The New Investment Climate for Blockchain Startups: New Approaches and Challenges
The ICO honeymoon period is well and truly over.
After the 2017 and early 2018 bull market, ICO funding levels hit their lowest levels this year in September and October. Many reasons have been suggested for this dry spell, from government regulation to investor distrust in the ICO model.
Whether we are witnessing the death of the ICO, a temporary blip, or even a maturing of the market, one thing is clear: approaches to raising funding for blockchain startups need to adapt to these new realities swiftly.
So how should startups proceed in this new, hostile environment?
The enthusiasm surrounding ICOs was based on excitement about the potential of this new, disruptive technology called blockchain — much like the early days of the internet, when investors were anxious not to be caught napping on the next big thing.
Startups were energized by the possibility of raising (enormous) sums of money based simply on a good white paper, without the need to pander to institutional or venture investors. Many investors made substantial quick profits, despite having little actual understanding of blockchain. Many young entrepreneurs with little business experience attracted quick, straightforward investment for often unworkable or just plain useless solutions.
Many are already declaring the crypto “bubble” burst. And yet, while the initial frenzy was certainly chaotic and volatile, undermining the reputation of ICOs among investors, the enthusiasm that drove the hype remains.
Crypto conferences and meetups are as jam-packed as ever, and blockchain technology still retains its disruptive, world-changing potential. The investors are out there… it’s just more difficult now to get them to part with their money.
The days of the ICO “Wild West” are over. New approaches are imperative.
Are ICOs Still Viable?
ICO funding is still an option for blockchain startups, but in a more conservative market, and only for the right projects.
Investors have been spooked by fake or half-baked blockchain projects driven by hype, and as a result have become wary and distrustful of the model as a whole.
Therefore, for the majority of projects, it is best to avoid the label of ICO and the stigma that is attached to it. Only projects that can offer a token with real utility, combined with demand that can sustain its value, will survive in this new, harsher ICO environment. Blockchain must be integral to the solution.
However, even in such cases, the key question is “who is the client?”
Even with a strong token and concept, not all clients are ready for blockchain adoption. For example, a company using blockchain to enable pharma giants to buy sensitive genetic data would be hard-pushed to expect the small genetics companies supplying the data to “go crypto” and buy tokens on the exchange.
Blockchain technology is poorly understood outside of the crypto community, and it can even be intimidating to outsiders due to its perceived complexity. In this company’s case, despite a useful and authentic use of blockchain, an ICO is still not the best option, as the taget client is highly unlikely to adopt crypto and participate in a token offering — other sources of funding need to be found.
Projects working in more crypto-friendly industries such as FinTech and digital solutions will find the door to an ICO slightly more open, but will still have to fight harder to prove the value and viability of their startups.
New Approaches to Raising Funds
In light of investor skepticism and distrust, the ICO model needs to adapt, reflecting more traditional types of investment. The interest is still there; investors simply need the greater security and oversight that classic equity investment models provide.
Against this backdrop, the Venture Capital (VC) model is entering the blockchain market, giving investors the opportunity to purchase a stake in the company in return for investment.
The benefits to this model include the control and involvement this offers, as well as a share in any revenues the project generates. The VC model also forces startups to be constantly on the lookout for new investors, keeping a project on its toes, rather than receiving all the money at once in an ICO, which in turn encourages reckless spending and decisions.
A new trend in VC financing — “small-steps financing” — is particularly well suited to the blockchain market.
This involves startups holding investment rounds every few months, rather than every year or so, and for 2-3% rather than for 10-25%, giving the investor a further security cushion while also pushing a project to prove itself at regular intervals, maintaining drive and focus. In this way, VC financing itself produces more successful startups, with greater investor control and more motivated entrepreneurs.
Enter the Security Token
Another attempt to soothe investor jitters has been the development of the security token.
These tokens are considered securities, and are therefore subject to legal regulations covering financial instruments. This has the power to remove one of the riskiest aspects of ICOs for investors: the lack of regulation and protection.
ICOs that do not comply with regulations could be punished, bringing credibility and some degree of certainty back for cautious investors who may have been burnt in the past.
In many ways, the security token offers the best of both worlds: smart contracts replacing middlemen along with all the associated fees and paperwork, and at the same time implementing the legal foundation of traditional investments in the crypto space.
