Kickstarting blockchain: designing blockchain-based tokens for equity crowdfunding

Entrepreneurship is a desirable goal for economies to foster innovation, stimulate economic growth and create employment [1‐3]. During the early stages of entrepreneurship, funding is often indispensable to drive forward and implement an idea or a project. Therefore, funding as a method of raising capital outside of operating cash flow is of utmost importance to mitigate early-stage companies' operational risks and secure long-term growth. However, entrepreneurs still face various problems during and upon a traditional early-stage funding process, including geographical constraints, exclusive networks, and the involvement of multiple intermediaries [1, 4, 5]. In addition, it is slow and expensive owing to the plethora of intermediaries involved [4, 6, 7].

In an endeavor to improve early-stage funding, equity crowdfunding emerged as an alternative funding tool, reaching a total funding amount of over $1.5bn globally in 2018 [8]. Equity crowdfunding is a crowd-based form of issuing company shares in exchange for capital via an Internet platform giving investors equity-like rights. These rights make equity crowdfunding more similar to the issuance of shares than they mimic the idea of donation- or reward-based crowdfunding [9‐11]. Although equity crowdfunding optimizes prior forms of early-stage funding, it lacks broad liquidity, entails bureaucracy and high administrative costs while still relying on trusted intermediaries, such as centralized platform providers [12‐14].

Initial Coin Offering (ICO) via blockchain technology proposed an alternative approach to traditional crowdfunding and enabled more efficient crowdfunding processes, thus, democratizing early-stage investments [6, 9]. In an ICO, investors generally trade in their cryptocurrency in exchange for a utility token, representing the right to use a particular offered service [15, 16]. Following substantial growth in 2017 ($6.2 bn) and 2018 ($7.8 bn), total funds raised through ICOs decreased to $0.3 bn in 2019 [17]. Consequently, initial enthusiasm has turned into declining investment in ICOs, mainly because of unclear regulation, limited configurability, and insufficient investor protection [18].

The stagnant technological improvement of the traditional funding process and the lack of regulatory compliance of ICOs led to the latest development of Security Token Offering (STO). A security token is a digital representation of particular security issued and managed on a blockchain using smart contracts and computer code that executes arbitrary business logic [16, 19]. Unlike utility tokens, security tokens issued via STOs comply with regulatory requirements by default, grant the token holder an underlying value, and, eventually, present a more matured form of token sales [20‐22]. As such, STOs can be seen as an alternative to equity crowdfunding platforms. Thus, we state that blockchain technology improves the efficiency, transparency, and interoperability of conventional equity crowdfunding. In addition, the configurability of smart contracts allows regulatory compliance and creates liquidity, facilitating trading in the secondary market.

Even though researchers recognize the value of blockchain for equity crowdfunding, theory in this area is limited [23]. In summary, existing research [9, 12, 24] focuses on the potentials of blockchain for equity crowdfunding but lacks design knowledge in this context. However, design theory is a prerequisite to understanding how such systems should be implemented and effectively foster added value [25, 26]. To address this gap, we define the following research questions:

Our research objective is to bridge the identified gap in the IS literature and answer the question by designing, implementing, and evaluating a blockchain-based equity token prototype following the design science research (DSR) paradigm [27‐29]. In doing so, we aim to respond to Treiblmaier et al. [30] call to design a security token and explore its potential to reduce information asymmetries, improve operations, and ultimately allocate capital more efficiently. In addition, we take up the research agenda by Kranz et al. [22] and the call of Perdana et al. [31] and focus on a particular security token, i.e., an equity token. This paper is the first to design a blockchain-based equity token for crowdfunding to the best of our knowledge.

Overall, we seek to make the following primary contributions. First, developing a blockchain prototype will allow us to gain practical insights into the opportunities and challenges of implementing complex blockchain-based solutions, expanding the blockchain-based equity token research and the early-stage funding fields. Second, we seek to deepen the understanding of mandatory requirements and the infinite design space of blockchain-based equity tokens, contributing to design theory in this field by developing and evaluating an instantiation of a blockchain-based equity token for crowdfunding. Third, we extend the crowdfunding model developed by Haas et al. [32] by outsourcing traditional financial and operational services to smart contracts and adding new stakeholders. Fourth, we seek to derive seven generalized design principles (DP) to guide the design and development of blockchain-based equity tokens.

