An initial coin offering (ICO) is a popular fundraising method for cryptocurrency projects that involves creating a new cryptocurrency or crypto-token and trading the newly-minted tokens or coins for established cryptocurrencies, such as Ethereum and Bitcoin. Learn more.
Before the advent of cryptocurrencies, startup businesses had limited options for raising equity. In many cases, their best option was to approach one or more venture capitalists and ask them for startup capital. For larger private companies that were attempting to go public, this process would take place using an event known as an Initial Public Offering (IPO). In an IPO, an investor offers shares of their company (an equity stake) in return for cash.
In recent years, however, startups are taking a new approach to raise funds called an Initial Coin Offering (ICO). Instead of issuing shares of their company in exchange for fiat currency (e.g. U.S. dollars), they offer virtual tokens in exchange for an investor’s startup capital (usually delivered as cryptocurrency such as Bitcoin or more commonly Ethereum).
The primary risk of investing in an ICO is that in a traditional initial public offering, an investor receives something of tangible value (i.e. an ownership stake in the company) for their investment dollars. With an ICO, investors receive something that has no tangible value – at least not initially. An ICO investor is gambling (yes, gambling) that the currency they “own” which at the moment has no value will increase in value and allow them to make a lot of money. The ICO market also has few, if any, regulations. Since literally anyone with an idea and the technical know-how to create an ICO can initiate one it is up to the individual investor to perform their due diligence on every ICO.
Throughout history, startups have come up with new and innovative ways to raise funds to help launch their businesses. One of the latest and most popular fundraising strategies for today’s startup companies is the Initial Coin Offering (ICO). In this article, we’ll break down what an ICO is and how it is different from an Initial Public Offering (IPO). The article will also go over a step-by-step process on how an ICO works and review some of the common risks involved in an ICO.
What is an Initial Coin Offering (ICO)?
An initial coin offering (sometimes called a token offering) is a crowdfunding tool whereby an investor gives a business an existing cryptocurrency (usually Bitcoin or Ethereum) and in some cases traditional fiat currency (i.e. U.S. dollars) in exchange for tokens. These tokens represent a piece of the underlying money supply for the technology project.
For example, let’s say an individual has an idea for creating a digital and encrypted payment system for the secondary ticket market. For this idea to work there has to be a new cryptocurrency. In this case, we’ll call it TixCoin. But since TixCoin is just an idea and not an actual asset, it has to be created. The individual or development team will set up an initial coin offering that will let them raise money to make TixCoin (which like any cryptocurrency is just software) without giving up any ownership stake in the company. This is important for many ICOs because in many cases the business cannot exist without the new currency. ,
Interested investors will send the developers either an existing cryptocurrency (Bitcoin, Ethereum, etc.) or traditional fiat currency in exchange for tokens which can be exchanged for TixCoin. The investor is speculating that TixCoin will get used a lot. The high circulation will raise the value of the currency which will make it profitable for the investor.
How does an ICO work?
Several steps are common to just about every Initial Coin Offering. They are:
- The development team for the startup proposes a viable blockchain project. Blockchain is the technology that is a key component to any ICO proposal. The decentralized, record-keeping technology provides accurate, secure data storage on a digital ledger. Any new project that is requesting an ICO has to have a viable project that would use the new cryptocurrency.
- The developers will also provide a white paper that explains the technical specifications, the business model, how the company plans to generate revenue, and future opportunities.
- In some cases, particularly for more complex ideas, the developers may include a working prototype to help potential investors better understand the project.
- The team markets the ICO through online avenues such as social media and blogs.
- The team provides information regarding the number of tokens that will be available, the price and utility of the tokens, and a maximum target price.
- The ICO is launched and coins are distributed to bidders.
- Once the ICO is complete, the tokens are made available to trade on a cryptocurrency exchange.
Initial Coin Offerings entail a high degree of risk
Our TixCoin example above illustrates the risk and potential reward of an ICO. As an investor, you are buying the tokens before a company has built the underlying technology. If TixCoin takes off and is well used, then the value of your TixCoin should correlate with the value of the business.
However, when you consider that most IPOs fail even though there is regulation in place, you can imagine the risk for an ICO that is highly unregulated. Remember this; an ICO is about launching a cryptocurrency. It is not about getting seed money for a bakery or a restaurant. Investors own a piece of a future technology ecosystem. Therein lies the risk.
In a traditional IPO, an investor gives the startup money in exchange for something tangible, an ownership stake in the business. Many investors in these startups will not only provide the funds, but they may also want a say in how the business is run.
In the case of an ICO, things get a little more complex. In the first place, an investor is not getting an ownership stake in the business. What they are getting is a currency that, at the moment of the ICO, has no value. The hope is that the business will thrive and the value of their new cryptocurrency will increase in value.
Another risk of Initial Coin Offerings is that there are few if any, regulations on an ICO. Anybody with an idea for a cryptocurrency project can issue one. With the proper technical set up, there’s nothing to stop an individual from creating an elaborate plan that makes it appear they have a great business idea when in reality all they are looking to do is make off with investors dollars.
How to research an ICO
Without a regulatory authority in place, the only recourse for investors to protect themselves from a fraudulent ICO is to do meticulous research on the company. In many cases, this will involve scrutinizing the white paper (a white paper that lacks a lot of detail is a red flag), digging deeply into the team members, keyboard members or investors. In this information age, prospective employers can find out a lot about you just by running a Google search. The same is true of anyone looking for your investment dollars.
There are third party resources such as Coinschedule.com that list ICOs only after they have reviewed them and found them to be legitimate opportunities. While this does not mean that there is no risk to the ICO, it can help narrow down your list of prospective opportunities.
What does the future hold for ICOs?
Today there are over 3,000 cryptocurrencies. However, only about half of these are available through exchanges. In December 2017, the SEC classified tokens from ICOs as securities. At that time, SEC Chairman Jack Clayton said, “a token constituted an investment contract and therefore was a security under our federal securities laws. Specifically, we concluded that the token offering represented an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”
With a statement like that, it’s clear that the SEC will be looking to take an active role in regulating ICOs that are deemed to be misleading.
The final word on Initial Coin Offerings
Blockchain technology is changing the digital economy in exciting new ways. As the underlying technology behind cryptocurrencies, blockchain is allowing entrepreneurs to create new cryptocurrencies as the underlying technology for their projects. To fund those projects, developers are turning to Initial Coin Offerings.
No investment is without risk, but an ICO is a speculative investment at best. Many Initial Public Offerings (IPOs) fail. And with over 3,000 cryptocurrencies in existence, and more being created almost daily, there is a high probability that any give ICO will fail. However, unlike an initial public offering (or IPO), an ICO leaves an investor with no asset of tangible, or intrinsic, value. There is a possibility of the investor recouping their investment multiple times over. However, there is also the possibility that the project – and the cryptocurrency that supports the underlying blockchain application fails.
The ICO market is also currently unregulated, although that may be changing. This means that aside from the inherent risk that exists with any new business venture, the ICO market is susceptible to scams. Sites like Coinschedule.com can help guide investors to ICOs that have a higher likelihood of being legitimate.