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Structuring an ICO : Sample case

ICOs are the big hype and lots of players are considered scams. Time to look at the whole concept on a high level to understand its economics.

Common ground: ICO entities are ideally following the concept of funds

There have been stories where start-up raise funds via ICOs – by allowing future partners and stakeholders to participate in the upside of the business case – and that is an alternative to crowdfunding – funding via end customers who don’t know a lot about the intrinsics of business – and Venture firms.

What these discussions are missing is the fundamentals. Namely, what is the creation of a new coin/money? It is a bet on the future appreciation of this money. It has nothing to do with anything a start-up would do. The entire concept of financing a start-up with an ICO and thinking that this is a wise idea is very obtuse.´What you do when you finance a start-up via ICO is in the best case just crowd-source financing of a company by having the company raise its money from the ICO. From the perspective of an investor, this raises the question why raise the money in an existing coin and not a normal currency? Isn’t that mixing a bet on the coin appreciation with the investment into the company? And if the company creates an own coin and the business case isn’t focused on how to use cryptocurrency and the Blockchain ledger system for a particular use case, this is even more moronic because it is similar to saying: “Let’s produce 1 ton of chocolate every year, put it into chocolate bars and let’s start trading our equity stakes in chocolates.” The overhead of creating chocolate doesn’t make any sense.

So the only way to see any value here is if the company is focused on actually creating a currency to capture value that is defensible and novel. But in that case, should the investment into the company creating the currency be put into the same box as the investment into the currency appreciation and success? Are we not mixing two concepts? That is similar to investing money for a fund into the fund manager. But we should keep the funds seperate from the funds manager.

There could be a lengthy discussion following on the reason behind splitting fund managers from fund and splitting companies creating currencies from the currency. But if you think about it long enough, this should make sense.

So our first understanding and common ground should be that an ICO should take place to give people early access to a currency to make bets on the currency appreciation (Financial investment case) or to use the access to generate transactions (use case case).

That is it. Keep the currency and the company seperate. Everything else should come off as dubious. Just as dubious as asking yourself “mmh, I can only found my ICO company in Switzerland, I hence should employ everyone in Switzerland.”

Revenue models of start-up cos:

So we established that an ICO should be done by an BlockchainOperationsCo and that it is the job of a StartupCo to make the ICO happen. The goal of the StartupCo is to create the technology for the Blockchain, set-up the capital infrastructure to operate the currency (BaaS vs Partnership-based usage of third party data centers vs. building own datacenters at own expense or with the money of a consortium or peer network owning the infrastructure). It is the role of the StartupICO to build the partnerships with companies that will offer services exclusive to the coin to get third parties to exchange other currency for the target currency to get access to the service, do lobbying effort the control regulatory risk, educate on the currency and structure the ICO. Good. Understood. That can be discussed again later on, but let’s look at the most interesting question: how do we have to structure an ICO?

Structuring an ICO.

The ICO structuring has to consider two key dimension. Dimension 1 is the types of investors in the ICO and their meaning for the both the long-term success of the cryptocurrency and whose risk exposure to the new currency must be managed. Dimension two is the structuring the control over the currency FX rate.

Issue 1: Crashing currency:

We start with a very simple example. Consider you raised a 500 million ICO and all your investors were companies that want to use your currency to offer services to generate revenue. Those guys are very relevant for the long-term growth of transaction volume in the currency that define value creation in your cryptocurrency economy. But if they are the only ones interested in the currency and you did bad marketing and they need to find people willing to sell their USD for this new currency, the currency value will immediately crash against the USD. Because no transaction volume exists and nobody excpect service users buy the currency, which means there is hardly any liquidity to sell your currency. The folks that invest 500 million into your ICO to unlock new revenue channels suddenly realize they only get 100 million USD for their entire coin ownership which equals a total loss of 400 millions USD from the moment they paid for the ICO. They really have to make a lot of revenues with a currency whose total value equals 100m to earn back their 400 million USD lost over night. Bad.