The remainder of this paper is structured as follows: In Sect. 2, we present the principles of traditional early-stage funding and equity crowdfunding, followed by blockchain-based crowdfunding. Next, in Sect. 3, we present our DSR approach, while in Sect. 4, we elaborate on the instance problem, i.e., equity crowdfunding. Section 5 shows the derived software requirements and provides a detailed account of the software prototype development. In Sect. 6, we evaluate the prototype and the research approach. Section 7 generalizes and discusses the results based on both the literature and semi-structured interviews and derives design principles. We conclude with a summary, highlighting limitations and outlining future research directions in Sect. 8.

To develop an equity token, we followed the DSR approach [28, 29, 60]. DSR generally seeks to solve an identified problem in a build-and-evaluate process that ultimately produces purposeful design artifacts [28]. Further, DSR's output can be constructs, models, methods, and instantiations, while a prototype is a typical instantiation [29]. In the end, the derived knowledge should be generalizable and, therefore, applicable to similar settings. To achieve this, we drew on both the early-stage funding and the blockchain literature when developing our blockchain prototype, deriving generalizable knowledge in a two-step evaluation. We addressed the shortfalls of the crowdfunding process and ICOs by developing and evaluating an instantiation of a blockchain-based equity token. We applied Peffers et al. ‘s [61] widely accepted research approach to structure our research (see Fig. 1). We iteratively used the design and development, demonstration, and evaluation steps [60, 61].

The following steps guide this research: Our research is motivated by a lack of knowledge on the design of equity tokens and their applicability. We identified traditional early-stage funding as a practically relevant problem that blockchain technology could improve [5, 7, 12‐14]. We analyzed traditional equity crowdfunding problem areas and the first wave of blockchain-based solutions, i.e., ICOs. Major problems in the traditional equity crowdfunding domain include the credibility of crowdfunding platforms, a lack of secondary market trading, and high administration costs [12‐14]. In contrast, ICOs pose great challenges, including missing underlying value, the need to comply with current regulations, and allowing for higher interventions [52, 54]. To address the identified challenges, we use both the areas for improvement of equity crowdfunding (EC-AfI) and ICOs (ICO-AfI) to derive design objectives (DOs) that an improved solution must fulfill.

Furthermore, we built our derivation of DOs on the literature on equity crowdfunding and blockchain technology and the examination of past ICOs. Accordingly, we elaborate on 14 DOs for the software prototype design, implementation, and evaluation. The DOs were a starting point for the development stage. As is standard in software development, we defined the required data types and the intended solution methods. Based on the defined DOs, we implemented our equity token with additional emission and transaction protocols. We developed the prototype in an Ethereum environment since it is considered a matured platform for smart contract development [62]. Finally, we conducted seven semi-structured expert interviews. This procedure allowed us to get feedback from experts on our reference implementation and the application of blockchain technology for equity tokens, which was fundamental to generalize from an instance solution to an abstract solution (see Fig. 2).

Limitations in the early-stage funding process are regarded as one major constraint for better exploitation of the economic potential of entrepreneurship [1, 4, 5]. In the background section, we point out several problems for early-stage equity funding raised in the equity crowdfunding literature. We argue that blockchain technology—a technology that enables trust among participants and automates business logic [40]—has the potential to address the raised deficits. ICOs promise to offer a blockchain-based alternative for crowdfunding but do not use the tokenization of equity.

As the funding mechanisms show potential for improvement, we derive several AfIs from the relevant literature (see Table 2). To ensure a practical improvement compared to conventional funding, we enrich the shortfalls derived in the literature with case-specific insights from real-world funding. In particular, one of the authors conducted a conventional funding process over twelve months as the leading manager in a startup. Please note that we follow U.S. regulations when considering compliance.

