What is an ICO?
What is an ICO?
An initial coin offering (ICO) is a fundraising method for entrepreneurs in which they solicit funds from investors in exchange for coins or tokens related to the project to be released at a future date. The term is derived from initial public offering (IPO).
Unlike IPOs, initial coin offerings do not have extensive disclosure and documentation requirements. In some cases, a white paper detailing the idea for a product and its associated token is all that’s required to conduct an ICO. The relative simplicity of ICOs makes it easier and cheaper for entrepreneurs to raise capital from investors. ICOs claim to democratize investing by offering regular people the chance to invest in products and services related to an emerging technology.
Initial coin offerings are similar to raising seed stage venture financing, but ICOs do not require entrepreneurs to give up equity in order to raise capital. Instead, they offer tokens or coins to investors in exchange for capital. These coins or tokens can be of two types: utility tokens and security tokens.
Most ICOs are for products and services related to the nascent cryptocurrency and blockchain ecosystem. Among the world’s first ICOs was Mastercoin, which was a protocol built on top of Bitcoin’s blockchain. EOS, the biggest ICO of all time to date, raised $4 billion from investors in 2017 for a new blockchain for smart contracts. (EOS is being positioned as an alternative to Ethereum’s smart contracts. Ethereum itself conducted an ICO for Ether, its cryptocurrency, in 2015 to bootstrap funds for further development.)
Despite the recent popularity of ICOs, the 2018 cryptocurrency bear market has significantly impacted the market for this type of funding. According to research from Ernst & Young, 86% of the 141 biggest ICOs from 2017 are trading below their listing price and 30% of ICOs have lost all value.
How Initial Coin Offerings Changed the World In 2017
ICOs had fairly modest beginnings. Based on data from Coindesk’s ICO tracker, only seven ICOs were held in 2014. That figure stayed consistent the following year. By 2017, however, development of new technology coupled with mainstream awareness resulted in an explosion of ICOs — the Coindesk tracker lists 346 ICOs in 2017. The amount raised by ICOs also skyrocketed; by the end of 2017, research firm Token Data reported that ICOs had raised $5.6 billion.
The popularity of ICOs can be attributed to several factors, among them the development of ERC20 token standard, a computer protocol that enables easy setup and deployment of tokens on Ethereum’s blockchain. First proposed in November 2015 by Fabian Vogelsteller, the ERC20 token standard made it easier for startups to conduct an ICO by facilitating easy distribution of tokens to investors through smart contracts. As of this writing, there are 160,382 token contracts on Ethereum’s blockchain. Similar token protocols exist on other blockchain networks, such as Stellar.
The development of an ecosystem for marketing and regulatory compliance for tokens helped further the ICO boom. Some advisory firms offer turnkey solutions to entrepreneurs interested in conducting an offering. The range of services includes marketing to investors and the media, escrow services and clarifying the legal status of cryptocurrency tokens. This has streamlined the process, making it easier for entrepreneurs to raise funds from a more diverse constituency — everyone from first timers to accredited investors.
The attraction of ICOs for investors lies in an offering’s ability to multiply their investment and generate profits. Early investors in ICOs are typically offered tokens at a discounted price. Thereafter, a liquidity event, such as listing of the tokens on a cryptocurrency exchange, is generally accompanied by a bump in its price. The amount raised by ICOs reached a peak in March of 2018, when offerings surpassed their fundraising totals for 2017.
Regulatory Status of ICOs
Simplicity is a major appeal of ICOs, but the tradeoff is a lot of legal gray area. In an effort to stem the growing popularity of cryptocurrency, regulatory agencies in China banned ICOs in August 2017; other countries have been largely silent about the status of such offerings.
The United States Security and Exchanges Commission (SEC) has been conspicuously quiet. Historically, the agency has used the Howey Test to determine whether a given token qualifies as a security. The test, which was established in 1946, is based on three criteria: the establishment of a common enterprise, expectation of profits by investors and use of a third-party foundation to promote the enterprise.
While the Howey Test has proved to be an effective evaluation tool for the sale of common securities, its use in ICOs comes with added complications, because ICO tokens can be classified as utility tokens or security tokens. As it stands, registering a utility token incurs significantly fewer fees and disclosures.
As its name indicates, the security token is used by investors to generate profits from their investment in the blockchain, rather than to pay for goods or services within an ecosystem. ICOs have managed to circumvent securities laws by declaring their tokens to be utility tokens, which allows companies to escape the expectation of a profit requirement, one of the key determining factors for a token to be classified as security. In turn, this substantially reduces costs and paperwork required in the registration process.
More recently, however, the SEC has become increasingly vocal about its thinking with regard to the status of tokens. SEC Chairman Jay Clayton declared earlier this year that every token he had seen was a security token. Additional actions by the federal agency — whether they relate to warning investors about ICOs or cracking down on suspect ICOs — have also sounded the alarm for entrepreneurs interested in tapping into the ICO craze.
By refusing to concretely clarify the status of tokens, the SEC has magnified regulatory risks for such offerings. In response, entrepreneurs have developed novel methods to distribute their tokens. The Safe Agreement for Future Tokens (SAFT), for instance, allows for the “evolution” of a token from being a utility token to a security token.
Meanwhile, Security Token Offerings (STO) are a modification of existing token offerings that allow for the sale of tokens already deemed securities.
Who Can Conduct an ICO?
Anyone can stage an initial coin offering, but most ICOs are launched by entrepreneurs interested in raising capital for a product idea. In the early days, when the market was hot, successful ICOs could raise millions of dollars with nothing more than a white paper with big promises. As the ICO market has cooled, however, investors and buyers expect more than just a white paper.
There are two main benefits of conducting an ICO. The first is convenience. As described earlier, ICOs can be launched without the extensive documentation, disclosures and regulatory red tape associated with IPOs. The second benefit of ICOs is that they enable product traction.
Utility tokens are generally used within a platform to accomplish a task or a transaction. Through token distribution, entrepreneurs can ensure initial traction for their product. For example, the token in Filecoin, which raised more than $257 million in its offering in 2017, is used to store or distribute data on its storage platform. For other organizations, ICOs offer an opportunity to raise money to test out new products or features.
How Can I Spot a Good ICO?
There are no established frameworks for evaluating ICOs. While they resemble an IPO in public markets, ICO investing is more similar to venture investing. The parameters that make for a good venture capital investment also hold true for ICO investing.
In Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond, coauthors Jack Tartar and Chris Burniske make the case that the tools of fundamental analysis, which are used to evaluate stocks, can also be used to test the effectiveness of an ICO, albeit allowing for adjustments relevant to the medium.
Evaluating market opportunity as well as an understanding of the product and the problem it intends to solve are key to understanding the ICO market. The product team and its history of executing projects should also be evaluated. But, white papers, which are exclusive to ICOs and intended to outline the product or system idea, are also extremely important to consider. Especially given that, according to research released last year, half of ICOs die within four months of being launched.