Who Will Protect Investors in a Cryptocurrency Crowdsale?
Cryptocurrency is moving from crowdfunding new startups to ‘crowdselling’ them, and several new ventures are promising to decentralize the whole process.
At least three new projects have surfaced this month, all of which want to put crowdsale ventures on the block chain. However, one of the biggest questions remains unanswered: how will gullible and inexperienced investors be protected from making bad decisions?
The idea of raising money for new projects using bitcoin began with crowdfunding – Kickstarter-style sites allowing projects to take bitcoins in payment. Success has been limited, however.
Others have experienced far more success by ‘crowdselling’ instead, in which they sell equity to large numbers of people, rather than simply taking pre-orders or donations from them.
Seedcoin, for example, works via Havelock Investments, which has been owned since last November by The Panama Fund. Havelock is a Panamanian registered bitcoin investment fund, dealing with only offshore investments.
The company retains a proportion of shares in the companies that work with it, and aggregates them into a fund. It then sells investors shares in that fund, meaning that they invest in more than one company at a time.
In that sense it follows a centralized model: administering funds from a single point. But, as with all things crypto, several parties are now moving to decentralize the whole thing via the block chain.
From crowdfunding to crowdsale
Adam Levine, a well-known bitcoin entrepreneur who is also involved in Humint, is the person behind one of these crowdsale projects, called CoinPowers. He points out that the by-now traditional Kickstarter crowdfunding model is flawed, because it doesn’t offer equity:
“The way things are now, if you don't want the reward there is very little reason to support such a project even if it's a good idea and you think it can succeed. Sure you can just donate, but in practice most people view their donation and its reward as a pre-order.”
One problem with that is that users don’t get to leave. Once they’ve made a donation, they’re stuck – even if the company changes direction, or sells itself to a large player. That’s what happened with Oculous Rift, the Kickstarter-funded virtual-reality goggles firm which sold to Facebook, infuriating users.
Companies are hoping that trading shares or assurance contracts in new startups using the block chain will cut through that whole tangled mess, while giving them more of a stake in the firm. Hence, the move from the crowdfunding to the crowdsale model. And there are a few firms already doing it.
BitShares is another venture that offers people the chance to trade shares in companies online. It may have morphed since we wrote about it last August, following the departure of cofounder Charles Hoskinson to form Ethereum.
And Counterparty, a distributed exchange offering people the chance to issue their own assets, is another potential platform for crowdsales.
We’ve already seen MaidSafe, the distributed, anonymous storage network, which sold its own coin via the Mastercoin altcoin to help fund itself, and made $6m in its first five hours. Now, there are other, slightly different models, all wanting to use the block chain to decentralize the sale of equity to large numbers of users.
Earlier in May, Mike Hearn launched a new project, Lighthouse, which he has described as a crowdfunding application, which uses assurance contracts. It isn’t designed to sell shares in a company, though – it’s designed to raise money for the initial development phase of a project, just to get a project off the ground.
Because it’s block chain based, you can revoke pledges to a project if it doesn't deliver, Hearn said, explaining:
“It’s usable for small, lightweight micro-crowdfunds, like someone who is organizing a small party or conference where people buy tickets by pledging. The organization only goes ahead once enough tickets are pre-sold and people only pay for their tickets if enough people will go for it to be fun. Existing crowdfunding sites have overheads that are too high for this.”
Then, there’s Levine’s CoinPowers project. He’s not revealing too much, other than to call it a “solution-agnostic donation and crowdsale platform”. It will enable people to build their own tokens that will be used to raise value for a project, and a platform to launch it on.
“We're primarily focused on distributed applications and project-based coins rather than so called ‘virtual IPOs’,” Levine adds.
Another project that will use tokens to represent assets is Swarm, created by software developer and entrepreneur Joel Dietz.
This platform would have crowdsale projects issue their own coins for sale to participants. If the project succeeded, participants would then receive profits based on the coins that they held. The venture is offering its own crowdsale, where participants can receive a share of coins launched by others on the platform.
“This is similar to an AngelList syndicate or eToro or other socially enabled platforms, where you can ‘follow’ a particular person or idea,” he says, adding:
“The exciting part is that we are building this in a decentralized way, where multiple parties can endorse a project and a retail investor can make their decision based on the success of previous investors.”
