Rob May is the CEO of Talla, which produces the Botchain, a network for managing autonomous agents on a blockchain. He also writes a newsletter on artificial intelligence.
Initial coin offerings (ICOs) seem like a dream come true for entrepreneurs.
They have to find a way to get their product in the hands of the public, and they also have to raise money to fund the building and operation of their networks. ICOs can kill two birds with one stone.
But taking a closer look at how ICOs work makes me wonder if there is a question entrepreneurs should ask, but aren't… are they giving up too much value creation to others?
Every entrepreneur I know has called me to talk about ICOs. In their minds, the primary benefit is non-dilutive financing. They don’t have to give up any equity, or control, of their companies.
But if you've ever had an introductory economics course, you know there is a famous idea called the "no free lunch" theorem. It says that everything in economics comes with trade-offs. Nothing comes for free.
So what are the hidden trade-offs for ICOs?
For starters, liquidity is a doubled-edged sword.
Early-stage companies go through many ups and downs. There are many times when, as an early stage investor, you would like to sell and get out. But, startup equity is illiquid and so you often have to buckle down and figure out a path forward for the company.
With tokens, you can drop them on a moment's notice. There is no reason to tough it out through the rough times. For the entrepreneur, that means you are relying on fair-weather friends.
The world today isn't run on truth – it's run on information cascades, and availability cascades.
What this means is that if one piece of bad news comes out, that causes a large token holder to sell, and the price goes down, and as more people sell, the investor actions will cause people to question your underlying business and network. Potential customers or network partners see the token price tanking and assume you aren't going to be successful.
The downward spiral becomes difficult to pull out of, and so, random actions beyond your control can become truth and kill your network.
Money on the table
You may have been better off selling equity depending on how difficult it is to build your network.
Say you build a network worth $1 billion. If you do an ICO and only retain 20 percent of your tokens, they are worth $200 million. The rest of the network is capturing $800 million-worth of value.
If you raise equity capital, your company is worth 5x as much – it's worth $1 billion. The average equity of a founding CEO at IPO is 9 percent. If you own 9 percent of one billion dollars, that is $90 million. To get the same valuation from your token holdings, you would have to personally retain 45 percent of the $200 million-worth of tokens your company owns. That seems high if your team is any decent size.
I'm not arguing one way or the other here; it depends on how difficult it is to build the network on each path, and the cost of the equity capital available to you. I'm simply pointing out that there are reasonable scenarios where you may be better off financially if you sell equity instead of tokens, and I think that is a counter-intuitive idea right now.
No simple answer
These issues are complex, and whether or not it is better to sell tokens or equity depends on a lot of different factors.
Building a network is harder without tokens because you have fewer tools to incentivize partners. And sharing value via tokenization may help sustain a network long term better than a single point of control.
But it is complicated, and not always a clear decision. From the discussions I have, entrepreneurs are thinking too simplistically about this and are just looking to sell tokens because of the non-dilutive nature. That is a shallow first-order analysis.
If you have a network idea, the best path is to focus on how the network will get built, and the economic incentives for partners to join you.
There is no free lunch, so think deeply and clearly about the opportunity before you decide if ICO is a better path than an equity financing round.
When selling tokens, you may be giving up more value than you realize.
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