Issue 2: Example mix of investors in an ICO

We now look from the other side: who could be interested in an ICO?

a. You: Of course your StartupCo will keep a few of the coins it created prior to the ICO. If it created 500 million coins and did a 500 million USD ICO, it will likely keep 10% just to have a potential upside in the future in the form of currency appreciation. Which is a strong sign that it believes in the value of the currency and is a healthy thing. But of course, if people paid you 500 million to get 90% of the currency, you and other 80% of people could sell – given stable FX rates – their entire stake and another company would be left with it’s 10% stake. Is it realistic that it also can sell its stake and that you earned a return on the total currency by simply offering it and selling everything? No. Of course the bite size of your StartupCo will depreciate the value of the ICO the moment the currency goes live. Giving a hit to the investors of the ICO.

b. Your partners: Again, partners are those guys that offer services exclusive to people who own your cryptocurrency. They will be part of the ICO for two reasons. First of all, they offer their services in this currency and they can only offer it for people that have the coins. Most likely, these people will buy the coins after the ICO. Without having coins from the ICO, they would have to buy coins from other investors and then sell them to their users. Only then they can offer the service and get these coins back and exchange back to let’s say USD to realize their revenues. It is way easier if they owned currency from the start and started offering them at an exchange rate to their users to give access to the service. Makes sense, right? And their buy in at the ICO stage confirms their belief into the strength of the new currency and is a bet both in future transaction expectations and an appreciation of the currency.
These guys are so important to your currency, that if your currncy is great, you just have to give them access. They build the transactions and the economic value add of the entire currency. they will provide liquidity in the FX market as they want to recognize their revenues and hence they will sell coins. And they will buy coins when they are out of it to offer them to clients and to gross revenue. They are important for FX liquidity and transaction volumes.

c. Financial investors: These guys invest for one reason only -> Currency appreciation. Having them on board and being undersubscribed in the ICO is a clear sign that people believe in the value creation story and into the long-term appreciation of the currency. These guys will later be able to sell currency to the partners, buy back currency from them, depending on their expectations on the future development and hence provide the “information” that the market needs to operate efficiently. With investors having high expectations and some others have lower ones, and with their expectations shifting and all of them having or not having positions, you ramp up the FX channels and liquidity that is relevant for the partners, your own company and the financial investors. They allow a strong and believe currency valuation to happen.

d. Miners: If you are not running on a BaaS solution and your StartupCo has to pay for the system operations cost and pay for it using transaction fees, but if you are using mining companies to mine and very blocks using proof of work, you have another set of people at hand. They are a mix of partner and financial investor. You can greatly lower your infrastructure capex by getting mining service contracts for basically free by offering coins in the ICO for a fixed-term free access to mining in their mining data centers. They will only do this if they believe into the long-term appreciation of your currency – which is a validation factor – and they will help strengthen the infrastructure backbone while providing specialized and optimized mining infrastructure at very low risk of creating sunk costs. So these guys will be part of your ICO.

e. Other currency exchanges: Of course, you don’t only want investors coming from a normal currency background, but you also want people from crypocurrencies to support the cryptocurrency exchange with liquidity building. Reasons for participation can be varied, but will also be financially motivated. So they will act like financial investors, but they are not confied to restrictions that would make them only trade for old school currency, but they will trade between cryptocurrencies. They will even more likely do so if there is any arbitrage in cryptocurrency exchange and this will help you smooth out FX to cryptocurrencies and overall efficiency of the valuation of your currency. Good news.

The role of StartupCo and OperationsCo in the ICO

So far we understood the FX risk effect on the partners side and we looked at participants interests. It must become clear that stabilizing a currency is something relevant in the beginning. So time to look at what StartupCo as the incubator of the cryptocurrency can do to make all this work together.

The overengineered ICO : Understanding the mechanics

We said in the beginning that we should consider ICOs as something that should be managed like a fund. When we raised the 500 million ICO, we did it with our fund called OperationsCo. This company has 500 million USD lying around that it has to put to use. We called it operationsCo because part of its job is to operate the Blockchain network. Maintain the Capex side of things, if Capex is outsourced, maintain the relationships with the mining companies. But it also plays a vital role in market making.

Look at the following graphic for understanding this

ICO Structuring Lockups

In this somewhat over-engineer example, we see the currency depreciate at the moment the ICO takes place due to the StartupCo having a share of coins on its own account. At the new price (blue dot), we enter a fixed exchange rate regime. Remeber that no transactions take place and there is really nothing but appreciation expectations from the financial investor side to give this currency a positive momentum. At this point, the example says that nobody can sell and buy his coins for a period of time except the partners offering services. And they can only do this at a fixed exchange rate. If this a B2C company, it will offer its clients access to a new service by buying the coin for a fixed price and then offering the service as a fixed coin price. The users of the service will use the fixed rates to calculate cost of service and decide if they buy or not. In this process, the partners are lowering their stakes. The OperationsCo and StartupCo have very important meanings here. First of all, if the partners run out of coins, they need new coins. The financial investors and capex partners will not sell their coins, because they are on an appreciation investment case and that would not make sense to them to sell now as everything runs well. In this case, the StartupCo has to provide coin liquidity by offering its coins at the fixed exchange rate. But it only has coins. It cannot necessary help the partners to sell their coins for USD to recognize their revenues. This is where operationsCo comes in and starts building a “treasury” position by using the ICO cash to repay the dollars to the coin owners. Makes sense? Yes. Thanks.

