Do you know that you have a great startup idea that just needs capital, but are unsure how to get your vision funded? While raising venture capital is still the established route to raise funding, blockchain is becoming another viable source of capital for entrepreneurs. Blockchain technology and startup founders can be a good match: both are innovative and seek to disrupt the status quo.
To get you started confidently in exploring blockchain-powered technologies as a funding mechanism, below is a step-by-step process to help you understand how to harness the power of blockchain in startup fundraising.
Beginner Blockchain: Start Here
The place to start with blockchain is to first establish an understanding of the technology itself. Blockchain is often referred to as a new kind of “digital ledger” or record-keeping system that is stored across a distributed system. In this way, blockchain solves many issues of the traditional single-source ledger, including risk of error or corruption.
NOTE: If you’re new to the lexicon of blockchain technologies or haven’t heard these terms before, check out our quick explainer here first. You may also be interested in reading our webinar recap about what the co-founder of Ethereum says the future of blockchain means for entrepreneurs.
Sean Williams of Motley Fool describes blockchain simply this way:
It's a brand new way of transmitting money without the need for traditional banking networks, as well as a means to store data in a transparent and unalterable way.
This framework for transmitting money is what powers cryptocurrencies like Bitcoin and Ethereum. But as our explainer piece outlines, the potential for blockchain technologies are much bigger than cryptocurrency alone.
Why Harness Blockchain for Fundraising?
Given that blockchain enables banking outside the traditional networks using cryptocurrencies, it also allows startup founders to raise money outside of the usual pathways. This can be good news for some founders, because blockchain can put added control back in the hands of the entrepreneur.
Three Letters to Know: ICO
So how exactly can blockchain be used as a source of funding? The key is the “ICO” or Initial Coin Offering.
Remember that digital coins are what is actually created and exchanged on blockchains. These coins are particularly powerful because they can be sold to investors at an Initial Coin Offering.
If this acronym sounds only vaguely familiar, it’s because an ICO draws deliberate similarities to an IPO, an initial public offering. Instead of buying stock however, when someone invests in an ICO they receive a digital coin, often called a token.
Michael Hiles is the Director of the Cincinnati Founder Institute and the CEO of 10XTS, a software company specializing indistributed ledger technology and enterprise blockchain development. Hiles says the single biggest game-changer for startup funding has been the rise of the ICO. Today Hiles is focused on helping new businesses to raise capital using blockchain in a legally compliant way, and he summarizes the ICO as a “special kind of crowdfunding.” The video below is taken from a portion of a presentation Hiles gave to the Founder Institute (with the full video at the bottom of this article).
Token Typologies
Before we move into the ICO launch process, it is important to mention the three types of ICO tokens: currency, utility, and security.
- A currency token is one that has a corresponding “fiat” value. Bitcoin is an example.
- A utility token is a hybridized token that has a stored value based on economics of supply and demand. Utility tokens are typically used for things like in-app purchases. An example is Ethereum.
- A security token represents real-world securities or assets. A security token can be efficiently fractionalized and can represent ownership in a fund. Examples of security tokens include Blockchain Capital (BCAP).
Of the token types, Hiles recommends using the security token, as it sets you up for the most alignment to current and future SEC regulations.
Planning & Executing an ICO
Follow this validated step-by-step approach that Michael Hiles, CEO of 10XTS, successfully developed for entrepreneurs.
We’ve set the stage, and now it’s time to for the headliner: planning and executing an ICO to fund your startup.
This guide is focused on regulation-friendly blockchain funding. We’re sharing insider knowledge on the best way to set up a business, while adhering to the rules associated with blockchain ICO fundraising. However, this guide should not be misconstrued as a substitute for legal counsel, and all entrepreneurs should speak with their advisors and an attorney familiar with their own specific businesses.
Incorporate your business in Delaware.
The first best practice Hiles recommends is to incorporate your business in the State of Delaware as a C Corporation. Delaware is widely considered to be the most pro-blockchain state, as well as the state offering the regulatory structure most familiar to traditional investors. In 2017 the governor of Delaware signed legislation making it legal to use blockchain for stock trading.
We highly recommend seeking an attorney with blockchain and cryptocurrency exposure to guide this step. There are specific attorneys and law practices that focus solely on blockchain law and regulations. Business Insider published a list of trusted blockchain lawyers. As a benchmark, Hiles estimates spending around $100k for legal setup and planning.
Create, Promote, and Sell Your Tokens
Once you’ve established your regulation-aligned business in Delaware, you’re ready to create your your specialty token. During this phase, you will raise excitement and awareness for your ICO, just as you would in any non-ICO fundraising effort.
Once you’ve driven enough awareness and buy-in, investors will purchase your ICO tokens. Upon purchases of your token, your business receives the purchased amount in the form of a currency token like Bitcoin or in the form of a smart contract. This capital can then be used to fund the growth and momentum of your project.
Tip: The Importance of Ambassadors
Don’t just “sell” your token, think about the ICO process like building a network of ambassadors. Why do you need ambassadors? Ethereum, the most successful ICO to date, attributes much of their success to creating a sense of community and investment among early adopters.
When you develop your marketing plan, it should include frameworks to serve your token investors a premium experience. Ways to foster ambassadors include: building an email list, periodically sharing product updates, giving token owners exclusive access to the behind-the-scenes of your launch.
Sell the next round of shares as a Regulation D offering to accredited investors only.
Once you’ve successfully completed the initial sale of your token, you move to the Regulation D offering phase. The purpose of raising Regulation D funding is to ensure that it will convert to Reg A Tier 2 offering and eventually a tradable token.
