Report: Initial Coin Offerings (ICOs) for SME Financing
Small to medium enterprises serve as the backbone to many of the world’s developed and emerging economies. These are companies with fewer than 250 employees, who contribute up to 60 percent of total employment and up to 40 percent of a nation’s income (GDP) to their economies according to the World Bank.
Despite their contributions, the biggest challenge that most SMEs face today is one of limited access to capital. SMEs often turn to banks to ask for a loan but are rejected because of their inability to supply enough collateral, audited financials, references, proofs and other forms of documentation. Through the tiresome application process, only a very small number of businesses get the support they need to grow, while the vast majority must rely on internal funds or loans from friends and family.
Traditional fundraising mechanisms like crowdfunding, IPO’s, or venture capital are all severely limiting in their own ways. In a January report from the Organisation for Economic Co-operation and Development (OECD), the think tank outlined some of the advantages that ICOs offer for startups looking to scale.
The Downside of Traditional Financing Mechanisms
IPOs are a highly regulated and restrictive fundraising mechanism that primarily favor accredited investors and companies with deep enough pockets to pay for the privilege of being listed on the stock exchange. Crowdfunding sites (although much more accessible than IPO’s) are primarily set up for charity and non-profit initiative and lacks the sophisticated infrastructure required to transfer company shares in a secure and transparent manner.
Venture capital is far too insulted and built on pre-existing relationships for SMEs that are not already part of the ecosystem to benefit from. Finally, banks tend to be highly risk-averse and stringent in their requirements, only lending to a handful of SMEs each year.
With the emergence of cryptocurrencies, a new fundraising mechanism called an initial coin offering (ICO) has the potential to completely disrupt how SMEs raise capital by allowing them to access a global pool of investors without the regulatory restrictions and constraining loan terms offered by traditional financing institutions.
What Is an ICO?
ICO’s are a unique fundraising mechanism that leverages either a native blockchain or Ethereum’s network. Blockchain technology provides a distributed ledger that enables the transparent and secure transfer of information and funds between anonymous parties.
In order for an SME to launch an ICO, they simply need to produce a token that represents ownership within their company or network (similar to the concept of shares, but they are a digital representation that does not dilute the actual shares of the founders).
Many blockchains enable companies to launch an ICO, however, the Ethereum blockchain is by far the most popular for this purpose. Companies develop their own tokens that represent value within the company, and then offer it publicly via a “token sale” for investors to purchase using ether (ETH).
There are a limited number of tokens produced and made available for sale by the company. The firm in question also sets a goal for how much money they wish to raise (referred to as a “hard cap”) and an ICO price is set prior to launching the sale.
Once the ICO goes live, users from anywhere in the world can simply log onto their computers and instantly purchase the companies’ tokens using ETH. Just like a stock, the level of demand for the token determines its market price. Buyers of the token are usually able to sell whenever they want, giving them to freedom to invest based on their goals to earn short- or long-term profits.
Ultimately, within a matter of weeks, an SME can raise millions of dollars from a global market of investors who are far less restricted by location or level of income.
The Benefits of ICO’s
- Cost efficiencies: ICO’s are a much cheaper alternative to fundraising because of the reduced cost of compliance (rules of compliance are embedded into the smart contract rules that govern the transfer of funds between parties during the token sale).
- Inclusive SME financing: ICO’s broaden SMEs access to retail investors by lowering the barrier to entry for investing. All an investor needs is a computer or smartphone and a digital wallet to store their ETH and the tokens they will receive from the SME. ICO’s offer a truly democratized system for fundraising. In the U.S., the term accredited investor describes someone who has special status under financial regulation laws. This status grants them access to exclusive investment opportunities that retail investors are unable to get involved in. The assumption with this status is that only people with large amounts of money should be afforded the privilege of investing in risky companies where their entire investment could drop to zero. Although the goal is supposed to be to protect retail investors, this is actually the opposite case, as early investors take more risk but earn the largest profits, while late investors take almost the same amount of risk but have far less to gain. What ends up happening is that the losses of less wealthy retail investors pay for the gains of wealthy accredited investors. The ICO model significantly reduces this imbalance by providing everyone with access to a company’s token at the same time (or within a very short period of time).
- Flexibility, speed, and liquidity: Cryptocurrency tokens are easily divisible, so investors can buy as little as a fraction of a token and still own an asset that could appreciate over time. Funds are instantly transferred when paying for ICO tokens and depending on the particular project, users can receive their tokens within a few hours or days of investing. A record of the investors’ transaction is permanently embedded on the blockchain, meaning that they will always be able to verify that a payment was made even if the ICO tokens take longer than expected to arrive. Lastly, the plethora of cryptocurrency exchanges available in the market makes it easy for investors to sell their tokens for bitcoin or ether once they are placed on the exchange.
- Value of a network: ICO’s are particularly beneficial for SMEs because they allow companies to harness a network of like-minded people who share an interest in the services provided. SMEs can continue to nurture and grow this network through all kinds of creative marketing and incentive-based programs. Tokens are particularly useful in this case because they allow the SME to utilize their own currency as a tool to incentivize members of their network to perform actions that help grow the network (sharing content, leaving reviews, referring friends, etc). As long as members of the network believe in the value of the services on offer, then the tokens administered will always retain value and can, therefore, be used (in place of fiat money) to fund what would otherwise be very expensive promotional campaigns.
- Ownership not necessarily conferred: When an investor purchases an ICO token, they are not actually buying an ownership stake in the company. Instead, they are acquiring a “digital contract” that ensures that they will earn profits from the increased value of the token. This contract is coded into the very foundation of the token itself, which means investors don’t have to be concerned about ownership rights and being unable to reap the benefits of the companies’ valuation increasing. This, in turn, allows company founders to retain equity and control of their company. As long as investors are guaranteed to make money if the token value goes up, most investors will only want to buy the tokens, leaving the control of the company to those whose job it is to make sure it grows in value.
- Unlimited investor pool: Launching an ICO allows SMEs to tap into a network of potentially billions of retail investors. The sheer size of retail investors is made possible by the fact that all it takes to be an ICO investor is a few dollars and an Internet connection. What an SME lacks in connection to large institutional investors, they can more than make up for by rallying millions of small investors to fund their company with a few dollars each.
Ultimately, ICO’s have the potential to bridge the gap between SME financing needs and retail investors demand for early and profitable opportunities.
As both parties continue to be rejected by the traditional financial system (SME’s rejected by banks and VCs, retail investors denied the best investing opportunities due to lack of accreditation), they can leverage the ICO fundraising mechanism as a way to build individual wealth while supporting businesses that function as the backbone to so many of the world’s economies.