OECD report: ICOs for SMEs an appropriate form of financing — under certain conditions

While Ini­tial Coin Offer­ings were recent­ly only much dis­cussed among cryp­to fans and com­mon­ly con­sid­ered to be scams, they are now receiv­ing more and more atten­tion from the gen­er­al pub­lic.

As ven­ture cap­i­tal firms and start-ups explore whether they are suit­able as alter­na­tive forms of financ­ing, con­ser­v­a­tive and insti­tu­tion­al investors are also begin­ning to take an inter­est in invest­ing in rep­utable, well-man­aged ICOs.

The OECD (Organ­i­sa­tion for Eco­nom­ic Co-oper­a­tion and Devel­op­ment) has now pub­lished a 72-page report on the nature of Ini­tial Coin Offer­ings. It exam­ines the ques­tion of whether ICOs are suit­able as a form of financ­ing for SMEs.

On the 72 pages ICOs are analysed in many respects, advan­tages and dis­ad­van­tages are point­ed out and the gen­er­al legal sit­u­a­tion of ICOs is dis­cussed. The OECD’s ver­dict in a nut­shell is: ICOs as financ­ing instru­ments for SMEs offer a lot of poten­tial, but only under cer­tain impor­tant con­di­tions.

An inclusive effect and low minimum investment as advantages of ICOs

One of the biggest advan­tages of ICOs over oth­er types of financ­ing is their inclu­sive effect. The authors point out that due to the effi­cient issuance of tokens by means of smart con­tracts, the low­er admin­is­tra­tive costs of the issuance, and above all the pos­si­ble tokeni­sa­tion of under­ly­ing assets (key­word “frac­tion­al own­er­ship”), ICOs offer small investors access they were hereto­fore exclud­ed from. In this spe­cif­ic case, of course, it con­cerns the abil­i­ty to make ear­ly-stage invest­ments in promis­ing start-ups.

Wait a minute, what is “frac­tion­al own­er­ship” any­way? The term describes the fact that tokens can be divid­ed and investors can also acquire cer­tain parts of tokens. As a result, it is pos­si­ble for investors to par­tic­i­pate in ICOs even with rel­a­tive­ly small amounts of invest­ment. This in turn has the con­se­quence that the num­ber of poten­tial investors increas­es many times over, which of course also ben­e­fits the issu­ing com­pa­ny. Instead of pitch­ing to a few investors, you can and must present your com­pa­ny to a broad audi­ence of inter­est­ed par­ties and make sure you reach them using appro­pri­ate mar­ket­ing chan­nels. Thus the top­ic ICO mar­ket­ing comes into focus.

In some cas­es, token own­ers (after an ICO has been held) even have a say in the deci­sion-mak­ing or gov­er­nance of the com­pa­ny. This advanced set­up is also enabled by the use of Smart Con­tracts. The authors of the report even go so far as to claim that „A com­pa­ny issu­ing tokens effec­tive­ly enrols future users of its prod­uct (before the actu­al product/service is even oper­a­tional)”.

Network effects as the biggest advantage of ICOs for blockchain-based companies

While the report gen­er­al­ly eval­u­ates the suit­abil­i­ty of ICOs for SME financ­ing, this ques­tion can­not be answered with­out con­sid­er­ing the com­pa­ny’s busi­ness mod­el and line of activ­i­ty. The OECD stress­es a major advan­tage of ICOs over oth­er forms of financ­ing, which has hard­ly been tak­en into account in the dis­cus­sion so far: net­work effects.

Net­work effects are a con­cept that orig­i­nates from the field of eco­nom­ics. They describe the phe­nom­e­non that as the num­ber of par­tic­i­pants in a net­work increas­es, for each par­tic­i­pant the val­ue of that net­work increas­es as well as the num­ber of pos­si­ble con­nec­tions with oth­er par­tic­i­pants. In oth­er words: the more users use an online plat­form or the more investors par­tic­i­pate in an ICO, the more val­ue is cre­at­ed for each indi­vid­ual par­tic­i­pant of the net­work.

