Tokenization: financing a startup through ICO

Justyna Laskowska
Justyna LaskowskaNovember 16, 2021
11 minutes to read
Tokenization: financing a startup through ICO

As you may know, an idea is very important in business, but even the best business plan won’t take you anywhere without sufficient financial support. When investing in startups, raising capital through ICO is becoming more and more popular. What is business tokenization, and how is it different from conventional ways of raising funds?

Business financing methods

There are several basic methods that allow you to obtain funds for development.

There are subsidies, banks grant loans, and some equipment can be leased. Of course, all of these methods involve either the obligation to repay the debt plus interest or complex requirements that must be met.

But what to do when we do not want to get into debt? Modern solutions come to the rescue. It is said that almost every Silicon Valley company was founded thanks to Venture Capital (VC). This type of solution is based on the fact that the investor allocates funds for the development of the project, and in return becomes a co-owner of the company. To this day, it is a very popular way to invest in startups. Angel Investors also operate in a similar way. The most important difference is that in the case of VC, the company invests funds while the Angel is a private individual.

The next step is Initial Public Offering (IPO). IPO occurs when a company starts selling its shares, usually to large investors, or just to the public.

If companies can gather a large community around the project, startup funding can be done through crowdfunding campaigns. Crowdfunding does not require the participation of large investors or wealthy corporations, while an idea for a business must arouse enormous interest in order to be able to raise funds.

Tokenization of startups

The above methods have been known for decades. However, if they are unable to provide financing, there is an alternative — tokenization of startups.

Tokenization of companies is one of the newest ways to obtain financial support. The process is about moving your business to blockchain. Although it may seem complicated and difficult to implement at first, almost any entrepreneur can tokenize their business. Tokenization is simply the transformation of a company’s value into a digitized resource in the form of tokens.

A token is simply a digital representation of a value. Its use is very wide. Tokens can be exchangeable (e.g., payment) and non-exchangeable (NFT).

What is Initial Coin Offering?

The most popular and widespread method of tokenization of startups is Initial Coin Offering (ICO). An ICO basically resembles an IPO, with the difference that instead of shares, the investor receives tokens created by a startup (moreover, ICOs, due to the decentralization of the blockchain, have a much more flexible structure than IPOs). Most often, the participant of the process financing the company’s activities pays in cryptocurrencies (e.g. Bitcoin or Ethereum). Investors usually only receive tokens when the ICO reaches its target. If the required amount of funds is not raised, the startup usually returns the invested funds.

The ICO also lasts a predetermined period of time, and the details of the project can be found in a publicly published document (white paper), which describes the idea, infrastructure, technological solutions, challenges, goals, and plans of the ICO creators.

Sometimes, the authors of tokenization decide to create cryptocurrencies that go into public circulation and can be exchanged on cryptocurrency exchanges.

We experienced the first ICO boom in 2017. That year, people invested over $5 billion in all Initial Coin Offering projects. The largest ICOs include:

  • Ethereum - the network created by Vitalik Buterin is not only the second-largest cryptocurrency in the world in terms of capitalization but also the most popular blockchain and a platform for decentralized applications (dApps) and smart contracts. In 2014, the creators conducted an ICO. In just 42 days, Ethereum raised $18 million worth of cryptocurrencies. At the time of the ICO, the token called Ether was selling for $0.31, today 1 ETH is about $2,900.
  • NEO - a super-project blockchain from the Middle Kingdom. Dubbed the “Chinese Ethereum”, the NEO had a massive ICO, thanks in large part to the support of the Chinese government, Microsoft, and several other large corporations. Although today this cryptocurrency does not play a big role in the digital world, the ICO managed to raise over $5 million, and the token sold for $0.03 at the peak price was worth $180.
  • Telegram - created by the Russian Durov brothers, the social platform is today known as one of the safest messenger apps. Few, however, know that in 2018 the creators conducted two sessions of ICO for their token called TON (Telegram Open Network), during which they managed to collect 1.7 billion dollars. However, the TON was never issued, and the developers had to return the funds to investors.
  • TaTaTu - over $575 million raised in ICO, Johnny Depp’s involvement in a marketing campaign, and advertising itself as Netflix on the blockchain - this is how the platform called TaTaTu was launched. However, the young startup had problems adding popular videos, and today it is only a niche social platform.
  • EOS - this is probably the biggest financial project you haven’t heard of. The Initial Coin Offering, which lasted for a year, managed to raise $4.2 billion. The company’s tokenization aimed to challenge Ethereum and delegated proof-of-stake (dPoS) supposed to revolutionize the cryptocurrency industry. It didn’t, however, fulfill its purpose because then the boss Dan Larimer resigned at the end of 2020, and the future of EOS was put into question.

Advantages and disadvantages of ICO

Investors were so attracted to ICOs because this type of investing in startups gave new opportunities. The biggest advantages of this solution are:

  • an easily accessible solution for investors and startups,
  • low entry threshold,
  • high liquidity of funds,
  • much less legal restrictions and requirements than traditional financing methods,
  • potential for a large return on investment,
  • global token sales market.

However, there is a reason why ICOs are not as popular today as they were a few years ago. Initial Coin Offering has some problems that discourage investors. The most important of them are:

  • high volatility and price uncertainty,
  • no security and guarantees of project maintenance (almost any regulation),
  • high fraud potential due to anonymity and decentralization (long history of scams),
  • no transparency.

The biggest problem in the tokenization of startups is legal regulations, or rather the lack of them. The legal status of investing in ICOs is still unclear in many countries. However, if there are already statutory provisions or laws covering Initial Coin Offering, they are not consistent. There are no international directives on this subject.

In the case of Polish legislation, we only have a statement from the Polish Financial Supervision Authority of November 22, 2017, regarding the sale of so-called coins or tokens (ITO or ICO). In it, the supervisor warned against a number of threats that investing in startups through ICOs may pose. However, there is nothing in the release about the prohibition of carrying out or investing in such projects.

If other rights are purchased along with the token, e.g., shares in a startup, then the ICO may be subject to the EU’s MiFID II directive. However, there is still no clear position as to whether any tokens sold under the ICO should be treated as securities and should be subject to all related legal regulations (for example, the United States Securities and Exchange Commission recognized them as such).

There are also countries (including China and South Korea, among others) where financing startups through Initial Coin Offering is prohibited.

Alternative methods of financing

ICOs are not a perfect way to tokenize companies. This is why the industry has begun to work on other blockchain-based investing methods in startups.

The best known is STO, i.e. Security Token Offering (issuing tokens reflecting securities). This type of investment provides greater security and fits into the existing legal framework.

Since we have security, the Utility Token Offering (UTO) had to be created as well. In this system, companies issue tokens that can be applied to their own ecosystem - similar to loyalty points - but as tradable assets. UTO can be used, for example, to pay bonuses.

There is also the Initial Exchange Offering (IEO) which has the same characteristic as the ICO, but the entire process of fundraising and issuing tokens is handled by the cryptocurrency exchange. Thanks to this, startups pass work onto an intermediary who takes a commission of the investment. Initial Dex Offering (IDO) is the same process, only carried out by a decentralized exchange.

The latest solution is Initial Loan Procurement (ILP), a blockchain loan. Employing legally binding smart contracts, the lender enters into an irreversible and unchangeable loan agreement with the borrower.

Financing startups through tokenization of companies is still a new solution. However, the potential of this technology and the methods that have already been created offer completely new and often very lucrative opportunities. Investing in startups with the help of tokenization opens a new chapter in the global economy.

Also read

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Blockchain 2023: 6 whizzy tech trends plus use cases
Fungibility and more. Get to know the main features of tokens

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