ICOs: No Worse Way to Fund a Startup

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An ICO may be a hot way to raise money but it’s a terrible way to fund a startup. Why? Because issuers get all the money upfront and have a huge incentive to spend the entire proceeds within one tax year to minimize Uncle Sam’s bite on their sandwich. Anybody with business experience would find the idea of building a business from scratch within one tax year to be counter-intuitive, to say the least. It flies at the face of the most widely accepted approach to building successful startups.

An ICO or initial coin offering is a fundraising arrangement whereby an entity creates coins or tokens which are offered for sale to buyers. These coins or tokens do not confer ownership in the entity, they are redeemable only for the services of the company or by exchange for other types of assets.

Under current US tax law, the proceeds from the coin or token sale are considered taxable income in the first year unless offset by deductible expenses within the same tax year. This creates a powerful incentive for founders to frontload their expenses to minimize their tax bill.

In order for coins or tokens to have enduring value it is necessary for the issuer to create an ongoing business that is profitable. Creating a business from scratch is not easy. This is why most startups fail. To understand this better, let’s review briefly how successful startups are funded and built.

The usual cycle for building a startup begins with a founder, or a few founders, scrounging for resources to try out their idea. They spend their savings, they moonlight, they look for freebies, they get friends and family to back them, and, in the extreme, they max out their credit cards. With these minimal resources they build a prototype or an experimental service, commonly known as an MVP or a minimally viable product. The MVP is a vehicle to elicit responses from customers that might indicate what type of product customers actually want. The reason the initial product is minimally viable is that you don’t want to spend too much money on it until you know what customers really want.

This idea arises from the aptly named Lean Startup Method, the predominant way in which startups are built today. It urges a series of cheap and quick experiments to find out what type of products or features the market will pay for. Once that discovery process has progressed and a fit is discovered between what the startup can build and what customers are willing to buy, more money is spent on building out the product for the most likely set of early customers. The early customers provide the startup with invaluable data that shapes refinements of its products and offers hints as to how it might address broader markets.

Note that the amount of money investors are willing to provide a startup is based on how much useful data it has garnered from its market experiments. Early on, only friends and family are willing to put money in, and usually it’s not much, because little can be known about the likelihood of market acceptance at that stage. As data about the startup’s ability to build a marketable product grows, it may be able to bring in seed funding from angels or early-stage venture capitalists, eventually venture capitalists and ultimately the public markets. More data brings in more money, which in turn allows the discovery of more useful data, and so on.

With ICOs, the Lean Startup Method for discovering product/market fit is turned on its head. The entity starts off with a big chunk of money, say five to ten million dollars, plus a big incentive to spend it all in the first year. Remember, anything not spent in that tax year is considered taxable income. Rather than starting with small experiments and then increasing the stakes based on favorable results, the founders have all the resources they are ever likely to see sitting in their bank accounts plus their accountant telling them to spend it fast.

No doubt a few prudent founders will choose not to spend it all in the first year and incur the one-time tax bite. These wise founders will put money aside to be spent when they know more about their businesses. My bet is that those founders will be rare. Human nature inclines us to think we know more than we actually do. If you are a founder and you just got a ten-million-dollar haul from a token issue (the kind of money normally available only to startups with a proven record of fast growth) you’re apt to think you know a thing or two. Such a founder is likely to blow the entire wad in one big spending binge and have nothing to show at the start of the new fiscal year.

There will be tears on planet ICO!

ICOs, combined with the tax code, create conditions that make it hard for startups to carry out the laborious and slow process of identifying the fit between product and market. By giving founders a big chunk of money up front and providing a tax incentive for much of it to be spent in the first year, ICOs contravene all the hard-won wisdom about how to build strong companies. If I tried, I could not imagine a worse way to fund a startup.

NB: My critique of ICOs should not be interpreted as criticism of the technology of the blockchain. I believe this technology holds great promise. We are just starting to see some of this promise realized in the area of insurance, funds transfer and voting, to name a few. I note, however, that issuance of a coin or token has not been a crucial part of the uses of the blockchain with which I am acquainted. I have yet to see a token-based implementation of the distributed ledger that would not work just as well in keeping track of balances and flows of conventional currencies.