What Happens When ICOs Fail was written by FlatOutCrypto, and it’s included in issue #12 of 21Cryptos Magazine. To read more articles like this subscribe today. To read other free articles check out our Magazine category. Follow us on Instagram, Facebook and LinkedIn.
This article is from an earlier date and as such can contain figures that were actual at time of writing.
The billions of dollars raised in ICOs in 2017-18 have littered the crypto landscape with hundreds of heavily capitalized companies with ambitious plans and frequently little experience (either from a business or technological standpoint). Furthermore, they are developing or building upon nascent technology which has seen precious true adoption. As such, even if they execute perfectly they could still find themselves unable to attract users.
This situation ensures we will begin to see the failure en masse of many projects. A high failure rate is to be expected; a high proportion of start-ups (which the vast majority of these ICOs essentially are) fail.
However, the difference with ICOs lies in the capital they attracted and the rights conferred to investors.
Shareholders in traditional companies have a legal right to the underlying assets of a company. When a company becomes insolvent shareholders receive back a proportion of the liquidated assets, ensuring some value is returned. It also prevents the team from folding the company and walking away with all of the company’s assets.
ICOs are a different beast. Token holders have, as a rule, no right to the assets of the company. Investments into tokens were by and large akin to donations, in much the same way that Kickstarter pledges are received. As Kathleen Breitman (one of the founders of Tezos, an ICO which raised c. $230m) told Reuters, participating in the Tezos ICO was akin to contributing to a public television station and receiving a “tote bag” in return.
As such, there is no legal right for any failed project team to consider returning assets to token holders. However, there are a number of good reasons why they should do so. Furthermore, future ICOs should commit to providing token holders with rights to assets in the event the project is wound down, a responsible attempt at self-regulation before such regulation is imposed.
How Projects Fail
Let us analyze first the reasons which will lead to an imminent rash of failures. I believe there are a number of core scenarios which will lead to the dissolution of projects, and with it the demise of the associated token. For the purposes of this article, I am only looking at the failure of projects in ‘good faith’.
a) the project merges/is bought out by another project
Although there is a great range of projects in the space, the sheer volume has led to a situation where there are clear overlaps in development. There will inevitably come a time where teams realize they would be better pooling their intellectual and financial capabilities and working together to accomplish shared goals.
In this event, the sensible move would be to merge the companies and the token offerings into a new token in a move akin to a standard stock for stock merger. Valuation could be done at an agreed average of the respective token market caps over 1-3 months (or longer, given the volatility in the space). This would provide token holders with a fair stake in the new venture and gives the company a larger community/an opportunity to avoid bad PR.
The other option would be for the project being bought out to return the remaining ETH/BTC to investors or for the purchasing company to use reserve stacks (if existing) to ‘buy’ token holders of the other project out – i.e. give them tokens in the continued project, without diluting existing holders. In either case, the merger/buyout of the token holders could be done in an analogous process to that of the formal process for the company itself.
b) an important part of the project is discarded
Not every project will be able to deliver what it promised at ICO. Some teams set achievable roadmaps and goals and will be able to meet those; many more over promised and will under deliver. What happens in this scenario?
Unfortunately for token holders, it is likely that token prices will simply adjust to the ‘new’ project aims and holders will absorb losses. Startups fail often and repeatedly, and pivots are commonplace. I do not see this as a scenario overly worth concern from a return of investment perspective.
c) realization that project is unviable/should shut
There are c. 200 projects as of today with a market capitalization of over $20m, a number down substantially from the more than 500 in January. Whilst the market capitalization of the token holdings should not be seen as equivalent to the market capitalization of an actual company, many of these projects have raised large sums of money and despite this many will not be able to achieve what they have set out to. Some projects will simply realize they have failed, and there is nothing they can do to rectify it.
The major issue here comes from the vast amounts of funds teams hold from the ICO – companies that have raised $20-250m will have been unable to spend all of that on employee costs (at least you’d hope so). What happens to the money in this scenario?
How Should Companies Close Shop?
In the event it becomes clear that the project cannot achieve its goals, the company has four routes open to it:
- Continue on as ‘zombie’ companies – unable to fulfil their goals, but too rich to fol, the team are able to pay themselves for working on a project they know they can’t deliver – but which will be much more profitable to the team personally than starting from scratch again
- Pivot to a new idea and not give token holders a proportional stake in the new token/business
- Pivot to a new idea and give token holders a proportional stake in the new token
- Liquidate their holdings and return it proportionally to token holders
I would consider (1) and (2) to be examples of exits in bad faith, so I will not focus on them further. 3, whilst perhaps not what investors originally pledged for, could be a viable workaround (depending on the new idea). Given the lack of protection for investors, I do not consider that a bad outcome. However, it is (4) which I think is the easiest and most sensible result for project teams who wish to conclude their time on a project with the fairest outcome for investors.
