Token sales: Cryptic beginnings
The sale of digitized contracts known as tokens has become a dominating force in early-stage start-up funding. Venture capitalists are beginning to cautiously participate as the phenomenon matures
Token sales – also known as crowdsales, token generating events and initial coin offerings (ICO) – have seemingly come out of nowhere to surpass traditional seed-stage equity funding by venture capital firms for the past two months. What happens next is difficult to calculate.
According to data provided by Coinschedule and CB Insights, as well as an analysis by Goldman Sachs, capital raised by company token sales comfortably exceeded $500 million and $300 million across June and July, respectively. Early-stage VC funding by comparison came in at $200-300 million for the same period.
Token sales are usually structured to give investors access to a company’s technology without selling ownership stakes. The blockchain-based contracts represent a variety of business exposure rights that can rise and fall in value depending on the company’s performance. VCs are increasingly active in such buy-ins, but although the volume of issuances is growing rapidly, actual platform creation remains scant.
VCs feel the prices are too high, but the market is its own counterargument to that – Peter Vessenes
Activity in this space is extremely flexible in context and deal structure, but one prevailing generality can be seen in the early-stage nature of either the companies or their sponsored technologies. As a result, a disconcerting offset has emerged whereby pre-seed concepts that would historically attract no more than $1 million are now hauling in tens of millions of dollars in mere hours under token sales.
“To say they are in different ballparks would be an understatement; they’re not even in the same country,” Justin Hall, a principal at Singapore-based Golden Gate Ventures, says of VC and token sale capital raisings. “The risk appetite needs to be huge, and even then, I do not see traditional VCs investing to the same amount and terms as retail token investors. Instead, I believe they would participate only with preferential, pre-ICO prices.”
Gold rush
Blockchain and crowdfunding are still nascent areas of the VC industry, so it seems reasonable that a combination of the two will be difficult to define. But while the explosive popularity of token sales reflects a familiar uptake curve for technology-based business enhancements, it also highlights a kind of gold rush that may level off in less predictable ways.
Some of the latest Asian VC activity in this space includes a $9 million token raise by Japan’s Tech Bureau with participation from Nippon Technology Venture Partners, Fisco Capital and ABBALab. Previously, Thailand’s Omise – a financial technology player supported by Golden Gate, SBI Investment and Sinar Mas Digital Ventures – raised $25 million in what was said to be the first cryptocurrency capital raise by a major VC-backed start-up.
Meanwhile, Singaporean gambling services developer FunFair raised $26 million in only four hours from the likes of Pantera Capital, Kryptonite1 and Ari Paul, the founder of Block Tower Capital. The valuations associated with such large rounds in unproven companies have been viewed with some trepidation.
“Generally speaking, VCs feel that the prices they’re seeing are too high, but the market is its own counterargument to that,” says Peter Vessenes, managing director at New Alchemy, a consultancy that worked on the FunFair token sale. “The question is how much value is added and how much risk is reduced to a typical venture investment if you can fractionally liquidate it the day after investing. That number has to be significant.”
Liquidity in the secondary token market is inextricably linked to community support for the underlying technology. A certain amount of hype therefore needs to be generated by assembling sufficiently reputable teams and isolating unserved areas of investor demand.
Exit success in this environment will likewise require a feel for the unique motivators of the blockchain space, where investors often follow economic turnarounds and non-profit ideals with equal gusto. Kryptonite1, for example, does not have a process for ensuring secondary market liquidity for token deals, citing a long-haul vision including improved ecosystem alignment and more direct access to proprietary technologies.
“Our approach to due diligence is very similar to a VC approach but adding the complexity of properly evaluating the mechanics of the network and working out what the business model of the token layer looks like, and we have seen all kinds of different business models,” says Janos Berghorn, an investment analyst at Kryptonite1. “A simplified question to ask is does the platform still work if we remove the token? If the answer is yes, then it is likely not a good token design.”
Risk factors
Other due diligence considerations include a lingering tendency for the value of tokens to mimic the pricing undulations of established cryptocurrencies such as bitcoin – regardless of the project’s independent progress. Token sales are also typically structured with vague language and registered offshore, creating situations where money can simply disappear.
“In terms of liabilities, it’s potentially extremely risky,” says Golden Gate’s Hall. “Token holders have zero resource to sue, recover their money in the event of default, or control or influence the company. Because tokens are not yet regulated, token holders are really at the company’s mercy.”
Urszula McCormack, a partner and regulatory specialist focused on financial technology, digital assets and financial crime at King & Wood Mallesons, emphasizes however that the intangible nature of tokens does not mean they are jurisdiction-less and outside of law. She notes that in recent weeks, regulators in the US, Singapore and other markets have made clear indications that they recognize certain tokens as properties already within their purview.
“These signals are already having an impact on market participation and behavior,” McCormack says. “You will see fewer tokens with income streams and profit upside being promised, more offerings that are limited to particular types of purchasers and jurisdictions, and more KYC [know-your-customer] taking place. Digital asset exchanges will limit the products they sell and the markets in which they operate, and even become regulated.”
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