How does a company raise capital? Even before the existence of blockchain technology, this question was one of the most important issues in modern business. However, the invention of this new type of technology has not only provided new answers to this old question, but it has also raised new questions, particularly when it comes to the regulatory status of such offerings.
Over the past few years, crowdfunding, private equity, initial coin offerings (ICOs), and security token offerings (STOs) have been some of the ways that investors have provided capital to small and medium-size enterprises (SMEs). Although the concept of crowdfunding goes back to 18th century book sales, the modern conception of crowdfunding is an internet phenomenon. Crowdfunding typically refers to entrepreneurs raising small amounts of capital from a large pool of investors online.1
There are several types of crowdfunding, but the two relevant ones are donation-based fundraising and equity. Donation-based equity crowdfunding is where investors give or “donate” capital to a startup in exchange for a future good or service or just to support the idea. Popular sites for donation-based crowdfunding include Kickstarter that has raised over $3.7 billion and Indiegogo, which has raised over $1 billion. In contrast, equity crowdfunding is the crowd-sale of securities such as equity, debt, membership units, and convertible units. Equity crowdfunding has raised approximately $500 million since its inception in the U.S. in 2015.2
One reason why equity crowdfunding has not garnered more attention is because the JOBS Act’s Regulation Crowdfunding (CF) initially allowed issuers to only raise up to $1 million, and the cost to receive approval from the SEC to raise capital with Reg CF often cost startups hundreds of thousands of dollars. However, this year, the SEC increased this amount to $5 million3, so more firms may use Reg CF in the future; however, this is still a paltry amount given the high costs associated with the regulatory hurdles in the US.
The blockchain technology has enabled six new methods for raising capital including:
1. Launching a free software protocol like Bitcoin (BTC), and then becoming an early miner of the coin when the difficulty is low
2. Doing an initial coin offering (ICO) like Ethereum (ETH)
3. Doing an initial exchange offering (IEO) like Band Protocol (BAND)
4. Garnering venture capital investment like Avalanche (AVAX)
5. Doing an initial decentralized exchange offering like Uniswap (UNI)
6. Launching a regulatory compliant security token like tZERO (TZROP)
However, each method does have unique benefits and disadvantages for issuers and investors. When an investor buys a token in an ICO, IEO, or IDO they are typically entitled to a bundle of digital rights (e.g. rights to use a platform or receive discounts on transaction fees). In contrast, security tokens represent investment contracts with legal protection and shareholder rights that can be enforced in traditional courts. Although ICOs have largely gone by the wayside due to regulatory crackdowns from financial market authorities and investor fatigue from the multitude of scams, there is growing demand for security tokens.
Security Tokens are combining the best of the cryptocurrency world and traditional markets. In comparison to traditional markets, security tokens allow for self-custody, instant settlement, 24/7 trading, higher liquidity via automated market makers, and a reduction in counterparty risk. There are, however, some drawbacks that still need to be worked out, including anti-money laundering (AML) compliance, something we will explore in depth in a practitioner perspective with Dr. Lewin Boehnke of Crypto Finance Group that will be published next week.
1 “Definition of Crowdfunding”. www.merriam-webster.com. Retrieved 2019-01-23.
2 Marks, Howard. How Crowdfunding Is Disrupting VCs. 2018. Forbes.
This article is an extract from the 90+ page Security Token Report 2021 co-published by the Crypto Research Report and Cointelegraph Consulting, written by thirteen authors and supported by Crypto Finance, Blocklabs Capital Management, HyperTrader, Ten31 Bank, Stadler Völkel Attorneys at Law, Riddle&Code, Coinfinity, Bitpanda Pro, Tokeny Solutions, AlgoTrader, and Elevated Returns.