We hear about venture capital and giant seed fundraising rounds for startups all the time. A good idea can receive tens of millions of dollars from accredited investors. In exchange, those early mega-backers usually receive an equity stake in the ownership of the company.
But what if a company doesn’t have the connections to raise millions from accredited investors? Or, consider a scenario where the startup doesn’t want to sacrifice equity. In those cases, startups might go directly to ordinary individuals and ask them to back the project. Traditionally, this has taken the form of crowdfunding where backers receive certain benefits once the product or platform is released. However, more recently, companies have begun to issue digital tokens that promise utility on future services. Those tokens can be traded, and therefore have a value that can change.
In this article, we’ll dive into the details of ICOs vs. crowdfunding to tease apart the differences between the two. They’re very similar in structure, but the differences in implementation lead to very different outcomes for startups and investors alike.
- 1. What is an ICO?
- 2. What is Crowdfunding?
- 3. Open to the Public
- 4. What the Money is For
- 5. Sketchiness
- 6. Regulation
- 7. Weighing the Options
What is an ICO?
ICO stands for initial coin offering. It’s a distribution event for tokens, and those tokens are generally hosted on a blockchain. During an ICO, ordinary people can purchase tokens in exchange for other, more established cryptocurrencies like Bitcoin or Ethereum.
The structure of ICOs can vary, but they generally take the form of a startup announcing an idea and setting a date for the funding of that idea. In advance of the ICO, the startup will publish supporting information about the problem, market economics, and potential implementation of their solution. Anyone can visit the startup’s website and read the documentation behind their idea.
If someone wants to support the startup, they’ll wait until the appointed date for the ICO. Then, they’ll pledge digital currency (e.g. ETH or BTC) in exchange for some number of tokens from the token generation event. Generally, the startup will set a funding minimum required to launch the project. If the minimum isn’t met, all backers will receive a refund on their contributions. If the project exceeds its funding goals, there is usually a cap on the number of tokens that the company will sell on a first come, first served basis.
The company gets to keep the contributions of its backers and use that currency to fund development of new products. Typically, ICOs come from technology companies, specifically blockchain startups. The token they sell will eventually be useful on a software platform the company is building. The expected future value of the product or service is what drives ICO investment and the price of a token after issuance.
What is Crowdfunding?
Crowdfunding is similar to ICOs in format. A startup announces an idea and a date for fundraising for that idea. Ahead of the crowdfunding campaign, the startup will release documents about the idea and the market need for such a solution. Once the crowdfunding campaign begins, the startup accepts contributions from backers. If a funding threshold isn’t met, the funds return to the backers. Above the threshold, the startup keeps the money and gets to use it to develop the promised product.
The major structural difference between crowdfunding and ICOs are the rewards. In an ICO, participants receive tokens. On the other hand, crowdfunding backers get some other type of reward. It may be a physical product or it may be as simple as a thank you card. The rewards for a crowdfunding campaign are entirely up to the startup to determine. This is the common type of crowdfunding you’d think of on Kickstarter, IndieGoGo, or GoFundMe.
There are also proprietary crowdfunding campaigns that offer a stake in the company to retail investors. These are known as equity crowdfunding. Because of their similarity to initial public offerings (IPOs) of stock certificates, equity crowdfunding is relatively rare. They require a close look at regulations around issuing securities, even though investors may only contribute small amounts like $10. They also issue far more and smaller tranches of stocks than an IPO, where typical minimum buy orders are on the range of $2,000. Since these types of crowdfunding campaigns are so rare and different from traditional crowdfunding, we’ll just be focusing on traditional crowdfunding in this article.
Now that we have basic definitions and context for these two types of fundraising, let’s look at the advantages and drawbacks of each.
Open to the Public
Both ICOs and crowdfunding are open to the public. However, a typical crowdfunding campaign will be limited geographically to the countries where the crowdfunding platform operates. For example, Kickstarter is only available in the US, UK, Canada, Australia, New Zealand, most of the EU, Switzerland, Hong Kong, Singapore, Mexico, and Japan. If you’re not from one of those countries, you can’t start a Kickstarter. You also can’t accept contributions from backers outside those countries.
In contrast, an ICO is hosted on a blockchain platform. Ethereum has been the most popular platform for new ICOs, since it makes it easy to create and trade tokens. Anyone, anywhere in the world can connect to the Ethereum network. That means an Ethereum-based ICO is a global event. Some countries, like China and the US, have placed restrictions on ICOs that mean their citizens can’t participate. Navigating between global reach and avoiding ICO bans is one of the primary challenges of conducting an ICO in today’s regulatory environment. As we’ll see later, regulation is one of the key challenges facing ICOs.
