Chapter 3: How Do Crypto Projects Raise Funds?
The rise of a new revolutionary idea always leads to a new breed of believers who think that it can change the world for the better. The advent of Bitcoin has successfully carved out a world of its own, and similarly, its loyalists believe that the blockchain is going to change the world for the better and that the solutions, projects, or ideas built on blockchain will take the world by storm.
However, to materialize those ideas, they need funding. This is where the crypto community swooped in. The developers rose to the occasion and created a parallel fundraising ecosystem which is not reliant on existing players. Let us walk through that journey.
First came the initial coin offering (ICO). It sounds similar to initial public offering (IPO) but there are stark differences between the two. In an IPO, projects or companies offer securities to the public to fulfill their funding needs. The securities (if equity) provide the public with some control over the operations of the company.
In an ICO also, crypto projects that want to raise capital hit the market to issue tokens in lieu of a cryptocurrency. They come to the market and tell the world that they have an idea that they are building on a particular blockchain. They explain the idea through a white paper, which can be considered as a version of a prospectus. However, whatever is written is regulated and vetted in a prospectus, which is not the case for a white paper.
Quite a heavy marketing sum is spent on various crypto platforms, which, in the world of shares fundraising, would be termed as “roadshows”. After that, if people like the idea, they can purchase the tokens.
The tokens are purchased through smart contracts. The tokens once issued can be traded in the market just like any other security. In certain cases, the issued tokens can just be utility tokens or denote voting rights. In addition, there can be scenarios where these tokens have no relation to the mechanics of the company.
To put things in perspective, IPO equity shares give a percentage of ownership in the underlying company. However, in an ICO, it is not impossible to issue tokens which do not do anything like that in the company–they are just plain digital assets (without anything underlying), which can be done through a smart contract. Most of these tokens were issued on Ethereum using ETC-20 in the past.
When it comes to an ICO, there is no authority to take permission from in order to raise capital for such projects. However, for an IPO, India has SEBI and the US has SEC, both of which regulate all steps of the process. This means that a project going for an ICO could be at the idea stage or be well into its operational stage, and there could be a limited amount of information on them.
All of this could potentially lead to several scams, which are called “rug pulls”. There are a few ways in which a rug pull can be executed. However, in all variants, the bottom line is that the developer takes the money and runs away.
And it happened as soon as it boomed. The first token sale took place in July 2013. Even Ethereum raised money with a token sale in 2014, where it raised 31,000 BTC. By the end of 2017, the market had raised about 40x the capital it did in 2016, but then the market collapsed. Companies like Facebook, LinkedIn, and Twitter did not let anyone advertise about the ICOs. Quite a few countries started banning ICOs and regulating cryptos as well. By the end of it, the whole crypto market collapsed by ~85% in 2018.
Finding the optimum model is a journey, and though there were many crypto enthusiasts, quite a lot of them burnt their hands in the crypto market as well. This is where the initial exchange offering (IEO) came in. Call it overcompensation, but there came a new way of raising capital. Although the market fell, exchanges stood tall and picked up the baton of ensuring that crypto projects continue getting funded.
If any project wanted to get listed, they now needed to sign up with the exchanges, which took on the task of vetting upon themselves. If they would find that a project was worth the while, they would list it and even engage in its marketing. For all the legwork that they did, they charged fees as well as took a cut on all the transactions on the platform, which would eat into the funds raised. Binance, as always, was among the first to jump at the chance, followed by several exchanges like Huobi Prime and OKE.
This mode of funding was operating well, as could be seen from the number of crypto projects that came up. However, there was a fundamental flaw in this structure–it led to centralization, which was anathema to blockchain. The crypto wave or revolution is being ridden on the idea that the world would not be controlled by a few.
This led to anarchists questioning why the exchanges should have the authority to decide who raises money and who doesn’t. For instance, if a founder had raised VC money, then it was highly likely that his/her project would get approved over someone who was bootstrapped. These exchanges could actually invest at the early stages in the projects themselves, and make money when the projects got listed. Such crony capitalism made the crypto world revolt again.
The next improvement is the initial DEX offering (IDO)–the current popular solution, “current” being the operative word. Over the last couple of years, some decentralized exchanges have come up. Think of decentralized exchanges as banks without owners. It is the smart contracts that regulate these exchanges. Through these contracts, people can lend, borrow, and exchange quite a few tokens in lieu of the more famous cryptocurrencies like Ethereum and Bitcoin.
When a new project wants to raise capital, it comes to the IDO. Some of the decentralized exchanges are Uniswap, PancakeSwap, Serum DEX, etc. These IDOs have a community of thousands of developers, who end up vetting the codes themselves. More importantly, these people are doing this voluntarily. While there is trust in the collective wisdom of the developers, if they end up finding a flaw, they can point it out to the world. Moreover, here, you do not need KYC, it is much faster than the centralized exchanges, and smart contracts ensure that there is liquidity at all times.
Having said that, it is not all roses. Since there is no authority here, it is not possible to have your grievances addressed. As mentioned earlier, you rely on the collective wisdom of the developers to sift out the bad ones. The problem of pump-and-dump still persists, where the developers can dump their tokens and take the money away. The situation is not as bad as IEO here, because the decentralized exchanges run on algorithms which can curb the pump-and-dump exercise to an extent.
As we conclude today’s part 3 in our crypto series, a major takeaway is to not get highly influenced by the amount of money which is flowing into the crypto ecosystem. The whole crypto economy is still in its nascent stages. This pattern leads me to believe that someone will figure out a way to fix the flaws in IDO in a couple of years, and then someone else will figure out flaws in the next solution on offer.
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This blog is the third part of a weekly series called “Crypto Talk” which goes through the A-Z of blockchain and untangles the matter. Subscribe here if you want it to be delivered right to your inbox.
