Advances in the blockchain technology, which we analyze in depth in the crypto finance course have also put blockchain on the radar as notable crowdfunding platform. In particular, in the last few years, the blockchain quote, unquote platform enabled many companies to raise a spectacular amount of capital, but on the other hand, generated quite a bit of controversy. In the next two videos, we'll look at how capital raising could be done on the blockchain, analyze performance so far and derive some basic risk factors that investors should be aware of before jumping into this market. Again, we're going to fit crypto-based fundraising into our now familiar crowdfunding framework. The starting point is, again, someone coming up with the very early stage idea for a highly uncertain projects, that's a little ahead of his time. Now, in crypto-based funding channels, many of these ideas, will involve blockchain to some degree, mostly about using blockchain to quote, unquote disrupt some segments of the real economy. For instance, say someone comes up with the idea of letting people renting our spaces on their hard drives for storage and using blockchain to keep track of their usages. Or maybe a supply chain logistics solution that uses blockchain to record the movements of actual goods. And again, instead of going to the banks or venture capitalists, you appeal directly to the crowd and try to get small capital contributions from individual backers online. And this time, you appeal through the venue of the blockchain. We've already discussed the technology in our crypto finance course and feel free to go back to that course for a refresher. In this module, we'll be talking about the business side. Using a public and programmable blockchain, typically, Etherium or similar platforms like Neo, the entrepreneur receives capital contributions, and in return, instead of sending products or equity stakes, sends crypto tokens to the contributors. Recall from the crypto finance course that a token is simply a smart contract, a piece of code running on the blockchain and anybody could generate these tokens relatively freely. And just like in non-crypto crowdfunding, crypto-based crowdfunding could also be classified into two types by the kind of token that participants receive. The first type is called the initial coin offering or ICO and a similar in some aspects to the reward-based crowdfunding we talked about earlier. Here, the crypto tokens that the contributors receive will essentially be accessed right to the products or services that the entrepreneur will develop and do not confer any control right. ICO was all the rage from 2016 to 2018, with billions of new dollars raised and then the market sort of dried up and replaced by other variants like initial exchange offerings or IEOs, which is just like an ICO except the exchanges themselves actively help in designing an issue in the tokens. The second type is called the security token offering or STO, and is essentially the crypto equivalent of equity crowdfunding. The tokens are the same as stock certificates and do carry residual cash flow claims and control right claims. And just like Equity crowdfunding or an IPO, firms doing STO need to be properly registered with the appropriate regulatory bodies like the ICC and FINRA. In this video, we'll focus on the first type, the ICOs and IEOs because there are a little bit more complicated, usually not regulated and generally much harder to value. Here's a brief description of how ICO works. Similar to Kickstarter, an ICO is like pre-selling your products or services. Except you're selling tokens representing access rights to these products and services. You would generate a token smart contract on the blockchain coding these access rights. Then you're going to hold a nice seal event, where you sell these tokens to the public in exchange either for other crypto currencies, like Bitcoin or Ether or in rare cases for actual fiat money. After you receive the money, just like on Kickstarter, the project proceeds to the development, scaling, and fulfillment stages. That's it, but have you noticed a key difference between an ICO campaign and a Kickstarter campaign? If you participate in a Kickstarter campaign, the products your promised is not really transferable. It's very difficult for example, to sell the Oculus VR goggle to someone else when you haven't even received it yet. In contrast, the crypto tokens you received in an ICO campaign can be bought and sold freely on crypto exchanges, just like any other cryptocurrency as soon as they're listed and usually way before the actual product is even developed. So critically, the ICO has features from both a reward-based Kickstarter campaign and equity IPO. Like a Kickstarter campaign, the issuer is pre-selling its products or services. Like an IPO, the tokens conferring the product access rights can be freely bought and sold in the secondary market, thereby enabling much faster liquidity to the project backers. Consequently, we can see that the ICO attracts two distinct types of participants. The first type of participants buy the tokens because they like the product. They want to use it and therefore need the tokens to access it later. The second type, by contrast, buy the tokens to speculate, they don't really care whether the product will be developed or not. As long as someone's willing to pay for the token at a higher price, they'll happily sell it to them. So an ICO is really a unique hybrid form of fundraising. It attracts both consumers who drawn by the products consumer utility