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21 March 2019 CFA Institute Journal Review

Initial Coin Offerings: Economic Reality or Virtual Economics? (Digest summary)

  1. Mark K. Bhasin, CFA

The amount of capital raised by initial coin offerings (ICOs) is comparable to that raised through venture capital–backed IPOs, but many concerns remain regarding the legality of ICOs, their place in the capital structure, and their underlying valuation.

How Is This Research Useful to Practitioners?

Initial coin offerings (ICOs) are an increasingly popular method of fundraising for venture capitalists. An ICO is a form of crowdfunding where capital is raised on the internet and a company issues digital tokens denominated in a virtual currency. In 2017, the largest venture capital–backed IPO or ICO was (an ICO), which raised $700 million using its EOS cryptocurrency. Although the average size of 2017 venture capital–backed IPOs was the larger of the two, at $290 million, the average size of ICOs was only slightly smaller, at approximately $258 million. Compared with the ICO process, the ICO process is cheaper, faster, and overall more efficient.

Significantly more effort and cost are required to raise capital in an IPO. An IPO involves the sale of a company’s ownership interests and, in the United States, requires filing a detailed registration statement with the SEC, which typically goes through many reviews. In an IPO, the senior management team of the underlying company conducts a time-consuming road show with the investment bank. The attendant investment banking fees for an IPO can also be very significant. In summary, the IPO process takes several months to complete, whereas an ICO can happen in only a few days without the requirement to file lengthy and detailed regulatory documents and without costly investment banking fees.  

How Did the Author Conduct This Research?

Although the author does not conduct formal research, he explores two valuation/capital structure concerns that investors should acknowledge: (1) Digital currencies are subject to the Fisher equation, and (2) token holders can become subordinated equity at the very bottom of the capital stack. 

The Fisher equation states that the quantity of virtual money multiplied by velocity equals the total value of goods and services produced by the company; the price level increases as the inflation rate rises. If the company increases the number of tokens outstanding and seeks to prevent the diminution of token value through inflation, it will have to increase the value of its goods and services. This value increase can be derived one of three ways: larger product discounts, a new stage of technological development, or greater access to the company’s technological ecosystem. Digital tokens will decline in value as the quantity of tokens increases without some “fiscal policy” adjustment by the issuing company. In recent times, speculation—rather than fundamental value—has supported many digital token valuations.

With more than 1,500 ICOs currently in existence, the market for digital tokens through ICOs may become saturated. Because demand and speculation are finite, companies may be required to offer a claim on their cash flows, rather than just product discounts or access to their technological ecosystem. Under this scenario, ICOs will likely be junior to every other source of capital that was attracted to the fledgling company—a position that is not expected to have any corporate governance rights, proxy voting rights, or rights to dividends. Investors would need to be comfortable in this bottom position of the capital stack.

Abstractor’s Viewpoint

Although the author explores several risks associated with cryptocurrencies, such as computer hacking, the threat of litigation, and the violation of US securities laws, ICOs will be a staple of crowdfunding for entrepreneurs in the future. Because the capital raised by ICOs now rivals the capital raised by venture capital–backed IPOs, investors should acknowledge the pros and cons of this relatively new funding source.

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