Based on the identified AfIs of equity crowdfunding and ICOs, we followed an iterative cycle of deriving DOs. Thus, a DO addresses one or multiple issues (AfIs) raised in the application domain. We discussed possible DOs internally and with other researchers and finally aggregated 14 DOs for our approach, which directly informs the prototype development like software requirements. For each DO evaluation, we defined criteria to evaluate the goodness of the prototype, an essential requirement for rigor DSR research (see Table 3).

Following DSR, thoughtful evaluation of the proposed design artifact is a key request [28]. The proposed design artifact should demonstrate utility, quality, and efficacy. That is, the artifact solved the intended purpose [67]. The prototype has been fully implemented and deployed on an Ethereum test network, satisfying the core utilities in a testing environment. We proceed with a comprehensive evaluation in two steps to gauge the efficacy; each step broadened the evaluation’s scope [67]. As Gregor and Hevner [27] proposed, we foremost strove for a comparative assessment, analyzing whether equity tokens are beneficial compared to the previous blockchain solution (efficacy). Thus, we applied a criteria-based evaluation and compared the prototype to the addressed AfIs. Finally, we presented our research approach and prototype to industry experts in seven semi-structured interviews to evaluate the quality and derive more general insights.

Our design has introduced an approach for automated, secure, and customized issuance of an equity token on the Ethereum blockchain, aiming to provide a novel approach for equity crowdfunding. Thus, we contribute to the body of knowledge on the developing blockchain-based equity crowdfunding domain [9, 12, 23, 24, 58].

The literature on equity crowdfunding points out that investors only have limited exit options, leading to higher risks and despair [12, 70, 71]. Conversely, our system allows an early-stage company to create and distribute their shares on a primary issuance platform and facilitates interfaces to exchanges for secondary market trading. In addition, investor relationships can be managed by the issuing company on-chain throughout equity lifecycle applications. Since every successful transaction of tokens is automatically recorded, the system provides a complete and tamper-proof transaction history and distribution of the equity token ownership. The system operates without institutional involvement through decentralized protocols and complies with a predefined regulatory framework, owing to self-regulating tokens. We find that by using an instance of a blockchain-based equity token for crowdfunding, the advantages of tokenizing equity can be realized, as demonstrated with our prototype, and therefore agree with Chen [6] and Roth et al. [14].

From a technological perspective, applying blockchain technology in the equity domain constitutes multiple benefits. First, due to decentralized protocols, trusted institutional intermediaries are not necessary to manage the system infrastructure like accounts and transactions, thereby largely reducing friction [72]. Not a single participant in the system needs to be trusted because the inherent consensus mechanism of blockchains ensures the network's administration and follows smart contracts' logic. Inadequate use is still possible but is lowered to a minimum since the deployed algorithms govern human behavior [12, 26]. Second, blockchains' decentralized structure allows us to store all the relevant data on the network's nodes [73]. Thus, our prototype enhanced general reporting and auditability since the nodes store all relevant data transparently and allow regulatory entities or third-party providers to retrieve them easily. Due to its high level of redundancy, the system becomes resilient against potential cyberattacks and prevents single points of failure [26]. The inherent security features of our equity token reduce the trust barrier in crowdfunding, which remained a major concern in traditional, centralized equity crowdfunding [12]. Overall, our system works like a transparency device that assures the availability of a complete, valid, and public record of both historical and present equity ownership, thereby encrypting and attaching key documents (e.g., KYC) [87, 88]. Third, the prototype significantly reduces transaction processing time since blockchain uniquely combines the recording and value transaction. Traditional equity crowdfunding suffers from cumbersome administration processes. These include paper-based documentation and global distribution by mail, which dramatically slows down the transfer of ownership and thus increases dependencies on intermediaries [13, 70]. Our equity token clears initial transactions in seconds, thus fostering the rapid exchange of ownership.

