TL;DR: Crowdfunding failed at fulfilling its goal of unlocking a massive new source of unprofessional capital for startups. Regulated, fully legally compliant token offerings (not the mostly unlawful ones done historically) may succeed where crowdfunding failed.

I am not going to spend any time in this post explaining or defining ICOs or Crypto. I know most SHL readers are familiar with them and, if not, a quick google search will do the job.

There was a time, I would say between 2016 and some of 2017, during which ICOs/Token Offerings were certainly on our firm’s radar as potential fundraising mechanisms for startups, but we were highly skeptical of their legal compliance; for reasons that the SEC and other regulatory agencies have now made clear. It is safe to assume that the vast majority of crypto tokens today are securities under U.S. law and that, just like a convertible note or SAFE, U.S. companies issuing them need to find some way of staying within the applicable legal boundaries. Forming some offshore entity to try to get around the securities law issues (tax issues are a separate matter) is playing with fire, and don’t expect us to play with you.

On top of the obvious legal issues, our skepticism of ICOs was supported by the fact that most of the teams we saw pursuing ICOs were, shall we say, not the “caliber” we like to work with. It was clear that in the early days the ICO space had an adverse selection problem: putting aside the small number of stellar teams building unicorns with legitimate reasons for being in crypto, the significant majority of the projects pursuing ICOs were simply the rejects of the conventional angel/seed fundraising world.

In other words, my skepticism of ICOs paralleled to a large extent my skepticism of “crowdfunding.” While the pre-sale kind of crowdfunding (Kickstarter, Indiegogo) has clearly been impactful, securities crowdfunding was pitched to the world as opening the floodgates of this vast world of middle class capital just dying to get into hot startups. It didn’t work out that way.

First, the middle class in America is trying hard to afford college, housing, and healthcare, and have some kind of retirement in place. It never was dying to invest in startups; beyond the occasional “man I wish I’d gotten into Facebook” hindsight remark. Second, average investors aren’t stupid, and are well aware that most crowdfunding sites are not full of A-level teams, but are often packed with the teams rejected by professional angel and seed investors. Startup investing in general is extremely high-risk even for professionals. Given the adverse selection issues, it’s orders of magnitude riskier for every-day investors seeing only the bottom 20%. Given all of this, the supply of capital simply isn’t there.

As of today, the impact of non-accredited investor crowdfunding on the general startup ecosystem has been marginal, at best, and I don’t see that changing much in the near future.

But… over the past year or so I’ve come to believe in the possibility that legally compliant (regulated) ICOs/token offerings may have a legitimate shot at realizing crowdfunding’s unfulfilled dreams. Here’s why: 

A. Unlike the average middle class American, the newly created “crypto rich” have (i) significant disposable income and, (ii) from the simple fact that they got into crypto early, tend to be much more tech literate and interested in early-stage projects than the average investor. They trust their ability to judge early-stage technology, and are therefore willing to invest in risky projects.

B. Regulatory agencies, instead of pounding the industry into non-existence by banning everything, have instead taken a more measured approach by going after the most egregious bad actors, but also extending an olive branch to those interested in finding fundraising mechanisms compatible with a valid legal framework.

C. Crowdfunding platforms, eyeing an opportunity to tap a market that actually exists, are pivoting toward supporting ICOs/token offerings that work within the legal framework created by the crowdfunding movement. That framework certainly adds some friction around how the classic wild-west “easy money” ICOs have historically been conducted, but it is significantly more greased (and could be greased further) than conventional startup investing; including “mini IPO” regulations that were previously passed that could allow tokens to be traded openly in a way that doesn’t bust securities laws.

D. The average caliber of teams we see approaching us with an interest in a token offering has gone up significantly. We have a few clients actively working on token offerings fully compliant with securities laws right now.

E. While most token offerings until now have involved utility tokens that actually serve a function in the operation of the company’s technology (which limits the types of companies that can offer them), the infrastructure is being built for “security tokens” that allow almost any asset – including shares in a corporation – to be sold and traded much like utility tokens.

I was quite skeptical of non-accredited “crowdfunding” generally. I was also deeply skeptical of the easy-money ICO boom that made headlines over the past few years. But I’m becoming cautiously optimistic that the infrastructure and demand is coming for a legally compliant ICO/Token Offering wave that could win where crowdfunding lost. The next 2 years will be interesting to watch.