What’s an ICO – and why should you care?
An Initial Coin Offering is a crowd-funding event for a startup in the blockchain arena. It is, in fact, a way for companies to raise funding without giving up stock and control to outsiders. For investors, it is a method of investing early in the future success of a product or service by buying its tokens.
Consider how money is traditionally raised. For companies that operate in more traditional ways, funding is obtained in a few, age-old ways: from banks, from friends, through peer-to-peer lending, through donations, from venture capital firms or from private investors (angels), usually in exchange for equity. More recently, crowdfunding (of the Kickstarter variety) has offered the possibility of supporting the development of a promising product or project by pre-buying into the product or project.
ICOs are at the intersection of traditional fund-raising, crowdfunding and the revolutionary possibilities offered by blockchain technologies. What they do differently revolves around these tokens. But what are they, really?
Tokens are digital assets built on top of a blockchain, which can be used on the internet – transferred, traded etc. – without the need for consent or supervision from a third party, as in the case of banks or regulators. We will discuss them in more detail later on.
Although the name is obviously a play on the Initial Public Offering, ICOs do not surrender equity, and investors do not get a say in how the company is run or where the money goes. The tokens that investors buy are a proof of interest and trust, rather. They signal faith in the potential of the proposed product of service, and interest in using it in the future. Once you do get them, there are several ways to use them: use them to access the product or service, trade them and cash out, or hold until they (hopefully) appreciate and you can sell them at a higher profit.
2. A very brief history
Tokens are a very new type of digital asset. They are all derived from the mothership: the initial Bitcoin philosophy and technology. Starting from the technology powering Bitcoin, other types of blockchain were created that allowed for different types of appcoins or tokens or cryptocurrency – the names are somewhat interchangeable – that can be used across various platforms as digital currency.
Somewhere in between a crowdfunding campaign, an IPO and an entirely new thing, ICOs first appeared in the blockchain space in 2012, when Mastercoin, now renamed Omni Layer, published a whitepaper describing the way in which “smart contracts” could be used to create new applications on top of the existing blockchain technology. To fund the development, JR Willet, owner of Mastercoin, also devised the basic ICO principle: in 2013, he offered 100 Mastercoins in exchange for every Bitcoin he received. He raised about $500,000, an impressive feat at the time, and thus offered a proof of concept for the idea of what was to become the ICO.
However, the actual real-life use case for such potential only became apparent with the rise of Ethereum, a blockchain platform with a new codebase that revolutionized the idea of smart contracts and provided a much easier way to create tokens through its ERC-20 protocol. Ethereum’s own ICO raised about 31,000 Bitcoin, which even then were quite a smash hit.
3. ICO structure
In order to go out and attract investors, startups must have what we might call an ICO kit, i.e. a few things that are virtually indispensable: a white paper, a convincing list of team members, a marketing strategy, a roadmap, an ICO strategy – how to divide the tokens – who gets what and when, how long the pre-sale and sale, capped or uncapped etc.
Once the kit is in place, the actual ICO can be set in motion. From the very basic first ICOs, a more standardized and complex structure developed, which allowed for preferential sales, staggered sale processes, varied time and price thresholds etc. Today, whatever the company behind it, most ICOs (though by no means all) have a similar structure.
Private pre-sale rounds
This is not really part of the ICO as such, but rather a preliminary motion. The company will want to first approach the big investors, that may significantly ease the financial burden without the hassle of a public ICO. So, if they are sufficiently confident they can catch the eye of the whales and VCs, startup owners will first give them a couple of pre-sale rounds. Sometimes that’s all it takes, and the company need never even go public. Telegram, for instance, raised $1.7 billion through private sale only and cancelled its planned public ICO.
This is the stage at which you, as a potential investor, are most likely to catch wind of the startup and want to get involved. The pre-sale stage is set at a given time before the “crowd sale”, usually about a month, and often comes with a bonus for early investors, i.e. usually significantly cheaper tokens. If you want to participate, you will most likely have to submit some personal information by joining a whitelist. The more compliant the startup is, the more you’ll have to observe its KYC & AML requirements (Know Your Customer and Anti-Money Laundering). This can range from your email address to uploading a personal document. If you are in countries that forbid ICOs (for instance China), you may not be allowed to participate.
This is the last stage and the moment of truth. If there was no pre-sale or you just missed it, this is when you can invest. In some cases, if there is a certain hard cap to be made, the sale can last minutes -or hours; if not, or the hard cap isn’t met so soon, it could last for a month or five, whatever interval the owners have preset.
The practice has changed over the past year or so, from short ICOs to longer and more complex ones, lasting well over a month, with private sales and/or staggered discount plans. No wonder most fundraising now comes from private investors. Pre-ICOs are also useful because companies can raise funds to proceed with the next stages, including marketing.
Other changes to the way ICOs are done include interactive ICOs (i.e. no private sales and allowing investors to keep their bids if satisfied or withdraw their bids if the sale price goes too high) and airdropping (the practice of offering giveaways).
