ICO “rounds” are coming

Last summer, the news came in dribs and drabs about initial coin offerings, the crowd sales of new cryptocurrencies that give entrepreneurs access to funding. A warning here that some coins sold in ICOs could be considered securities. An alert there that celebrity endorsements of ICOs might be unlawful.

Fast forward, and the warnings are starting to come with the kind of velocity that should give founders who are contemplating ICOs some pause. In fact, suggest some in the crypto industry, these founders would be smart to start structuring their ICOs more like traditional venture rounds.

Certainly, it seems like things are headed in that direction.

Just Monday, the SEC announced that it had obtained a court order to freeze the assets of Dallas-based AriseBank, a company that it says used social media, a celebrity endorsement, and other wide dissemination tactics to raise what it claims to be $600 million of its $1 billion goal in just two months. Just two of the many problems with this scenario, says the agency: AriseBank’s so-called offering lacked required SEC registration, and it claimed, untruthfully, that  it could offer investors FDIC-insured accounts.

The SEC also spoke up last week to note that it’s monitoring companies that suddenly incorporate or market cryptocurrencies or blockchain technologies in an attempt to “capitalize on the perceived promise of distributed ledger technology . . .”

Such actions are certain to have a chilling effect on ICOs, a slowdown of which actually began late last year, according to recent research produced by Ernst & Young.

Element Group founder Stan Miroshnik, whose investment bank is focused on digital token crowd sales and ICOs, calls it the somewhat inevitable bifurcation between “tier one issuers and everybody else,” wherein the “big, quality offerings are drawing the majority of capital.”

(Telegram, a messaging app that is planning to raise a staggering $1.2 billion in an ICO to build and support a payment system on its platform, is evidently among these.)

Now, with the SEC plainly focused on ICOs, there’s reason to believe the offerings will evolve further still — from one-time financing events that almost anyone can participate in, to the very thing they looked to displace, which is companies that receive funding over a series of rounds, often from accredited investors only.

We’re already partway there. Take Telegram, which, like a number of the stronger companies to stage ICOs, is also orchestrating a $20 million “pre-sale” in which numerous venture firms are poised to participate, including Sequoia Capital, Benchmark and Kleiner Perkins, according to Recode.

These private pre-sales to a group of buyers have been happening for some time, though increasingly, companies will stage a private pre-sale, then a more public pre-sale to a broader group through a newish legal framework called SAFT structures (more on these here), then, finally, a public sale.

Separating these financings as founders grow their businesses “meshes well with where regulators are going, which is that [by the time] you host a public sale, you should have a product that works and has true utility,” notes Miroshnik.

Paul Veradittakit, a partner with the investment firm Pantera Capital —  it was among the first outfits to raise a fund focused exclusively on ICOs — is also seeing a shift, he says.

Even before it became clearer that the SEC wants to bring sales of ICOs under its authority, a growing number of founders was growing “more receptive to the token-fundraising model,”  he says. It makes sense, in his view. “If you’re going to [sell] a token, you may as well be raising token rounds and having investors come in and build up the value of these tokens.”

Besides, he adds, as the “space matures and we gain more clarity on the regulator side, more and more of these institutional investors are not going to be receptive to these [ICOs] where there are no boards or protective provisions or liquidation preferences or caps.”

The rounds won’t look exactly like venture rounds. They’ll likely look more like layered seed rounds, says Veradittakit.

“Right now,” he says, “a team will say it’s going to sell 30 million tokens and [as a result] give away 30 percent of the company, which establishes the company [valuation] at $100 million. But is it worth it at the white paper stage, which is often when ICOs are taking place? Probably not.” Veradittakit instead envisions more teams raising a bit of money to get themselves going, then pricing rounds at more traditional valuations, then ultimately staging their ICOs.

He says founders themselves would prefer their fundings shake out this way, in large part because the people embracing ICOs are changing. Whereas it was the “early crypto guys who were fundraising last year and who understood the model and who’ve been in this space,” more seasoned entrepreneurs are beginning to see the value in ICOs, too.

These days, he continues, “They’re telling me they want [the equivalent of ICO rounds] — they want people who will help them build companies for the long term. They don’t want to go through that quick flip and for the price [of their cryptocurrency] to tank.”

Some of them may have in mind Tezos, a little-known Zug, Switzerland- based project that said last year that it wanted to create a “new decentralized blockchain that governs itself by establishing a true digital commonwealth.”

Tezos managed to raise $232 million via a token sale last summer, but its plans were promptly thwarted by fighting between its cofounders, delaying the development of even the digital tokens — Tezzies — that its ICO contributors expected to receive.

The company is at the center of several public lawsuits as a result.

Even without infighting, one could imagine a young company being drowned by so much capital. Indeed,  on stage in Lisbon in November, investor Tim Draper, an early investor in Tezos, suggested that ICO rounds would make far more sense.

Said Draper at the time: “I do think that an ICO should be just the first of many offerings, so that people can raise the money as they need it rather than raise it all at once. [T]here’s not a good use of capital there [otherwise].

“If I raise the $240 million that Tezos raised and it sits in this weird, convoluted legal structure in Switzerland, what do you do with that? How do you manage that money when you really only need $2 million or $3 million a year?”

Asked about his comments last week, Draper reiterated his earlier point, advising ICO issuers to “think ahead to make sure they have enough tokens to make subsequent issues in order to better manage the cash flows of the token offering.”

Either way, none of the people we spoke with for this piece — Draper, Miroshnik, and Veradittakit — is worried about ICOs going away. “They are here to say,” Veradittakit says enthusiastically.

It’s time for them to grow up, though, the three suggest. And the SEC seems prepared to ensure they do.

“Things are becoming more standardized,” says Miroshnik. “Buyers are more open to lock-ups. Buyers coming in earlier are asking for larger discounts. We’re seeing more people gravitate toward SAFT structures.”

As the regulatory guardrails narrow, expect to see much more of the same.