ICO vs Centure Capital
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High information asymmetry (Petersen and Rajan, 1995) and high uncertainty, as documented in the organizational ecology literature and reflected in their “newness” and “smallness” risks (Hannan and Freeman, 1989), typically constrain start-ups. availability of traditional funding sources. In contrast, venture capital firms have the necessary capabilities to deal with these factors and participate in the management of new companies.
Venture capital (VC) investments in blockchain-related projects have been used as a benchmark for ICO issuance in order to describe the proliferation of ICOs as a funding vehicle for early-stage financing of start-ups relative to the broader venture capital landscape. Such a comparison, while effective in showcasing the growth of ICO supply, may be unwarranted for a number of reasons.
Venture capital financing can and has in practice supplemented the ICO offer. Venture capital funds have participated in several ICO offerings either in the pre-ICO stage by participating in private pre-sales or by financing the costs of the ICO. For example, in Filecoin The issuer’s ICO (Protocol Labs) raised $52 million in pre-sales a week before launching a public offering to investors including venture funds Union Square Ventures and Sequoia Capital (Wall Street Journal, 2018).
Such complementarity should be sought by new companies offering ICOs in order to take advantage of the non-monetary support provided by the venture capital fund. The VC’s non-monetary contribution consists of expertise, industry know-how, connections and a network of contacts, as well as management and strategic assistance. Venture capital firms provide “coaching” to start-ups and play an active role in monitoring the development of the firm (Fried et al., 1998). This uniquely meets the needs of start-ups in their development phase and is needed by start-ups raising funds through ICO.
The founding team of the company is of paramount importance in both cases, and the expertise, previous experience and qualifications of the founding teams are success factors in both cases. However, a venture capitalist would scrutinize it more carefully than a retail token holder, as a startup’s business plan will be.
Accordingly, venture capital funds perform a strict due diligence process, which analyzes, among other things, the management team, the proposed business plan and its viability. On the contrary, the due diligence check of ICO offers is not done systematically.
The indisputable relative advantage of an ICO offer compared to venture capital financing, from both an investor’s and an entrepreneur’s point of view, is liquidity. Tokens issued in ICOs can be traded on secondary markets with immediate liquidity from the listing date.28
Venture capital investments, on the other hand, are highly illiquid, and it can take several years before the fund is able to exit the investment. ICOs allow founders to “raise” their company immediately after raising funding, although as we noted in section 5.2, this may reduce the alignment of interests between the entrepreneur and the investors funding the company.
Recent academic research on the funding of entrepreneurial ventures in ICOs shows that volatility is high29 For projects, ICO funding is expected to be more common (if not the most popular source of funding), as venture capitalists would require higher returns to cover such volatility. Similarly, ICOs have been shown to dominate venture capital funding for companies with a higher proportion of idiosyncratic risk (Chod and Lyandres, 2018).
Naturally, ICOs are the primary funding channel for entrepreneurs, as they can receive tokens without having to commit personal funds to the project. Academic research suggests that ICOs are preferred in projects where the risk of failure is high and the profit distribution is really skewed, because if the entrepreneur retains some of the ICO’s profits, the entrepreneur’s benefit is positive, even if the project fails. (Chod and Lyandres, 2018).
Entrepreneurs may choose to seek funding through an ICO instead of venture capital in order to attract a consumer base and build a network around the project rather than seeking personal financial reward. Although there is a fundamental difference between the two methods of funding, easier network effects may partly explain why ICO funding has overtaken VC funding in recent months. Instead of resorting to an ICO in the absence of other options, companies can seek to fund their businesses through token issuance to create and earn value from network effects.
It should also be noted that according to market participants, some venture capital funds are considering ICOs as a potential alternative exit option to their traditional venture capital investments.