When founders launch a startup they are most often faced with the funding gap, given by the fact that entrepreneurs do not possess the financial means necessary to operate and grow their businesses. Among the various means of traditional early (to mid) stage financing, there is bootstrapping, business angels, venture capital, crowdfunding and bank loans. Recently and as discussed in our previous post, a new financial instrument emerged: the Initial Coin Offering (ICO) aka Token Sale.
Much of the current discussion revolving around Token Sales, concerns their legitimacy and usefulness as a form of entrepreneurial finance. While many analysts will say that raising money through a Token Sale is simply a way of garnering “cheap cash”, the truth is that the flaws inherent to the current capital markets actually gave thrust to this new form of startup finance.
But how did this happen?
To understand these dynamics, it is necessary to reflect upon the current state of the abovementioned instruments.
Bootstrapping
Bootstrapping is typically a seed stage strategy employed to avoid the need of external financing. Strategies include the employment of own funds and subsidies, the use of interim personnel (such as student internships) and the minimization of account receivables. It follows that bootstrappers work in a low-resource context that can slow growth: as such, it is not considered a form of sustainable and long-term financing.
Business Angels
Business angels are affluent and knowledgeable individuals who provide capital in the range of a few thousand to 1 or 2 million in exchange of a minority ownership. They are known for injecting smart money as they bring industry knowledge, network accessibility and business acumen that they have accrued throughout their careers. Angels also have strong intrinsic motivation: many of them have been entrepreneurs with a successful exit and seek to contribute to the success of other founders. Business angels account for almost as much money invested annually in venture capital funds but the number of investee companies is much greater. It follows that business angels are not core investors in new ventures: rather, they fill the funding gap between F&F (family and friends) and formal venture capital.
Venture Capital
Venture capital funds invest substantial amounts of money in startups (typically in the range of millions) in exchange of an equity position (which can be either majority or minority). Their goal is to grow the company as fast as possible to reach a successful exit before the end of the lifetime of the fund. The very few firms that attain VC investments receive large amounts of money in a staged fashion and upon meeting specific milestones. Further, majority VC investors may require a certain amount of board seats and for the CEO to be replaced. On the upside, they provide access to their commercial networks and knowledge of the industry — although this latter aspect is not so strong in nascent high-tech markets where savvy VCs may still be lacking. So while venture capital may provide large amounts of money, their objective is to optimize the exit and exert a lot of control on the start up in doing so.
[Startups Destroyed By Venture Capitalists]
https://www.investopedia.com/articles/investing/121015/startups-destroyed-venture-capitalists.asp
Crowd funding
Crowd funding is an open call mostly made through online platforms for the provision of financial resources either through a donation or in exchange for a product or equity. Benefits for the company include the possibility of trialing the offering in the market, receiving feedback, and creating a network of followers. This form of financing is actually the closest to the concept of the Initial Coin Offering (ICO), with the distinction that traditional crowd funding typically raises less money, aims to sell a product that is less technology intensive, and typically requires the presence of a (paid) third party (i.e. Kickstarter, RocketHub etc.).
Bank loans
Bank loans are provided by credit institutions in exchange of an interest that matures on a regular basis. In order to have access to this type of finance, founders need to provide collateral, an asset belonging to the startup or to the founders that can be seized by the bank should the borrower defaults. Nonetheless, seed stage entrepreneurs usually do not have enough collateral to cover for the amount needed to start a venture, especially if it requires substantial amounts of capital (i.e. born-globals, technology intensive firms, etc.). It follows that, should it be pursued, credit is typically limited to smaller amounts.
In sum, the current state of startup capital markets is best represented by a two-sided coin. On the one side, sources of external financing such as venture capital may allow founders to raise very large amounts of money but this entails loss of control, loss of ownership and a costly misalignment of objectives between the investor and the investee. On the other side, the less pervasive means of finance on running the firm such as business angels, crowd funding and bank loans usually do not provide enough money to support the start-up and growth phases of a company.
It is exactly from this dichotomy that the concept of the Initial Coin Offering (ICO) took off: the market needed a new financial instrument that allowed founders to maintain ownership of the company and pursue long-term growth while having access to enough financial capital to do so.
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