4. Types of tokens
With so much being made of crypto’s resistance to regulation, it was only a matter of time before regulators took the challenge and started looking into ICOs. The scrutiny has forced the ICO industry to clarify, to some extent, the type of tokens it creates.
In the US, tokens are evaluated according to the Howey Test, which, to simplify, consists of a four-point checklist.
– It is an investment of money. Depending on what you define as money, that may or may not be the case with ICOs.
– There is an expectation of profits from the investment. That, again, depends on what you mean by profit. There may exist a benefit “in kind”, for instance right-of-use for a certain product, as well as financial profit from trading the crypto, for instance.
– The investment of money is in a common enterprise. Once again, it depends on what the law means by common enterprise. In most cases, it would probably apply to ICOs.
– Profit comes from the efforts of a third party. While in theory there is no third party between a token buyer and the company selling it, there is a case to be made for various intermediaries and ancillary involvement, from wallets and exchanges to marketing and advertising professionals. The subject is still poorly defined and leaves a lot of room for interpretation, which is why regulators are reluctant to be very firm on the topic. As everyone will keep telling you, though: expect more regulation.
The list above is one of the reasons why many ICOs will try to steer clear of US regulators and launch on more permissive markets. It is also one of the reasons why there is so much uncertainty and fudging and dodging regulations even for common ICOs.
Security / Equity Tokens
ICO owners can issue true security tokens, i.e. stock. This will place startups in a better position to enter the traditional financial markets, allowing more transparency and providing potential interest from a wider pool of investors, since shareholders will be able to be involved in how the company is run and see where their money is going. For various reasons, many ICO companies do not offer real equity – one of the reasons being there is little reason to conduct an alternative type of fundraising if the company is operating with such a very traditional structure.
On the other hand, a number of companies issue something that regulators may see as security tokens, yet without shareholder privileges and disguised under various shapes and forms. These ICOs usually try to pass their tokens as primarily utility tokens. Yes, the field is that nebulous.
Utility tokens, otherwise known as appcoins, give token owners access to a product or service. This type of token lies in uncharted territory, since regulators around the world are unsure as how to tackle them. They are in-platform currency used to purchase in-platform services or products, but they can also be seen as investments, since, if the platform appreciates, you can later on sell the appcoin at a profit.
5. Bounty programs
A bounty program is a program that offers users the possibility to perform certain tasks in exchange for rewards. There are lots of ICOs that save a lot of money by such crowdsourcing of efforts, and quite a few independent actors that are willing to offer exposure in exchange for these tokens. The tasks rewarded by tokens include bug fixes, YouTube, Facebook, and Twitter advertising and mentions, project improvements etc.
As they offer incentives for engagement and overall improvement, bounties are an already standardized method of both economizing and spreading the word across the relevant communities.
6. Spotting ICO scams
A recent study claims almost 80% of the ICOs conducted in 2017 were scams. With the success of this method, this was only to be expected. However, the lesson was learned. With experience comes wisdom, and, the more established the field, the easier it gets to spot the scammers. Now most potential investors have learned there are a few clear pointers in the field of fraudulent ICOs. Some of the things include checking the team’s profiles, reading their white paper to see if there more fluff than actual content, how tokens are distributed among ICO owners and investors etc.
For a detailed guide to how you should check for scams in the ICO field before you decide to jump in, you should read this brief primer.
7. How to participate
There is every reason to participate in an ICO, because, if you choose your ICO correctly, you stand to gain quite a bit. If you’ve done your homework as specified above and found the project you believe in, and if you own Bitcoin or especially Ether in a wallet (not an exchange! never hold your crypto on an exchange), you are almost set.
Further on, you pretty much only need to register if required, or, if not, just, you know… buy the tokens. Every ICO will try to make it as easy as possible for you to participate. You send the crypto, they send you the transaction confirmation, then the tokens. The tokens won’t be instantly accessible, as everything on the blockchain takes quite a bit longer than what you’re used to when buying coffee with your Visa card. However, that is pretty much it: choose, check, buy, receive. Once you have your tokens, it’s your call whether you dump them or keep them.
Don’t forget, though: before investing, do your due diligence. It’s not a failproof guarantee that you’ll make a profit, but it’s a minimal safeguard. Read more about investing in an ICO here.
Just to recap, then, what happens in an ICO is this: a startup will design a smart contract token on a given blockchain and try to convince you to buy that token in large quantities so they could fund the development of their project. The startup will create an impressive whitepaper that outlines what the project consists of, who will be running it and how, and what your money will be used for. If you’re convinced, you send them crypto and they give you a private key to access your newly acquired tokens.
8. A brief glossary
Pre-mining. Creating coins privately, before the coins are officially launched to the public. Pre-mining allows company owners and developers to allocate tokens to themselves before the public is even aware of the existence of the tokens. This can be done legitimately, although the lack of transparency often raises concerns.
FUD. Fear, Uncertainty and Doubt, or FUD, is a strategy that helps marketers, politicians etc. influence perception of a certain company, product or situation by spreading fear and distrust.