The authors of the report argue that ICOs enable the cre­ation of such net­work effects. This is due to the mutu­al­ly rein­forc­ing influ­ence of investors and users. Inter­est­ed investors who also become users of the plat­form in turn increase the adop­tion rate of the plat­form, which leads to an increase in val­ue of the entire plat­form. The increased val­ue of the plat­form can in turn lead to exist­ing users also want­i­ng to become investors in the ICO, or fur­ther investors can be attract­ed “from out­side”. Of course, it should be not­ed that not all par­tic­i­pants in an ICO are real­ly long-term investors but might be spec­u­la­tors. Net­work effects only arise through long-term investors and plat­form users. In con­trast, when the num­ber of spec­u­la­tors increas­es, the net­work effects achieved in the ecosys­tem start to decline.

For com­pa­nies whose busi­ness mod­el is based on the use of DLT or blockchain tech­nol­o­gy, these net­work effects can be seen in the course of an ini­tial coin offer­ing. The OECD there­fore regards ICOs as a very promis­ing financ­ing method for such com­pa­nies.

ICOs are hardly suitable for companies not using DLT technology

How­ev­er, the author’s assess­ment is more crit­i­cal for com­pa­nies oper­at­ing entire­ly with­out DLT/Blockchain. Since the net­work effect around the out­put of tokens does not arise in this case, the authors argue that ICOs with their giv­en dis­ad­van­tages are not worth the effort and the risk. Nev­er­the­less, some com­pa­nies have opt­ed for ICOs, which, accord­ing to the authors of the report, is due to the fact that they want to exploit “the momen­tum of the mar­ket”.

If the busi­ness mod­el does not require a blockchain, the ben­e­fits of an ICO would be lim­it­ed to low­er costs and accel­er­at­ed rais­ing of funds. Giv­en the dis­ad­van­tages of ICOs iden­ti­fied above and the fact that the need to use tokens in trans­ac­tions (after the ICO has been con­duct­ed) can be an obsta­cle, the OECD strong­ly advis­es such SMEs to choose a dif­fer­ent form of financ­ing.

Further major advantages of Initial Coin Offerings

Apart from the exten­sive­ly dis­cussed net­work effects, Ini­tial Coin Offer­ings offer a num­ber of oth­er advan­tages which are also dis­cussed in the report. For one, there is the increased effi­cien­cy of rais­ing funds, because invest­ment trans­ac­tions are processed auto­mat­i­cal­ly by Smart Con­tracts and the cost­ly use of cen­tral under­writ­ing bod­ies is elim­i­nat­ed. This in turn makes it pos­si­ble for com­pa­nies to address a broad­er tar­get audi­ence of poten­tial investors, which also means a high­er poten­tial of funds to be raised. In some places there is even talk of a “democ­ra­ti­sa­tion” of the financ­ing of SMEs, because pow­er­ful play­ers have lost part of their influ­ence.

This increased effi­cien­cy nat­u­ral­ly also means a reduc­tion in costs com­pared with oth­er forms of financ­ing such as an ini­tial pub­lic offer­ing, where high costs are incurred for the issu­ing bank and its under­writ­ing ser­vices. Ide­al­ly, both the issu­ing com­pa­ny and the investors should ben­e­fit from these cost sav­ings.

The Importance of Meaningful and Sustainable Token Economics

The authors also dis­cuss in detail the impor­tance and neces­si­ty of well thought-out token eco­nom­ics. By this they mean all deci­sions con­cern­ing the out­put and imple­men­ta­tion of a token in the ecosys­tem of an ICO and the pos­si­bil­i­ty of its use by users. In addi­tion to the struc­ture of the offer, this also includes the pric­ing of the token as well as sales mod­els and dis­tri­b­u­tion mech­a­nisms.

