A gentle introduction to Initial Coin Offerings (ICOs), Bits on blocks
Bits on blocks
A gentle introduction to Initial Coin Offerings (ICOs)
Some technology startup companies are raising money in a fresh way, by issuing digital tokens in comeback for funds. This is often colloquially called “doing an ICO”, and this article aims to explain how this works.
Traditionally, there are three main ways for a company to raise money:
- Selling shares (the company sells ownership of the company for cash)
- Issuing debt (the company receives cash and promises to pay back the amount borrowed, with interest)
- Pre-selling goods and services (this ranges from customers pre-ordering a book or computer game, to Kickstarter-style crowd funding of to-be-made items or services. Perhaps even package holidays, or aeroplane tickets fall into this category)
Any of the above can be done with a petite group of investors or a large group. If it’s a large group, it’s usually called crowdfunding.
In each case, it is very clear what investors get in comeback for their money. In general, the higher the risk to an investor, the greater the regulation of the mechanism. This is for good reason: it is a regulator’s job to prevent con artists from scamming the public too lightly.
Initial Coin Offerings
ICOs are being marketed as a fresh way for companies / projects / groups of people to raise money, and the characteristics seem to be a hybrid of the traditional methods of fundraising, but presently without regulatory safeguards suitable to the risk that investors are subject to.
How is money raised?
ICO funds are usually received in Bitcoins (BTC) or Ether (ETH). The project creates a Bitcoin or Ethereum address for receiving funds and displays it on a web page. This is like opening a bank account, and displaying it on a web page for people to send money to.
Investors send BTC or ETH to the published address, in come back for the fresh tokens. The project uses the BTC or ETH to pay staff, or sell the cryptocurrency for fiat currency on a cryptocurrency exchange to fund the project.
Usually the website will also contain some details about what it will use the funds for, and why investors should invest.
Where are the fresh tokens stored?
The tokens issued by the project to investors are generally created and tracked in one of two ways:
- as the intrinsic token of an entirely fresh blockchain (for example Ethereum was funded by exchanging wallets funded with ETH tokens in exchange for BTC from investors)
- or as a token on top of an existing blockchain
- eg as a Colored coin on Bitcoin’s blockchain
- or a token held in a wise contract on Ethereum’s blockchain
7 characteristics of an ICO
Each ICO is unique, but below are some of the usual characteristics.
Some of these characteristics are collective with traditional methods of fundraising (seed rounds, Series A, B, C, etc). See if you can spot them! However, reminisce that traditional private company fundraising is regulated in most jurisdictions due to the risks to the investors, whereas presently ICOs aren’t.
1. The project is usually a technology project related to cryptocurrencies or decentralisation. These projects tend to appeal to those investors who are familiar with or already own cryptocurrencies, and so are familiar with how cryptocurrencies work.
Two. Investor documents are usually a webpage, a whitepaper (usually not peer reviewed), and some internet forum posts. Rules or laws that compel funraisers to make accurate statements in documents are often overlooked or worked around. Often ICO ‘whitepapers’ (prospectuses) exaggerate benefits, do not identify risks, and create unsubstantiated hype.
This is different to traditional forms of fundraising where fundraisers attempt to obey with rules and regulations, knowing that investors have recourse if investor documents are frantically inaccurate.
Trio. Usually identification is light on both sides. Investors often do not need to self-identify; nor do the people running the project. Often the projects will not perform identity checks on investors or the investors’ source of funds to determine if the project is obeying with global sanctions, or if they are accidentally laundering the proceeds of crime, or funding terrorism.
This is different to traditional forms of fundraising, where the identities of investors are usually known or broadly vetted.
Four. The amount raised is semitransparent but can be gamed. BTC and ETH payments to a ICO deposit address are logged on public blockchains, permitting anyone to see the quantity and amounts going to an ICO address. Albeit the amounts invested are translucent, it’s hard to know who sent the funds. This means it is almost unlikely to tell if the project itself invests, without disclosure, to give the illusion of popularity and momentum, and create hype and fear of missing out.
Traditional forms of fundraising share the characteristic of “seeding” the round with big names and commitments, but the investors are known and identified.