Security tokens are undoubtedly a safer bet for investors, but are still largely untested on the market.
While the elimination of middlemen is certainly an advantage in many respects, cutting costs and time, opening up investment opportunities to a wider audience, this places the onus on the buyer and seller. They must now perform the functions of the middleman, preparing legal and marketing materials, underwriting deals, and ensuring compliance with regulations.
These are complex procedures which issuers still need to get to grips with, meaning security tokens still require further development to be the workable financial tools they were meant to be.
Security tokens are therefore more expensive and time consuming to launch — although the potential and hype surrounding them are palpable.
A third option for startups is offering a utility token which grants access to a network or services for use on a specific platform.
Here, the utility of the service is key, as the token will only increase in value if the service on offer can stimulate sufficient demand. The project must therefore place the concept and usefulness of their solution at the heart of their activities in order to create maximum demand.
Understanding who the client is here is also key, as utility tokens require users to participate in a token offering, which is not realistic for many target markets.
Startups Need To Up Their Game
The new ICO environment has not only led to a reassessment of the tactics for raising funding, but has also raised the requirements and expectations placed on the startups themselves to reassure investors.
A flashy white paper and slick marketing campaign will no longer cut it. Projects need to be able to demonstrate their value and trustworthiness. Newly “woke” investors will leave no stone unturned.
The #1 consideration for startups in this climate is the preparation of a watertight and comprehensive legal framework.
Reputable and well-established legal partners, preferably with experience working with blockchain projects, are a huge bonus. This is especially important in the case of security tokens, as compliance with regulations and drawing up a decent smart contract requires in-depth legal knowledge.
The jurisdiction of incorporation is also a potent indicator of reputability for investors, and off-shore jurisdictions are an immediate red flag and turn-off, and other jurisdictions present complex and time-consuming bureaucratic obstacles. Crypto-friendly jurisdictions likely to put investors at ease include those of Singapore and Switzerland.
Projects need to provide a comprehensive set of clear, well-prepared, and consistent documentation, in addition to a strong legal foundation. This includes technical information such as github, token code, MVP, and any working prototypes as well as business models, marketing mateirals, revenue streams, agreements signed, and spending plans.
The key here is transparency.
This gives the investor all the possible information on the project, reassuring them that nothing is being hidden or withheld, allowing them to make an informed decision based on facts.
Scrutiny of the business model and strategy by potential investors will also help the startup itself develop and grow by poking holes in flawed assumptions.
The new reality is that startups now need to prove themselves to investors, not just as promising, potentially world-changing projects and solutions, but as trustworthy and legitimate partners. Startups have to make sure all their books are in order before even approaching the market for investment, and for this they will most likely require guidance and expertise from legal partners and investment consultants.
What Does the Future Hold for Blockchain Investment?
Funding for blockchain projects will start adopting practices seen in traditional equity funding. This is already apparent in the entrance of VC financing onto the blockchain market and the development of the security token.
While still enthused by the potential of blockchain, cautious investors need the protection and involvement offered by more traditional models.
The security token is in many ways a bridge between the freedom and openness of the ICO model and the security and protection of traditional investments. These new tools and approaches, if executed correctly, will enable startups to regain investor trust and capitalize on the still-significant enthusiasm and interest.
Startups will, however, be made to work much harder for any investment. Projects will be under greater scrutiny from all standpoints.
While it will undoubtedly be more difficult for startups to raise financing going forward, these developments are ultimately a good thing for the market, and a sign that it is maturing from a heady and tumultuous beginning.
Investors will have greater security and protection in their investments, while the trials and scrutiny now involved in raising investment will result in better and more successful projects. Startups will have to prove themselves to investors as viable and useful solutions, demonstrating a coherent and comprehensive legal structure and business strategy on a regular basis.
The new investment climate for blockchain startups is harsh but by no means barren. The increased competition for funding will yield a new generation of stronger, more viable companies and more secure, transparent financing.
Contributed by Victor Michaelson
Victor Michaelson is the Managing Partner at Memorandum.Capital, an international investment company focused on blockchain-based assets. Their expertise in Venture Capital, Private Equity and Investment Banking allows them to provide exemplary services to their clients and great opportunities for investment attraction.