ICOs to Raise Debt, Not Equity - An Alternate Funding Strategy
So I was reading this post by @buggedout where he is making the point the traditional stock markets are pretty much unnecessary now that decentralized exchanges are a thing. And he's right.
A company can create a token on a platform like ethereum (or soon eos or soon STEEM with SMTs). That token would represent a fractional share of ownership in the company just like shares on the NYSE or NASDAQ or DAX or FTSE do. There would still be market makers. There would still be a bid-ask spread. Pretty much the only things that would change would be fees would be MUCH lower and national securities regulators would have a harder time cracking down on people. That of course would have its pros and cons. Way more opportunities, but also way more scams.
By complete coincidence, I saw a post this morning from @buildteam talking about how they use their own token to reward stakeholders. This is a great example of this new model.
The Idea
As I am wont to do, my mind started wandering on the topic. Equity is always messy. You're an owner in a venture that you may or may not have any influence over. You don't really have any security at all because your recourse is more or less zero if things go south.
Debt, on the other hand, is much cleaner. Part A loans funds to Party B. Party B promises to pay back Party A according to terms laid out in the contract. If Party B defaults, Party A can at least theoretically file suit and get a judgment against Party A. Collecting can be a different story, but it's at least possible.
Consequently the debt market is several times larger than the equity market.
So why couldn't someone issue an ICO as debt instead of equity?
For this thought experiment, I'm going to use the ethereum platform, but there are lots of different ways this could work depending on what platform you are using and the underlying technological possibilities.
The Math
Say I want to raise some funds to start my new company, ClevelandSteemers. I need 100k USD to get off the ground. I've already hit up my family and they won't talk to me any more.
But the business idea is sound, I've had experience in this type of business before, so chances are better than average that it will work. And I'm willing to promise whoever lends me the funds that I will guarantee simple interest payments quarterly at 15% APY in ETH.
So I create a token and a contract on ethereum. I create 100k CS tokens with an ICO price of 0.00147 ETH / CS.
( 0.00147 ETH / CS x 100,000 CS token supply x 680 USD / ETH = 100,000 USD )
Now interested parties can go and send ETH to my account and in exchange receive CS tokens. I now have 147 ETH to fund my grand venture, and the buyers have CS tokens which guarantee them a stream of payments, cumulatively 5.5125 ETH per quarter.
The Aftermath
I go off and do ClevelandSteemer operations, start making some profits and pay 5.5125 ETH per quarter to all the addresses that hold CS tokens, apportioned by wallet balance.
Depending on the terms of the contract, I might have the option to call the debt back and reduce the total outstanding token supply. Perhaps I have this option once a year to pay back principal. Or maybe it's set up on an amortizing basis where principal payments are made each quarter and lower the total supply of CS tokens each time. Whichever way, the terms are specified in the original contract.
The cool thing that happens though is the same thing that happens with all ICOs. A market forms. So maybe you loaned 10 ETH, which translates to 6802 CS tokens receiving 0.375 ETH every quarter. But you need some funds for something else. So you could sell some or all of your CS tokens to another party who wants the 0.375 ETH quarterly income stream.
The market price of CS tokens will vary depending on several factors: how many payments have already been made on time, overall business prospects, the principal's trustworthiness, and the general sentiment in the crypto market. If we were to get another bull FOMO run like in December 2017 - January 2018 the price of the loans could take off.
The Summary
I think issuing ICOs as debt has a lot of potential. Regulations are much easier, the relationship between parties is much clearer, and the recourse on the part of lenders is much stronger.
Depending on the platform, I can imagine staking functions where profits coming into the business would be held in an escrow account so that lenders could see the funds with which they will be paid back.
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I think there's a market for someone to find a blockchain method to improve bankruptcy reorganization. You might need that before the debt issuing, though.
The key thing with bankruptcy is that if all debts are recorded on the blockchain (or at least the secured ones), then there is no question as to who the creditors are, how much they are owed, what their seniority is, etc. So it would simplify a lot of the process.
Come to think of it, you could turn unsecured debt into secured debt by issuing a class of tokens. So if a business buys 10,000 of inventory on net-90 terms then the business could issue a corresponding amount of tokens to the vendor to be reclaimed when the bill is paid. That would probably require that the vendor be paid in crypto in the first place though.
Hi, this is not really how equity and debt works. Equity holders have every recourse to a failed business. However, they come lower down in the capital structure meaning they will get what is left after debt holders have been paid off. When you own equity, you own all the assets. When a company fails, its mainly because, they face a liquity crunch, so whether you hold debt or equity, you basically hold a failed asset. If the company had no debt, equity holders will get all the salvage value.
Tbh, I read an article a few months ago written by someone who worked at the IMF, who had discussed the potential of blockchain and its application for debt markets. What blockchain can achieve is get rid of custodians/agency banks as they can be replaced by smart contracts.
The real question with debt is how to determine a coupon that accurately reflects the riskiness of that business. Debt does not have unlimited upside like equity because risk associated with a venture cannot go to 0. Even the likes of apple and google have to pay interest that accurately reflects the risk that the markets assign to them.
Coding everything on a smart contract isnt the real problem here. Its determining what numbers to code. And equity is not messy. At present icos are risky because they circumvent the law and are neither equity nor debt. You can have a separate class of equity that mimics debt and pays a set dividend.
Eventually i do think that traditional markets will move to a blockchain because it makes life easy and fast for people to invest and raise capital. But there are other multiple problems with blockchain based companies today that make both equity or debt ico risky.
Debt 😊
Great post! A consideration for the issuer though is the fixed payment in ETH. If ETH moons, the cost of that capital increases substantially so it may be better to pay in the token issued or a stable token. Very interesting concept as the potential is great.
Yes, there will be exchange risk if you are using something like USD as your monetary base and dealing in ETH.
Could be interesting is the stablecoin has come sort of scandal and crashes in value 😂 Tether went through something like that a few months back (related to Bitfinex). I guess that as crypto markets mature that sort of risk will diminish. I like the underlying idea of the original post.
It's an interesting idea. For me it comes down to being able to collateralise assets against the debt. I believe the SALT project is heading in this space if you are not familiar with it.
When I saw your title I thought you were going to write about the bond market. I think debt is harder and more complicated than equity (the opposite of your view) but still do-able.
A debt based ICO would be equivalent to corporates. That's what I was alluding to when I was talking about the value of the interest payments changing the price of the tokens.
I didn't want to get into all the terminology. My main point is that everyone thinks about them in terms of equity, but that's not a requirement.
Interesting, I thought the same thing :-)
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