Overall, our understanding of blockchain-based equity crowdfunding differs from traditional equity crowdfunding. Thus, we extend the traditional crowdfunding model proposed by Haas et al. [32] by redesigning the service ecosystem holistically through the introduction of blockchain in the context of equity crowdfunding. Our model extension reveals the elimination of payment providers and banks through blockchain, which now covers all services provided by the former intermediaries (see Fig. 7). To consider the regulatory requirements of equity crowdfunding, we also include attorneys, regulatory authorities, and external auditors as vital stakeholders within the system. We correspondingly note that our model also differs from the one proposed by Schweizer et al. [56]. While there are differences, as Schweizer et al. [56] describe their model in the context of crowdlending, we disagree with the general conception that blockchain entirely cuts out intermediaries and all tasks can be outsourced. In essence, their model shows that smart contracts can be responsible for all services provided by the crowdfunding partner, including crowd activation and customer support.

Although it is theoretically possible to outsource these tasks to very complex smart contracts, we still see the crowdfunding partner as an essential stakeholder to provide the mentioned services. Similar to exchanges providing services on top of ICO tokens, we propose that crowdfunding partners offer services on top of equity tokens, e.g., due diligence. Besides, operations that financial institutions previously managed, such as authentication, custodial services, and dividend payouts, are now automated through smart contracts. Furthermore, blockchain facilitates instant clearance and settlement of payments, removing transaction friction.

Design science should provide archival knowledge [28], and, thus, contributing to design theory is a vital part of conducting DSR [27]. Following Beck et al. [26], we propose design principles (see Table 6) to contribute to the body of knowledge on designing blockchain-based systems [26, 27]. Due to extensive prototyping, rigorous evaluation, and semi-structured interviews, we generalize our findings and thus argue applying equity tokens beyond the equity crowdfunding domain. Accordingly, they could act as comprehensible guidelines for the effective design of equity tokens.

We position our research to fill the gap in the IS literature on the design theory of blockchain-based equity tokens. We used a rigorous DSR approach to the design, development, and evaluation of a blockchain-based equity token prototype for crowdfunding [27, 61]. Thus, we answer our research questions on how blockchain can be incorporated as an alternative infrastructure for equity crowdfunding. In addition, we extended an established crowdfunding model and developed seven principles for the effective design of equity token. Overall, we embedded our theoretical insights in the current academic discourse, thereby following the calls by Treiblmaier et al. [30], Kranz et al. [22], and Perdana et al. [31] to contribute to the design theory on blockchain tokens.

The developed blockchain prototype sought to offer new insights into the design of equity tokens. We designed an instance solution toward the problem areas of equity crowdfunding and ICOs, developing an equity token that covers the entire equity lifecycle. We derived general knowledge that is eventually applicable to blockchain-based equity beyond equity crowdfunding through the development, evaluation, and expert interviews.

We sought to make several contributions to the body of knowledge. First, by focusing on a specific form of company funding and presenting the solution design, we provided an answer to effectively tokenizing equity for crowdfunding. Second, the research process helped us better understand whether a particular type of crowdfunding could benefit from the characteristics of blockchain. Third, we provided an extended model for the blockchain-based equity crowdfunding service ecosystem. Fourth, we derived generalized design principles to guide the design and development of blockchain-based equity tokens.

In addition, our research offered various practical implications. First, early stagy companies can use the source code of our prototype to build an equity token to fund their business, thus, improving the funding process holistically. Second, we showed that certain third parties will still play an essential role in the early-stage funding ecosystem regarding the complex regulatory requirements. Third, the prototype demonstrated how using the token ecosystem could increase the liquidity of equity shares and encourage secondary market trading, opening the equity market to new investors.

Also, this study had limitations. We used the Ethereum blockchain as an instantiation reference. However, public blockchains could function as an infrastructure with improved privacy features and performance. Although we have provided an instantiation example, our design principles required additional validation with qualitative interviews backing our findings. We, therefore, call for future research into understanding the relationships between company funding and the benefits equity can gain from being tokenized. In addition, future design-oriented research could apply our design principles in different contexts, e.g., private equity or venture capital, and can thus assess their general applicability.

Equity token will establish their places in the blockchain ecosystem considering the rapid development and increased interest in the equity token ecosystem. In the following years, we expect that many equity tokens will enter the market. From a technological perspective, equity tokens have substantial potential to improve legacy financial infrastructures vastly. From a business perspective, equity token will facilitate the funding process.