The struc­ture of the ICO offer­ing is above all intend­ed to ensure that the com­pa­ny suc­ceeds in main­tain­ing the high­est pos­si­ble degree of con­trol over the per­for­mance of the token and that the risk of a future loss in val­ue can be avert­ed after the ICO has end­ed. How­ev­er, this is made more dif­fi­cult by the fact that it is hard­ly pos­si­ble for issu­ing com­pa­nies to esti­mate how high the financ­ing require­ments for future prod­uct devel­op­ment, mar­ket­ing, etc. will be. If fur­ther tokens are issued at a lat­er date after an ini­tial ICO, this infla­tion­ary mea­sure can, in addi­tion to caus­ing annoy­ance, result in a loss of wealth for token hold­ers.

The use of min­i­mum and max­i­mum invest­ment sums for indi­vid­ual investors as well as soft cap and hard cap for the entire ICO is pre­sent­ed as a mea­sure to cush­ion these risks as well as pos­si­ble. The for­ma­tion of reserves which can­not be touched by the founders for a cer­tain peri­od of time is also a pos­si­ble approach to remove uncer­tain­ty.

Global cooperation & the need for international regulation

As would be expect­ed of such a supra­na­tion­al organ­i­sa­tion, the OECD calls for clos­er inter­na­tion­al coop­er­a­tion and debate on these issues. This would be the only way to cre­ate a secure and trust­wor­thy frame­work, pre­vent legal and finan­cial arbi­trage by nations act­ing uni­lat­er­al­ly, and be able to exploit the poten­tial of ICOs as a financ­ing method.

Hence, the authors write:

Giv­en the glob­al nature of ICOs issu­ing and trad­ing across bor­ders, coop­er­a­tion at the inter­na­tion­al lev­el is war­rant­ed for a coor­di­nat­ed glob­al approach that will pre­vent reg­u­la­to­ry arbi­trage and allow ICOs to deliv­er their poten­tial for the financ­ing of blockchain-based SMEs, while also ade­quate­ly pro­tect­ing investors.”

Unresolved problems, important disadvantages and minor issues with ICOs

But of course there is not only praise for ICOs as a form of SME financ­ing. Accord­ing to the OECD, there are cur­rent­ly many more obsta­cles, unre­solved prob­lems and unan­swered ques­tions that stand in the way of ICOs becom­ing a main­stream form of financ­ing. So what are they? First of all, there is the reg­u­la­to­ry uncer­tain­ty for investors and issuers result­ing from a vari­ety of fac­tors. Often it is nei­ther clear nor obvi­ous which laws and reg­u­la­tions are applic­a­ble to a spe­cif­ic ICO. In addi­tion, there may be a lack of super­vi­sion by a com­pe­tent author­i­ty, which fur­ther increas­es the risk for investors. Of course, a lack of a legal frame­work also exac­er­bates the risk of pos­si­ble vio­la­tions of the law and crim­i­nal offences for the com­pa­nies con­cerned.

Unre­solved ques­tions at the tech­no­log­i­cal lev­el, such as the legal enforce­abil­i­ty and bind­ing nature of smart con­tracts, also sow uncer­tain­ty and uncer­tain­ty. Since, as a rule, there are still no bind­ing require­ments regard­ing infor­ma­tion duties, and whitepa­pers are not reviewed by inde­pen­dent insti­tu­tions, this would fur­ther increase infor­ma­tion asym­me­tries between founders and investors.

Anoth­er dis­ad­van­tage is the dif­fi­cul­ty of token val­u­a­tion. Since many ICOs are made for com­pa­nies whose solu­tion is still in the con­cept stage, invest­ments are often not yet matched by real mar­ket val­ues. Con­flicts of inter­est can arise if founders have already expe­ri­enced a great increase in the val­ue of their tokens after a token sale, with­out there hav­ing been any seri­ous fur­ther devel­op­ment of the con­cept or prod­uct.

