Trends in blockchain

Initial coin offerings
Initial coin offerings (ICOs) are sales of tokens by blockchain companies looking to raise funds. According to teams holding ICOs, tokens provide access to, or utility within, a decentralized ecosystem. Tokens are scarce, and could rise in value if demand outweighs supply.

As an example, if the network in question is – say – a decentralized social network, tokens might grant access. If more people want access, then the token’s value might rise as people buy and sell their tokens.

Given this context, let’s dive into some key trends.

THE LINE BETWEEN ICOS AND EQUITY FINANCING IS BLURRING
Where VCs trade cash for equity, ICO investors trade cash for tokens. Although regulators grapple with this definition, we’ll use it for our purposes to understand how this financing method is changing.

Increasingly, the line between equity financing and ICOs is blurring. Traditional equity investors are investing in companies that plan on using tokens within their business models. Further, traditional investors are acquiring tokens outright via pre-sales, SAFT contracts (described below), and regulatory-compliant offerings – something that seemed out of the question months ago.

Pre-sales are rounds held before larger, public ICOs. These don’t follow a uniform structure. In some cases, pre-sales offer discounted tokens to early investors (accredited and unaccredited). In others, teams sell small equity stakes in exchange for runway before an ICO. ICOs are expensive, and often incur legal, marketing, and advisory expenses. Venture funded pre-sales could cover expenses before an ICO infuses cash into the company.

In still other cases, accredited investors buy tokens via cryptocurrency purchase agreements. A common version of this is the SAFT (Safe Agreement for Future Tokens). The SAFT acts as a forward contract for tokens, with the contract converting upon deployment of a functioning network. Thus, startups aren’t selling equity stakes, but the rights to some of the tokens it will use as part of its network. Such a conversion might happen years after the initial sale.

The rise of pre-sales and SAFTs reflects venture funds wanting to cash in on the token economy. Recall that the median time between first funding and IPO for VC-backed tech companies that went public in 2017 was about 9 years. Tokens trade on exchanges (often before the network launches), and provide near-immediate liquidity. As for the SAFT, a token conversion could happen within one or two years, also providing quick liquidity to venture investors.

Additionally, many venture firms have mandates that require them to invest in specific asset classes — namely, private companies. SAFTs and certain pre-sales might be a way to invest in tokens while still conforming to this asset class requirement, whereas buying tokens via an exchange or directly via an ICO likely would not meet those requirements.

A shift toward pre-sales is borne in the data, with venture rounds trending up and pure-play ICOs trending down.

In February, ICOs raised almost 60% of their capital in private rounds and pre-sales, according to TokenData. Some of that data is captured below, with “other” VC equity deals up considerably as a share of blockchain deals. These include some private rounds and pre-sales.

REGULATORY ACTIVITY IS A DOUBLE-EDGED SWORD — BAD FOR ICOS, GOOD FOR OTHERS
ICO evangelists like to argue that ICOs are new financial instruments which require new legislation and regulatory agencies. So far it looks like US regulators do not agree. US regulatory agencies, including the SEC, CFTC, and FinCEN, have generally reacted skeptically and unfavorably toward the new financing mechanism. At the same time, regulators’ increasing scrutiny of the sector is actually encouraging new companies to enter the sector.

The SEC, CFTC, and FinCEN (in addition to other government agencies) seem to be approaching the sector in different ways.

The SEC (Securities and Exchange Commission) thinks that most tokens are securities. In November 2017, SEC Chairman Jay Clayton said: “I have yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.” Three months later, in February, Mr. Clayton said before Congress: “I want to go back to separating ICOs and cryptocurrencies. ICOs that are securities offerings, we should regulate them like we regulate securities offerings. End of story.” At around the same time, the SEC subpoenaed a number of cryptocurrency hedge funds and organizations that held ICOs.

From its rhetoric and activity, it appears that the SEC is treating ICOs as securities. This doesn’t bode well for teams that held them, or their legal advisors. These companies could now face legal repercussions. At the same time, it appears that the SEC is treating some existing cryptoassets as currencies or commodities — not securities.

SECURITY TOKENS ARE SEEING INCREASED INVESTOR INTEREST
Regulations have also given rise to a new class of companies building security tokens platforms.

Security tokens are exactly what they sound like; securities on a blockchain. A security token could digitally represent any number of real-world assets, from real estate or vehicular title, to shares of a company. These are markedly different than utility tokens, which represent access to, or utility within, a given network. Most importantly, security tokens are subject to securities regulations.

Security tokens are also “programmable.” This means that code can determine how they’re used. For example, a loan — represented digitally — might automatically pay out according to an agreed-upon repayment schedule. Such code might execute without the use of a traditional middleman, like a bank.

Another advantage is liquidity. Tokenizing illiquid assets — like a venture fund, or a car — can make it easier to trade these assets over the web. Easier trading reduces friction, which correlates to increased liquidity.

One company working on this is Harbor. Harbor’s $28M Series B in April saw participation from a who’s who of the VC world, including Andreessen Horowitz and Founders Fund. Harbor’s “R-Token Standard” encodes rules in tokens. These only allow eligible investors to invest, and require them to follow KYC/AML regulations, among others.

Another company operating in this sphere is Polymath. Polymath hopes to help “trillions of dollars of financial securities migrate to the blockchain.” When launched, the company’s POLY token will also optimize for existing regulations, like KYC/AML.

Other teams working on security tokens include Overstock’s tZero, CoinList, and Securitize. All said, security tokens appear to less legally ambiguous than ICOs, especially amid regulatory inquiries. Top investors concur, and we expect more securitized token companies to emerge.

To be continued