What the Money is For
Another major difference between ICOs and crowdfunding is what the startup will build with the funds they raise. ICOs usually correspond to a technology project or platform. That platform will then accept tokens as a method of payment for services. Essentially, this type of ICOs sells the future usability of the platform. Buying tokens early means you’ll likely get them at a discount compared to future prices. If you plan on using the future platform, it makes a lot of sense to buy tokens in the ICO and use them later. Even if you don’t plan on using the platform, buying tokens early means you can sell them later at a profit once the platform is fully developed and demand for tokens increases.
Crowdfunding, on the other hand, usually results in the creation of a physical product or project. You can crowdfund to build a new device or to create a budget for a new movie. Then, when the product gets released, backers might get first dibs on buying the product, a free sample of the early product, or other special perks. Typically, a backer couldn’t sell or transfer their rewards to someone else and there’s no secondary market for trading crowdfunding perks like there is for ICO tokens.
This difference of product and rewards leads to a key distinction. In ICOs, we call the contributors to the sale “investors.” Although not strictly correct, because they aren’t buying securities or equity in the company, we use the term investor because many ICO participants expect a return on their initial investment. This stands in contrast to crowdfunding “backers” who may receive a reward but don’t expect to see a significant financial return on their investment.
The difference between investing in and backing a project has far-reaching consequences. There are certainly crowdfunding campaigns for fake or unrealistic products. However, a Kickstarter campaign is generally a safe investment. Kickstarter itself has a fraud department that can sometimes catch sketchy campaigns and return backers’ money. Additionally, most backers don’t contribute large amounts of money to a Kickstarter campaign. Kickstarter backing is more like purchasing a perk than it is making an investment. After all, there are no financial gains to be had from trading backer rewards.
ICOs are entirely different, and they’ve gained a reputation for being sketchy. Part of the problem is many blockchain platforms promise technical advancements with little documentation of how they’ll achieve those advancements. As a result of puffery and marketing, investors believe the token could be very valuable. Over time, however, investors have learned to become wary as projects with successful ICOs have repeatedly failed. Some ICOs are outright exit scams where organizers take the money and run shortly after the ICO. Others are ideas that fall short or teams that fall apart, resulting in the token’s value falling to zero.
That’s not to say that all ICOs are scams. Indeed, investing in a legitimate ICO with a great idea and an experienced team can be a great place to put your money. However, for startups considering an ICO, the sketchiness factor of this fundraising vehicle is a hurdle to overcome. Investors are skeptical, and there’s an enormous burden of proof to show that your idea is real and your team is qualified.
The final major difference between crowdfunding and ICOs is the way they’re regulated. Since crowdfunding campaigns involve relatively small dollar amounts and backers have no expectation of return on investment, they’ve largely gone unregulated. As long as participants and platforms follow all applicable banking rules, there are no major regulatory consequences to running a crowdfunding campaign.
ICOs, however, fall into a different camp. Because investors in an ICO expect a return on investment, many governments around the world have deemed ICOs as equivalent to IPOs and their tokens are tradeable securities that are regulated like the stock market. Other countries have banned ICOs outright since they’re a completely new class of assets that are difficult to regulate.
Unlike an IPO, buying tokens from an ICO doesn’t mean you own a portion of the company. ICOs have nothing to do with equity, and only in rare cases do they confer voting rights to token holders. So, it doesn’t seem appropriate to regulate them as strictly as IPOs. That said, ICOs do result in tokens that trade on secondary cryptocurrency exchanges. Since these tokens can change in value and investors expect a return on investment, governments are understandably worried about consumer protections. This is especially true since so many ICOs have turned out as failures or scams.
Weighing the Options
If you’re considering a fundraising campaign, an ICO can bring in a significant amount of revenue in a short period of time from investors all around the world. However, it comes with the baggage of reputation and the burden of proof. Additionally, ICOs really only make sense for projects where a token could provide some utility to the resulting platform. If you don’t have a legitimate use case for a new currency, an ICO probably isn’t the best option.
That said, the burden of proof and the need for a well-researched concept and solid team are qualifications any startup should consider before raising any type of funding. If you don’t have a great idea and an expert team that can execute the idea, you’re not likely to see success with ICOs, crowdfunding, venture capital, or any type of fundraising. An ICO makes investing in your idea accessible to people all over the world. However, it’s important that you consult with a lawyer to make sure your token is compliant and follows regulations in the countries where it’s sold.
ICOs and crowdfunding can both generate buzz and public support for your project, as well. Those marketing benefits are often more valuable than the money raised. As such, don’t make the mistake of considering your ICO as an end in your journey, think of it as the means to an end of building a great product and delighting customers.