In phase two, the lockup period is loosened. It is now possible for third party financial investors or partners to buy the coin from existing holders of the coin. This can either lead to an appreciation or a depreciation of the coin. In case of an appreciation, existing owners can freely decide if they exit parts of their position and sell their coins. The level at which they are no longer willing to sell their coins determines the new price level. Once the new price level is fixed, the treasury / operationsCo has the ability to sell even more coins to third parties wishing to enter the currency to lock in a small profit and exit its position. Because the operationsCo really shouldn’t hold a position but have cash at hand. It’s goal here is to onboard relevant new stakeholders usings it treasury stock.
On the opposite, if the currency devalues and no third party is willing to buy the coins, the OperationsCo will buy even more coins at the fixed rate of phase 1 to keep the price stable. Keeping the price stable is very relevant to build trust from customers of services of the partners and from keeping the partners from losing money on the FX channels, when all they worry about is how to use the coin to generate revenues. This would be a classic market making example where the ICO vehicle starts carrying currency risk on its balance sheet in order to clear the market and keep prices stable.

In the third phase, the system enters a partial or capped free float regime. Why? Because the transaction amount in the currency has somewhat stabilized and the currency is operative. It is now relevant to understand where FX rates are possibly heading and what determines an appreciation and depreciation. The latter is important to generate market-signals based on liquidity. The market should work if new financial investors enter the currency when it is undervalued and they exit when it is overvalued. Because the risk of partners offering services still exists and signalling to new service users is still important, the operationsCo is still relevant now for capping the volatility. It buys  at low volumes to keep the downside under control, and progressive sells when traction is being build to prevent excessive spikes. The financial investors will change a lot of coins during this course untill the strongest believers have long hold positions, swing trader and free float will determine market liquidity and keep spreads lowder on the exchanges and so forth. Finally, before entering a free float mode, the operationsCo finally exists to have a substantial cash position to eventually buy back most of the coins at a price that makes all ICO investors feel substantially protected from the down side.

And why all this structuring? Because the security of this system impacts the bargaining power of the StartupCo to earn higher basis points on every cryptocoin value transacted in the system and because the liquidity attracted by the stability of the coin is earning revenues on spreads in exchange transactions. Something that gives a bit of a downside protection for investors in the StartupCo.

The value driver of currency appreciation

The value drivers of the currency are exactly two and both are driven by the total transaction volume in the new currency.

First of all, lots of transactions implies a steady and strong demand in the services or value add exlcusive offered via the coin. Stability isn’t everything, but it de-risks the currency and stabilizes FX channels and if there is additional growth in transaction volume, there is a forward looking expectation of currency appreciation if the currency isn’t inflationary. This again increases the loyalty of vendors/partners offering services, because this increases their ability to realize growth in revenues from transactions in the coin. Great! With vendors offering new services and generating more transactions, expectations appreciate and the need to realize revenues in their base currency drives the liquidity of the exchange rate from coin to other currencies. The growing number of transactions drive the demand for coin and hence the total exchanges from currency to coin.

The second driver is the financial investor interest in an appreciating currency. If the currency is appreciating, it will increase the numbers of investors covering and considering the currency. The transaction volume driving FX liquidity further reduces FX risk and the total set of investors and their expectations drive the market efficiency of the FX rates and the liquidity of the FX channel, further reducing the FX risk.

Everything breaks with bad or lower-than-expectated transaction volume and deterioriating expectations of future outlook of this.

Side note on additional risks

That sounds already like a simple story to use to evaluate crypotocurrencies. But of course there are substantial risks from the operations side from a business continuity side – failing data centers, etc. – fraud – manipulation of the block chain currency – hacks and cyber attacks and most notably regulatory issues and interventions.

Hope this was an interesting read. Opinions are my own.

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