Although the ICO market may change, many existing companies have assets approaching (or in excess of ) their market capitalization. The simplest thing to do would be therefore to return these assets to token holders, proportional to holdings. While this may mean that ICO investors may have sold and therefore are not eligible for a refund, there is little that can be done about this. Refunding ICO investors would be unfair, providing double rewards (original sale plus a refund of assets) at the expense of subsequent buyers who would receive nothing.
There are projects which have begun to refund their investors in such a way, including Cofound.it who recently announced that they would shutter their doors and return existing assets to holders. Their market cap at the time of the announcement was substantially less than the assets to be returned. This theoretically means that token holders will receive more than the value of each CFI at the time of the freeze.
On the face of it this seems the best possible outcome for all parties:
- It returns some value back to holders
- It prevents a zombie company from wasting capital with no end value creation
- It allows the team to move on, reputations intact – many startups fail
- The more ICOs wind down in such a manner, the less stigma there will be attached to it
- Failing doesn’t need to mean exit scam – by preserving some value, it also means investing in ICOs becomes more reputable and attractive to investors
Furthermore, there are hundreds of companies that have raised money for ideas which will never come to fruition. Better they follow this path of a pre-emptive windup than burn through investor’s money with no chance of success.
The devil as always, however, is in the details.
A Framework for Dissolution
ICOs have suffered from a lack of transparency ranging from details on what raised proceeds will be spent on to employee compensation and burn rates. This lack of accountability is not acceptable. It hinders development and gives too much power to an often newly enriched team. Just as funds shouldn’t vest all at once, but rather should be unlocked according to a pre-set timeline/company progress, equally there needs to be thought given during the ICO itself as to how exactly the company will be dissolved in the event of failure.
This framework need not be overly complicated:
How Assets Should be Liquidated
The sensible option is to appoint a predefined company or individual (with appropriate experience of insolvency/liquidation and who is independent of the project) to be in charge of selling all assets. The administrator would then be able to present a plan for liquidation, including timescales, expected distribution dates and outstanding liabilities to be settled from assets.
Many crypto assets are illiquid. This process need not be rushed – better to take several months and avoid shocking the market or selling at bargain basement prices than selling quickly and not achieving the best value for investors.
Records should then be kept of all sales, including purchasers (particularly if it is an over the counter sale rather than on an exchange) and money realized vs notional value of the asset.
We have already established that token holders are to be the beneficiary of any asset liquidation. However, most ICOs assign themselves at Token Generation Event (TGE) a substantial chunk of tokens. Furthermore, advisors are also often compensated in free tokens. Therefore, the total raised at ICO often only amounts to 50% or less of the total supply.
If a project raises $20m, and at the time of dissolution has say $15m left of assets, it would be inconceivable for the team to then taken millions of dollars for themselves for a few months’ work. This would amount to nothing more than a dressed-up exit scam.
Teams should take an appropriate amount to be able to pay staff costs to ensure employees are not left in the lurch (e.g. perhaps three months pay, a fairly generous amount by most countries standards of statutory redundancy). That should be all the team takes.
It is another reason why teams should see their tokens vest over a period of time, preferably with the majority coming three to five years (and on) post ICO rather than unlocking at launch or in the first few years.
Walking away from millions may seem unfair, but equally the team has not done anything to deserve that money. That money was to build a product, which they are admitting they cannot do. Failure should not be punished – but neither should it be excessively rewarded. Founders accrue benefits, largely in networking, reputational and subsequent job opportunities, even when they fail anyway.
This will admittedly lead to misaligned incentives – if teams can’t take the money, better just to live an easy life and burn through the assets until nothing is left – but we should not be sanctioning projects to raise huge sums of money, close their doors 18 months later and walk away with huge bonuses. That would be tantamount to legitimizing robbery.
The issue of advisors is slightly trickier. Advisors paid in ETH, BTC or fiat have no need to worry. Advisors paid in tokens are different; I would suggest they are subject to a similar vesting schedule as the team should be, perhaps receiving tranches at launch and then after each year. They would then, if they hadn’t already sold their holdings, be eligible to receive assets like others.
Self-Regulation for the Greater Good
Legal authorities have enough reasons to be clamping down on ICOs and crypto in general without handing them further reasons to do so. If ICOs aren’t capable of self-regulation, then the space as a whole will find it dictated to them.
There are other reasons for projects to elect for self-regulation:
- As more projects fail, there will be increasing clamor from investors for projects to clarify their plans
- Teams offering a framework as to how they will return funds will likely be able to better raise investment, as it demonstrates both responsibility and is more attractive to investors
- Teams that blatantly steal from investors will likely eventually suffer the consequences of doing so, even if punishment may be years into the future
- By failing responsibly, founders will find themselves better able to raise capital for subsequent ideas.
There are differing degrees of failure. We need to incentivize responsible failure in order to produce an environment in which more capital can be returned to investors and thus recycled into newer and more productive endeavors, rather than being taken by the team or squandered on infeasible ideas.
Failure need not be seen as the end – it is just a natural consequence of starting highly ambitious companies at the forefront of unproven technology. Given the popularity of the token model most teams do not have a fiduciary responsibility to their investors, but they should act as if they do – it will lead to a better industry for all.