In the Regulation D step, you must sell to accredited investors only. Recall accredited investors have a net worth of $1 million or more, not counting the equity value of their primary residence, or who had an income of $200,000 or more for the previous two years or $300,000 as a couple.
Typical investors in the Regulation D phase include Angel Investors, VC funds, and more traditional startup investment groups.
At this stage, you will have the benefit of an already-established group of investors from the initial coin offering.
Use Decentralized Peer-to-Peer Trading of Assets.
Ultimately, once you complete your Regulation D round, your token has blazed a trail to be used as an internal, tradable token.
At 10XTS, Hiles uses a global peer-to-peer trading system for any asset class token. However, Hiles argues that trading should occur on new blockchain ecosystems, free from regulatory uncertainty and legacy issues that may plague some legacy trading systems. Your peer-to-peer trading system needs to be fully decentralized to deter hacking. He cautinos to avoid centralized exchanges, because they are historically at risk for security breaches.
At this stage, if you successfully follow these steps you will have an internal tradeable currency.
Continue the Momentum
Sales: Blockchain Asset Tokenization Without Code
Hiles recommends that your system should always be asking “Can these two entities engage in this specific transaction?” To assure this, you need to have the following in place:
Regulatory Controls – VERY IMPORTANT
Along with understanding blockchain technology, it is important to spend a significant amount of time educating yourself on regulatory controls like KYC and AML.
As more and more attention shines on blockchain and ICOs, regulatory scrutiny will also grow.
KYC/AML – Know Your Customer and Anti-Money Laundering
The first area to understand is Know Your Customer (KYC) which encompasses the due diligence that financial institutions must complete in order to secure relevant information from their clients to conduct business with them in a trusted way. KYC also applies to bank regulations governing these protocols.
KYC is not only used in the realm of blockchain and ICOs. It is employed by all types of companies to ensure across-the-board anti-bribery compliance. Compliance and security are paramount concerns and financial institutions, credit agencies, and insurers are holding fast to strict regulatory requirements to enforce anti-corruption and due diligence.
Why Care About KYC?
The holistic goal of KYC is to emphasize the need for institutions to clearly understand their customers, their finances, and their professional behaviors. Adherence to KYC prevents suspicious transactions and other regulatory problems. Financial institutions and regulated companies are held responsible to enforce Know Your Customer and all the procedures within KYC.
The more you emphasize KYC in your ICO development, the better chance you have of being in compliance with regulations.
KYC Recommendations
KYC controls include the following requirements. As you plan your ICO, refer to these requirements repeatedly to ensure there are no gaps.
- Collection and assessment of identity information usually with a Passport or government-issued ID. This identity information collection process is called “Customer Identification Program” or CIP.
- Name matching against lists of known parties, including “politically exposed persons” or PEP.
- Evaluation and determination of the customer's likelihood to commit crimes like money laundering, terrorist finance, or identity theft.
- Creation of an expectation of a customer's transactional behavior.
- Monitoring and cross-referencing a customer's transactions against their expected behavior.
KYC Jurisdiction and Locality
To make things more complicated, KYC regulations are local and vary by country and locality. KYC Jurisdiction is enforced on a country to country basis. We recommend reviewing your KYC regulations based on your country or the country where you intend to conduct business: http://kycmap.com.
The complexity of regulations is another reason why hiring a lawyer with blockchain competency is paramount in the planning phases of your ICO.
KYC and Cryptocurrency Exchanges
When your token is ready to be sold, this will be done on an “exchange.” Be strategic and cautious in your choice of exchange. Research cryptocurrency exchanges thoroughly, specifically diving into the exchange’s KYC and AML policies.
Here’s a list of exchanges with relatively strict KYC policies:
AML and what you need to know for your ICO:
AML means “Anti-money Laundering” and is a set of regulations designed to prevent illegal money-making activities. Money launderers typically hide their illegal activities by creating the illusion that their money is coming from legitimate sources and actions.
FinTech weekly summarized KYC and AML nicely this way:
If an ICO project has a strong KYC during the token generating event — it’s a sign of legitimacy for banks. It means that such projects won’t find it difficult working with banks and following AML regulations.
Who has to enforce AML?
For a historical context of money laundering, the creation of AML regulations occurred in response to mounting concern over money laundering. The Financial Action Task Force on Money Laundering (FATF) was first founded by the G-7 Summit in 1989.
The Task Force examined money laundering practices and reviewed the actions which had already been taken at national and international levels, and defined the lengths that still needed to be taken in order to effectively fight money laundering. In 1990, the FATF issued a report containing a set of recommendations and a plan of action needed to combat money laundering.
The FATF challenges all countries to implement tight regulations in their national systems to prevent money laundering and terrorism financing. Financial institutions and regulated companies must enforce and implement AML policies.
AML Jurisdiction and Locality
Like most financial regulations, they are country specific. Some countries choose to make AML streamlined by inheriting their AML policies from the FATF. Other countries choose to create their own policies and reconcile them with the FATF recommendations.
In the event that a country refuses to model after the FATF policy guidelines, that country is excluded from membership, which creates major complications to access the international markets and financing.
You can review here which countries are FATF members: View the full list of FATF members.
AML and Bitcoin Exchanges
Exchanges (*currently, as of January 2019) in AML compliance:
The Bottom Line: ICOs Must Inspire Trust
Following KYC and AML regulations is crucial for an ICO, because following regulations shows transparency and competency. These rules help minimize criminal acts and protect backers.
We hope the process of using blockchain to fund your startup helps you more confidently move toward your launch. The key is to hire the right legal representation upfront and follow regulations as closely as possible to the letter of the law.
For further inquiry into how this process works, Michael Hiles has shared his experience with ICO funding in the video below, where you can learn how his team successfully used each of these steps to raise funding through blockchain.
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