Five. Tiering / early investor advantage. Often the crowdsale is suggested with tiering, where early investors are suggested a better price than later investors. For example, in Ethereum’s initial crowdsale early investors received two thousand ETH per one BTC and later investors received only one thousand three hundred thirty seven ETH per one BTC. This can be done by creating limited investment opportunities: either time-bound, where the best price is available for the very first week; or amount roped, where the best price is available for the very first Two,000 BTC invested.
This is similar to traditional fundraising, where early investors get a better deal than later investors by tiering the company valuation. However, ICOs operate at a different timescale, where price switches can happen in a matter of minutes rather than months for a traditional series of investments.
6. Coin retention and price discovery. Usually the project will hold back some tokens (eg, 60% will be sold in the ICO, and the project will retain 40% of the tokens). This gives the project a valuation of their token holdings based on the price of the token ICO multiplied by the number of tokens they retain. Sometimes the project will state how they intend to use these retained coins, eg compensating staff.
This is similar to traditional investments – the price of an illiquid chunk of equity is usually determined by the company valuation of the most latest funding round.
7. Minimums and maximums. There are sometimes minimum and maximum total amounts to be raised. If the minimum is not reached, investors are refunded and the project doesn’t proceed. When the maximum is reached, no more coins are given out; any extra (late) investments are refunded. With cryptocurrencies this can be done automatically, without the ICO managers needing to know the identity of the investor.
What do investors expect?
Profit. Albeit hard to prove, there is an expectation that if the project is successful (loosely defined), the value of the tokens will appreciate and investors can sell the tokens at a profit. It is unclear what proportion of investors buy ICO tokens for their stated use (eg file storage, access to a computer game, or running wise contracts etc).
This risk/prize profile of an ICO is closer to that of equities than a Kickstarter style rewards-based crowdfund or an Amazon style book pre-order.
Liquidity. The expectation is that the tokens will be listed on cryptocurrency exchanges soon after ICO, and often much before the tokens become usable for their stated intent. This provides the secondary market where early investors can sell their tokens.
This is different to the Kickstarter / pre-order types of investment where the secondary market doesn’t exist because pre-orders are usually tied to an individual, and the beneficial holder cannot be lightly altered.
It’s worth noting that while stock exchanges impose requirements on the companies they list such as periodic public disclosure of financials etc, cryptocurrency exchanges usually do not have any listing requirements, nor are the exchanges obligated to perform any due diligence on project whose coins they are listing. Some cryptocurrency exchanges are blessed to list any token (known colloquially as “shitcoins”) because the exchanges make revenues from trading fees, and so are indifferent to the quality of the project or the price going up or down. The cryptocurrency exchange makes money as long as there is price volatility.
There is a disconnect inbetween the phrase ICO (Initial Coin Suggesting) that deliberately sounds similar to IPO (Initial Public Suggesting) and the disclaimers associated with these tokens, written in petite print, suggesting that the tokens are not an investment or a security. These investment rounds are sometimes called “donations” or “presale tokens” instead of using the “ICO” terminology, in order to disassociate with legally sensitive words and phrases.
So, the projects want investors to think that they are investing in something with a high risk/prize profile, while using petite print to disassociate the chance with investments!
History has proven that ICOs are indeed high risk/prize. For example, the ETH token has appreciated some 200x in USD terms since ICO: The price at ICO was 25c per ETH (Two,000 ETH per BTC at approx. $500) and is now trading around $50 per ETH (Apr 2017). However, many ICOs have failed and the price of the tokens quickly became zero, fully wiping out the investments from hopeful investors.
The risk profile of an ICO is more similar to the risk profile of equities than to a kickstarter project for the following reasons:
- Investors can buy large dollar amounts of tokens
- Investors hope that the value of the asset will go up by multiples
- Investors can lose all their money
Presently ICOs fall in a regulatory grey area. At least one ICO (Ethereum’s) has created large profits for early investors. Con artists are taking advantage of these success stories to cheat investors who have little recourse. Some well-meaning ICOs have totally failed, leaving investors with worthless and futile tokens; tho’ it is hard to tell if a project is indeed well-meaning or a well-orchestrated pump-and-dump.
You have been warned!
Thanks to Stephen Palley for his comments on this lump. Stephen is a lawyer and has written an excellent lump on ICOs, which I recommend reading.