While all this is going on, regulators are still grappling with the concept of centralized crowdsales. In 2012, the US passed the JOBS Act, which included a provision that allowed non-accredited investors to invest in companies.
However, Congress passed the details off to the SEC, which last year finally released proposed rules for the solicitation part of the law, which governs crowdfunding. Those rules have not yet been passed.
“Crowdfunding has taken three steps in the right direction, but is hitting a regulatory wall. We, and a million others like us, are either going to climb over or walk around or blast through this wall. We aren't going to wait,” says Dietz.
The question is, will regulators let it? Crowdfunding site BitFunder was shut down by last October, after pressure from the SEC, indicating that regulators are taking notice. It was the latest in a line of dead bitcoin ‘stock exchanges’.
“In a truly decentralized system, anyone could create a [crowdsale] project on the block chain, and it wouldn’t have to be vetted.”
The SEC plays a role in protecting investors from securities that may be very risky, or even fraudulent. Companies that sell shares in themselves via an Initial Public Offering (IPO) regulated by the SEC must undergo an incredible amount of hoop jumping before they can get there. Even then, they’re sometimes found to be actively defrauding the markets.
In angel and venture capital funding, the investments aren’t publicly available, but are instead restricted to experienced people who want to participate.
Crowdsales on the block chain are effectively funding rounds, because they allow investors to buy assets related to new ventures.
Those ventures are selling the assets to raise money for their own development. But they don’t have the same level of scrutiny as an SEC IPO, and yet they’re open to everyone, rather than just accredited investors.
Protecting the retail investor
So what is being done to protect these retail investors?
“Nothing, and some people will probably get rapped by the SEC for it,” says Lighthouse’s Hearn.
Others hope to offer some protection by vetting their projects. Dietz plans to conduct his own due diligence on potential fundees, by having them fill out a form. But where is the auditing process?
Havelock tries to offer some protection in the form of a prospectus.
“It can’t guarantee your investment, but at least it can check to ensure that the guy is who he says he is,” said a source close to the company, who added that it issues a prospectus for funds that it launches.
The fund is liquid, meaning that it’s freely traded under an exchange, said the source, and that users’ money isn’t stuck there. He also argues that investments are usually small:
“The amazing thing is that you can have thousands of people putting in five dollars each.”
CaVirtex, a successful Canadian exchange, started off at Havelock Investments.
“If you want a poster child from something that started as an idea," said the source, "and then later on were able to reach physical shares, that’s your poster child for a successful company that was able to raise capital in 12 hours.”
CaVirtex, which launched on the exchange in March 2013, had the advantage of being able to ride on bitcoin’s incredible success. Other Havelock-listed companies – and their investors – were not so lucky. Neo & Bee, for example, was a Havelock-listed company that collapsed.
“There are worse players before and there will be worse after. It’s a risk-to-reward ratio. [Havelock] didn’t specifically launch this company, it was a passthrough fund, which it doesn’t do anymore,” the source said.
Eddy Travia, the co-founder of Seedcoin, which lists its funds on Havelock Investments, argues that the accountability lies with the investor.
“I would advise them to gauge the public interest in this project, the relevance of this project for the community, the seriousness of the project leaders, the solidity of the fundraising process itself,” he says, giving the MaidSafe project as an example.
“I know the Mastercoin team and I trust they are doing a very serious and professional work in putting together the crowdsale process. Of course, as an investor I would also need to look into the project itself and see if this is something I feel represents an attractive value proposition for my own objectives.”
Ideally, Levine hopes that a lot of this will be solved by reputation systems:
“No matter the form, fraud is illegal. Beyond that, most of the projects I'm consulting on are reputationally binding rather than legally binding. If you start a project, create a token and use that as the fuel to build your project and then when it's ready you do not follow through and honor the token, you've disenfranchised your earliest and probably most passionate supporters. Those people who were and would have been your evangelists are now very burned by you and incentivized to share their experience, which will make it more difficult for you to operate."
That’s all very well, but in a truly decentralized system, anyone could create a project on the block chain, and it wouldn’t have to be vetted. And leaving accountability entirely in the hands of the investor has always been fraught with danger, because as we know from traditional financial markets, it’s usually pretty easy to separate a fool from his money.
No one has yet been able to answer the question of how we’ll protect non-accredited retail investors in the age of the block chain-based crowdsale – and if it takes off, that, rather than any technological issues, may prove to be its biggest challenge.
Crowdsale image via Shutterstock
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