the system. This is, in fact, how anonymous developer(s) came up with bitcoin—both the first real-world application of blockchain technology and the first successful implementation of cryptoeconomic thinking, aimed at creating the first decentralized, trustworthy digital currency.

If you are interested, here is a crash course on bitcoin created by the Ivey Business School’s Crypto Capitalism Centre . For the purposes of this article, let’s just say that it might still prove to be the new gold, or at least give gold a run for its money as a storage of wealth in the digital age, but it probably isn’t going to do what initial true believers wanted, meaning displace fiat money. Either way, as far as making history is concerned, bitcoin’s legacy is secure as the digital spark behind cryptoeconomics.

So how can ICOs create value? When users hold tokens that they have a reasonable opportunity to cash out, their behaviour becomes incentivized and desired outcomes are more likely to ensue. When that happens, the user community as a whole creates more value due to positive network effects, which attracts more users.

Arguably, incentivizing proper behaviour is crucial in network settings. Imagine peer-to-peer file sharing (from Napster to The Pirate Bay) without the virus-infested files, and with decent users who always seed what they download. Imagine Facebook without the fake accounts, the click farms, and the fake “likes.” Imagine dating apps without the predators, the bots, and the scammers.

When behaviour is incentivized in line with the platform’s objectives, everyone gets to enjoy a more valuable product. As a consequence, the value of the tokens that represent the goods exchanged in the network is likely to increase.

Cryptoeconomics should not be dismissed because of a few bad digital apples. But to unleash its potential and limit risks, it needs more attention. Scholars need to research it. Fund managers need to understand it. And entrepreneurs need to leverage it.

Bitcoin is dead, long live cryptoeconomics!

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