Yet it is also spec­u­la­tors who only invest in an ICO in order to sell the acquired tokens post-ICO at prof­it, that pose a threat to the val­ue and sta­bil­i­ty of the token. In extreme cas­es, this leads to a sit­u­a­tion where com­pa­nies no longer have any influ­ence on the val­ue of their tokens. Since the com­pa­ny is paid for its ser­vices in tokens, such a devel­op­ment very quick­ly endan­gers the liq­uid­i­ty and con­tin­ued exis­tence of the SME.

Oth­er dis­ad­van­tages and risks are also high­light­ed. These include the dif­fi­cul­ty of esti­mat­ing the exact financ­ing require­ments in advance, the lack of mech­a­nisms to pre­vent the token from los­ing val­ue and the con­stant dan­ger of hacks (whether on the web­site, cryp­to-exchanges or even the blockchain net­work through a so-called “51% attack”).

The solution: create legal certainty and exploit the potential of blockchain technology

What does the OECD report mean for SMEs and oth­er com­pa­nies plan­ning to car­ry out an ICO or STO? The report rep­re­sents a com­pre­hen­sive and impor­tant start­ing point and jus­ti­fi­ably draws atten­tion to the dan­gers and risks. It should also be not­ed, how­ev­er, that some gov­ern­ments have already addressed pre­cise­ly these prob­lems and come up with ways to resolve them.

Blockchain Island Mal­ta is the first coun­try in the world to have a clear legal frame­work for DLT tech­nol­o­gy. Many of the prob­lems men­tioned are com­plete­ly mit­i­gat­ed, legal uncer­tain­ty elim­i­nat­ed. The Vir­tu­al Finan­cial Assets Act pro­vides for the manda­to­ry imple­men­ta­tion of AML and KYC pro­ce­dures and defines dis­clo­sure require­ments for com­pa­nies and nec­es­sary ele­ments that whitepa­pers must con­tain.

As the com­pe­tent super­vi­so­ry author­i­ty, the Mal­ta Dig­i­tal Inno­va­tion Author­i­ty (MDIA) exam­ines all ICOs to be held in Mal­ta in detail and must issue its approval. Once the strict require­ments have been met in full, com­pa­nies can get their DLT mod­el licensed in one of 4 VFAA license class­es and offer investors secu­ri­ty. At the same time, the design of the frame­work offers the nec­es­sary flex­i­bil­i­ty to safe­ly explore future appli­ca­tions of the blockchain.

Binance and OkEX, the cryp­to-cur­ren­cy exchanges based in Mal­ta, can be con­tact­ed and, in the event of a suc­cess­ful list­ing, pro­vide the com­pa­ny with the desired liq­uid­i­ty on the sec­ondary mar­ket. In Mal­ta, ICOs can only be applied for and car­ried out with the assis­tance of licensed VFA agents. This is a fur­ther mea­sure to ensure a cred­i­ble and trust­wor­thy ecosys­tem.

About Dr. Jörg Werner

Dr. jur. Jörg Wern­er, born 27 May 1971, attend­ed the law school of the Uni­ver­si­ty of Leipzig and passed his first state exam­i­na­tion in the State of Sax­ony in 1996. After suc­cess­ful­ly com­plet­ing his manda­to­ry legal intern­ship, he suc­cess­ful­ly passed the sec­ond state exam­i­na­tion of the State of Sax­ony-Anhalt in 1998 and was admit­ted to the bar and began to prac­tice as a Ger­man attor­ney (Recht­san­walt) before the court of Magde­burg the same year. He worked as an attor­ney at the Law Offices of Prof. Dr. Fre­und & Kol­le­gen until he formed the firm of Wrede & Wern­er. He was also admit­ted to prac­tice before the Supe­ri­or Court of Naum­burg. In 2001, he moved the firm’s offices to Cen­tral Berlin, where he was admit­ted to prac­tice before the Courts of Berlin. Dr. jur. Jörg Wern­er then com­plet­ed his doc­tor­al stud­ies at the Uni­ver­si­ty of Ham­burg and grad­u­at­ed as a Dok­tor der Rechtswis­senschaften (Doc­tor of Laws).

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