HODL. The origin of the acronym is unknown, but it is usually held to refer to “Hold On for Dear Life”, a strategy that has investors holding on to their coins when prices are low. It may also have originated in a misspelling of “hold”.
Pump and Dump. A practice of manipulating the market by having a number of people buy stock or tokens in massive quantities, creating a buying frenzy to drive prices up, then dumping shares or tokens at a high price.
Token distribution. One of the key elements to look for in an ICO, it specifies how much of the tokens created are reserved for the team, how many for bounties and operational costs, and how many for investors. Below is the token allocation for one of the top ten ICOs of all time. While there are more complex allocation/distribution systems, most will fall along the same general lines.
Soft cap. This is the pre-set amount for an ICO to be satisfactory; a sort of minimally required sum at which the ICO is considered as fulfilled. If the ICO falls short of this soft cap, ICO owners may have to return the investors’ money.
Hard cap. The maximum amount (the upper limit) to be fundraised in an ICO. For most, this is “wishful thinking” realm at which the ICO will close.
Whitepaper. This is the guiding document by which ICO shows potential investors what their business idea consists of, who will implement it and how.
9. ICO categories
You will notice that, in the ICO space, there aren’t all that many categories to choose from. The top categories predictably have to do with improving what the blockchain was created for in the first place: financial operations. When considering a long-term investment in an ICO company, look for what category the startup will be operating under as an indicator of how involved they really are in the blockchain space. If the answer is “not much”, there is a chance that the ICO owners may just want to cash in on their idea and either make off altogether or use the funding they get to transfer their project to a more comfortable platform. In either case, the tokens you get from your investment may not be worth much in the long run. If, however, you want to cash out – no problemo. That’s an investment strategy, too.
Statistics about ICOs are not all that easy to come by. Lots of unsuccessful ICO owners choose to not reveal what actually happened to their ICOs. As the blockchain is such a, well, cryptic field, it’s also hard to find out on your own without full disclosure. There are two statistics that are interesting when contemplating the risks of investing in an Initial Coin Offering:
– that over three quarters of the ICOs launched last year were scammy in one way or another (from deliberate fraudulent owner profiles to faulty code sloppily slapped together, ludicrous project ideas, sketchy presales or pump-and-dump post-ICO schemes).
– that more than half of the 2017 ICOs failed, either at the ICO stage by not achieving their funding goals, or later on, by not being able to carry out the projects or simply falling off the map.
While in 2017 there were 371 ICOs, already there have been over 770 ICOs in 2018 so far. The amounts went way up too, from an estimated $6 billion last year to well over $18 billion just in the first eight months of 2018.
However, despite the fact that the number of ICOs and the amounts invested in ICOs have grown massively year over year, there are still fewer than half successful ICOs, by some measurements. Additionally, the hype is slowly dying down as ICOs have had slower months in July and August. There is a growing concern, in fact, that a number of ICOs are being launched that have no reason to be in the blockchain universe. With the hype surrounding blockchain technology at the moment, it is no surprise that a number of startups (and even well-established companies) are looking to cash in on their association with the new buzzword.
What this means for the industry is that investors need to beware of inflationary tokenization, where competing companies have no real plan of upholding a token strategy or operating on the blockchain for the long term, and useless tokens are being created merely to be dumped post-ICO.
As a potential investor, you should always bear this in mind and weigh the advantages against these known risks. You can still get fooled to invest in a shady ICO, and you can still simply fail to see a profit out of your crypto investment, but at least start by understanding that ICOs have a frothy history and need serious scrutiny.
11. Rewards and outlook
Even the harshest critics and the most negativistic bulls will bow down to the reality of hard money. ICOs do, in fact, raise a lot of money; three times the amount raised in 2017 so far. Whatever changes are happening are caused by two main shifts: more regulation coming to crypto in general and ICOs in particular, and, on the other hand, a more mature market, with, at the same time, more companies looking to get funded, more investors looking to score a hit, and more caution around the potential for fraud or failure.
The bottom line is the same, though: if you have chosen carefully and done due diligence on a project that you believe in, you can still see your ICO go down, either before the closing line or at some point after the ICO has “successfully” closed. Bear in mind that most ICOs do not make crazy money for their investors. There are just a few that take most of the money: not even the 20/80 rule, but a much slimmer portion of the ICO owners get the lion’s share. If you look at the top 15 ICOs of all time, you’ll see how, even among the elites, the top layer is thin indeed.
On the other hand, in Cryptoland as anywhere else, you don’t need to be in the stratosphere to make a decent return on investment. Even if you don’t pick the absolute winner of the race, you can still make good money off of your bet.
Most ICOs don’t pan out. And that’s OK. There were other search engines when Google came out, and most are now reduced to rubble. Facebook wasn’t born into a social media void. You only need to back a teeny-tiny version of Facebook, Alphabet, Amazon, whatever – a company that harnesses the power of new technology to streamline, improve or revolutionize a product, process or service. If you choose right, you could be gaining a foothold in the coming revolution – or just, you know, a decent amount of money. Either way, not bad.