Capital Evolution

There’s a new way of raising capital that is taking the world by storm. This smart application of blockchain technology will create a number of opportunities and challenges for businesses and investors alike.

IS ALL CAPITAL CREATED EQUAL?
Throughout the world, companies raise capital from investors for some combination of shareholding and debt. Whether it be angel funding, venture capital, private equity or public listings, generally speaking there is an exchange of financial capital (equity or debt) for financial capital (cash). Fair enough.

But what if there was a way for companies to raise financial capital in exchange for one of the other six capitals, such as intellectual capital or human capital?

ICOs, or initial coin offerings, may just do that. They have the potential to completely up-end the way that capital is invested and raised.

Since June 2017, at least four companies have raised more than $100 million through ICOs, including the highly touted Bancor, which is trying to change the way the global financial ecosystem works. According to coinschedule.com, at the time of writing this article businesses had raised more than $2 billion in capital via nearly 150 ICOs in 2017 alone. Sure, that’s a drop in the ocean compared to overall capital markets, but don’t discount the speed of change in today’s world.

Just look at Tesla, which only delivered its first vehicle in 2008, yet in February 2017 its value of $51 billion surpassed that of General Motors. General Motors was formed in 1908 and delivered 10 million vehicles in 2016, compared to fewer than 100 000 that Tesla delivered in that same year and without yet showing a profit.

It’s clear from that example – and many like it – that investors are willing to place a premium on ideas and the execution thereof (intellectual capital), or even on specific people involved in the business (human capital). Using ICOs, a business is able to access that willingness without having to give up an equity share in the business, and possibly with less red tape as well – at least in the short term.

WHAT IS AN ICO?
At first glance it appears to be a mix of an IPO (an initial public offering used by companies listing on a stock exchange to raise capital) and crowdfunding (a less formal means of sourcing capital, often from the general public). Looking a bit closer, it’s clear that an ICO is much more than that. It’s a new asset class that uses blockchain technology to enable and empower an invested community.

If you don’t know what blockchain is yet, you should have at least heard of Bitcoin (you might even have bought some yourself, or at least been tempted to). Blockchain is the tech innovation making Bitcoin and the other cryptocurrencies (all 1 000 of them and counting) possible. Cryptocurrencies are basically decentralised digital cash systems represented by tokens.

During an ICO, a company creates its own cryptocurrency – digital coins or tokens – and makes these available to investors to purchase directly from the company. Investors can use either Bitcoin or its distant cousin, Ether, to purchase the token. This allows a company building an innovative new product the chance to monetise and fund their product upfront.

Investors should ideally be early-adopters and believers in the vision for the business being pitched. To try to eliminate the perception of the ICO being an equity issue, there is some type of right-of-use, or utility, attached to the token which is then given a value during the ICO process. In theory that value will rise as the underlying right approaches maturity, such as a product being developed and taken to market. This is where the investor can potentially achieve a return on their investment, or if applicable, ultimately redeem the token for whatever goods or services it was initially based on. The investor can also trade that token (since it is a cryptocurrency) for other cryptocurrencies should they want to exit the investment.

There is substantial risk associated with an ICO as an investor could admittedly lose their full investment. If the company or product fails and there is no value left to be attached to that right of use, then the token is worth nothing. This is no different from the world that investors already live in where decisions about capital risk are the norm.

At their best, ICOs are the most logical way to fund a business and make sure that interested parties can be investors. At their worst, ICOs are a digital Monopoly money that a business can use to raise capital without any underpinning value whatsoever. Where they lie on that spectrum between the two depends on who you ask. The risks are real, but so are the opportunities for a smart business and investor willing to understand this new asset class.

WHY DOES THIS MATTER TO INVESTORS?
There are currently two clear views – those who trust blockchain and those who don’t. This is rather ironic, since blockchain’s primary value proposition is creating (or replacing) trust through its distributed ledger technology.

China has moved to outlaw ICOs completely. Initially it seemed this was due to fear of the unknown, but it has since been suggested that they plan to have the first national cryptocurrency and simply want to control the market.

As blockchain increasingly proves to be a transformative technology, adoption is expected to increase and regulation in some form or other is inevitable.
South Africa’s largest banks have already formed a collaboration to develop a sovereign blockchain for South Africa. Private equity and venture capital firms are starting to structure deals using ICOs so as not to miss out on potential investments. The bottom-line is that all investors will in some way be exposed to ICOs (or a similar application of blockchain technology) in the very near future.

HOW CAN INVESTORS BE BETTER PREPARED FOR ICOS AND SIMILAR OFFERINGS?
As an investor, you need to understand exactly what you’re getting. At the moment this is difficult with the information that is made available by these businesses raising capital.

Unlike IPOs, ICOs are instigated by the company raising funds. The company publishes a ‘white paper’ containing details of the proposed ICO. They’re not regulated, so these white papers are not standard and contain debatable amounts of useful information for investors.

The hype-machine obviously plays a role too, as some investors invest in the latest big thing while not fully understanding what they’re investing in. But again, this is no different from the types of investment decisions that investors are already making.

As the world of investing evolves, perhaps this is also an opportunity for ICOs to give investors better information and address concerns on both sides.

WHITE PAPER, BLUE OCEAN?
One alternative is to build on the fundamentals of Integrated Reporting. The International Framework provides an excellent basis for a useful stakeholder report, although it’s most often used by larger listed businesses. There are elements that could be incorporated into ICO white papers, in something of a hybrid with a public-offering prospectus, that would help these businesses better consider their offering’s investment case, while also helping investors better understand the business case.

Sections of the framework such as those for ‘Business model’ and ‘Risks and opportunities’ would be welcome to investors reading a white paper. These, along with suitable diagrams to help make the value proposition more understandable, could potentially make the investment more appealing to a wider base of investors.

Having a higher standard for white papers makes sense if it adds value to both parties. Mere regulation wouldn’t be helpful and would likely become a tick-box exercise, but if the document adds value then it would be more readily adopted and hopefully even insisted on.

One way or another, the landscape is going to evolve as blockchain continues to contribute to a capital evolution.

With thanks to Monica Singer and Sven Wüsthoff who gave valuable input on drafts of this article

AUTHOR: Darren Gorton CA(SA) is Chief Financial Officer at SAIPA

This article was first published online by SAICA and is available at the following URL: http://btpubs.co.uk/publication/?m=&i=461866&p=32