Initial coin offerings (ICOs) can be an effective approach to start-up financing, argues a paper from the Bank of Canada.
A new staff working paper from the central bank examined the ICO phenomenon that has emerged in recent years as a way for fledgling companies to secure early-stage financing.
While the approach has attracted a fair amount of negative attention amid reports of failed and fraudulent offerings, the paper found that it can actually be the ideal way to fund a company in certain circumstances.
Specifically, the paper looked at how the ICO structure impacts the incentives of entrepreneurs, compared with traditional debt and equity financing, and concluded that it can be the better way to finance a company.
“Our results show that ICOs can have beneficial economic properties when compared with conventional financing strategies,” it said. “For certain projects, ICO financing generates a higher net present value than conventional modes of financing and is sometimes the only profitable form of financing.”
According to the paper, the essential factor is that returns to ICO investors be based on a project’s sales revenue, rather than profits.
“This can make things better in situations where effort by the entrepreneur leads to cost savings rather than higher sales,” it noted, as the benefits of cost savings are entirely retained by the company.
At the same time, the paper also highlighted a couple of unique risks to ICOs, including the risk of market manipulation. “Token ownership needs to be sufficiently widely dispersed to avoid [that risk],” the paper said.
And it points out that it can be difficult to use this method of financing for projects that require large initial investments, as “there is an upper limit on the fraction of future sales that can be shared with outside investors.”
Nevertheless, the paper finds that ICOs do represent a valid alternative financing method.
“When ICOs first broke onto the scene, there was a perception that this was a way for start-ups to raise money without giving away ownership in the company. There was a sense that ICOs allowed companies to obtain ‘money for nothing,'” the paper said.
“Our results debunk this notion by showing that ICO funding generates no additional value beyond the increase in the value that results from a better alignment between the incentives of the entrepreneur and the interests of outside investors,” it concluded.
For full details, read the staff working paper from the Bank of Canada.