and it attracts speculators who just want to make a profit. In order to analyze the ICO process in detail, let's first review the process of its big brother, the stock IPO, and derive some important differences. Suppose you have a company that wants to go public. Ideally, you should be in a relatively mature stage with good funding in place, develop your product and establish your cash flow. Now, how would you go about the IPO? Well, first, you need to hire an investment banker. They act essentially like a financial advisor that look through your company's operations numbers to try to come up with an accurate valuation for your company. Then they'll prepare the paperwork to essentially generate your stock certificate. Which is a legal contract specifying that the holders of this stock certificate is entitled to a percentage of the ownership of the company. It can vote on corporate matters and also gets a claim on the residual cash flow just like other owners. In fact, if you have a bigger company, you'll probably want to talk to a bunch of investment banks and they will get together and form the so called underwriting syndicate for your IPO. Now, the next step is also crucial, once the homework is done, it needs to be examined by the regulators for approval. In the US, this is done by the ICC. The firm needs to file a so-called prospectus or form S-1, which is a really detailed document describing the company, the IPO itself and offer a considerable amount of detail on the operations and financial conditions of the company. This document is usually hundreds of pages long. The SEC will examine the offering in detail and approve or deny the IPO based on its assessment of the risk to investors. And the IPO can only start once the SEC approves it. This starts the so-called primary market and it's where serious marketing begins. You, the CEO of the company, will go with the investment bankers to be paraded in front of a host of institutional investors, like Big Pension funds, Mutual and Hedge funds etc. This is called the roadshow and the goal is to get the investors to buy your stocks at the highest price possible. And of course, the final pricing of the deal is not really up to you, it's up to the investor demand. The investment bankers will carefully negotiate with the IPO investors to arrive at a final IPO price, which could be higher or lower than your initial valuation in the first step. Once everyone agrees on a price, then the stocks are transferred to the investors and the primary market ends. Shortly after though, the secondary market begins, the stock will be listed on one of the stock exchanges and begins trading. And this is the familiar scene where you see CEOs at the NYSE ringing the opening bell. Other investors, both retail and institutional, will come here to trade the stock. And there are usually other mechanism in place to prevent the key stakeholders like the founders or key management personnel from selling their stocks too soon. Now, with this structure in mind, let's transition to the ICO market, the beginning and the end are similar to the IPO. We have a firm, this time, a much earlier stage startup with possibly just an idea or white paper. And at the end, we have a large number of secondary market participants who either want the company's eventual product or wants to speculate on the company's tokens. But there's some interesting tweaks in the middle. First, the underwriting syndicate is going to be replaced by the blockchain. You don't actually need to hire anybody. As long as you have access to a programmable blockchain, which everyone does, to say Etherium or Neo, then you can coat your token as a smart contract on the blockchain. And specifically, the token is going to be called an utility token. And as its name suggests, it does not grant any control rights or cash flow claims. Instead, it grants the holder of that token usage or access rights to the company's product or service. For example, if the proposed product is an encrypted messaging service, you could specify that once the messenger is developed. Each message could consume say, one token to be sent and received. So in contrast to an IPO, instead of owning the actual company, the utility token gives you the right to quote, unquote open the eventual product of the company. And this right is coded as a token smart contract and recorded on the ethereum blockchain, for example. Once the token is generated, well, there's no SEC registration here, the deal proceeds directly to the offering stage. There will still be marketing, but instead of roadshow to institutional investors, the company will directly market to the public instead, using all the channels at its disposal, particularly social media channels, like Twitter and Telegram as well as other channels like celebrity endorsements and viral marketing. Moreover, since there's no pricing negotiation, the company is free to set whatever ICO price it wants. The initial sale will then happen, usually automatically on the blockchain, where the buyers will send Bitcoin or Ether to the company's respective blockchain addresses and a smart contract will usually be in place to send the utility tokens to the investors once they're fund is received. Finally, the secondary market begins on one or more of the hundreds of crypto exchanges, where the utility tokens will be traded just like a cryptocurrency with much more flexible lockup options for the key stakeholders. As of early 2020, for instance, out of the 5,000 or so cryptocurrencies tracked by coin market cap, about 1500 of them are tokens.
