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What is an ICO (Initial Coin Offering) and How Does it Work?

By:
Bob Mason

We are seeing the rise of a new phenomenon, which has gripped the tech world and is changing the way in which start ups raise capital, shifting away from initial public offerings (IPO), crowdfunding or seeking the assistance and influence of venture capitalists, with Initial Coin Offerings now all the rage.

ICO initial coin offering

By the end of the 1st quarter, close to $400m has been invested through initial coin offerings and, in not too dissimilar fashion to the dot.com era, companies are managing to raise millions of Dollars with just a white paper and a cryptocoin.

Cryptocurrency_market_capitalizations
Crypto-currency_market_capitalizations

To put it into perspective, Bitcoin is now accounting for just under 50% of total market share of cryptocurrencies, despite the fact that Bitcoin’s market capitalisation has surged from around $10bn to over $40bn over the last year and having accounted for as much as 80% of total market capitalisation of cryptocurrencies a year ago, taking the total market cap of cryptocurrencies from $12.5bn to a whopping $90bn.

So, is this the new revolution in fund raising or another pyramid that is soon to explode?

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When searching for active and upcoming initial coin offerings better known as ICOs, one sees a mind boggling list of companies looking to raise money through ICOs, companies ranging from online sports gambling to regional banks being established for the digital generation, the only pre-requisite to qualify for raising funds through ICOs being that they must have a cryptocurrency and token as an integral part of product on offer.

Who needs venture capitalists when you’ve got the digital world and a rapidly growing medium for fund raising?

So what is ICO (Initial Coin Offering)?

An initial coin offering is similar in concept to an initial public offering (IPO), both a process in which companies raise capital, while an ICO is an investment that gives the investor a cryptocoin, more commonly known as a coin or a token in return for investment, which is quite different to the issuance of securities as is the case in an IPO investment.

Before getting into the details, it’s worth providing some detail on blockchains, tokens and cryptocurrencies.

What is a Blockchain?

A blockchain is an incorruptible digital ledger of economic transactions that can be programmed to record, not just financial transactions, but anything of value. It’s essentially a digital spreadsheet that is duplicated across a network of computers. The network is designed to update the spreadsheets on a regular basis. As the information is shared and regularly updated and not stored in a single location, it’s considered to be truly public and easily reconciled.

Why is it considered revolutionary? Imagine not needing a single database that must be passed across global geographies and companies for updating…

What are Tokens?

Tokens are coins that are offered during an ICO and would be considered an equivalent to shares purchased in an IPO and are also referred to as cryptocoins.

What are Cryptocurrencies?

Cryptocurrencies are a digital or virtual currency that uses cryptography for security. It is not issued by any central authority, such as a central bank, taking it out of the reach of governments who can interfere or manipulate. The transactions are anonymous in nature.

Tokens issued from an ICO will have a value, with the ICO allocating equivalent to equity to the token, which gives the investor ownership with voting rights and, in certain cases, qualifying for dividends.

While this will be the closest format of an ICO to IPOs, the vast majority of ICOs issue tokens that are an asset giving investors access to the features of a particular project rather than ownership of the company itself.

It’s ultimately the process of crowdfunding a new cryptocurrency project, involving a token sale, with the cryptocurrency project raising capital to fund operations, with investors receiving an allocation of the project’s tokens in return.

ICOs tend to be open from between a few weeks to a month, though some have been open for longer and fund raising for a particular ICO possibly taking place on multiple occasions, unlike an IPO which is a onetime event.

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Some key characteristics of an ICO include:

  • Participation in a project, Decentralized Autonomous Organization (DAO) or an economy.
  • Coin ICOs generally sell participation in an economy, while token ICOs sell a right of ownership or royalties to a project or DAO.
  • Owning tokens do not always give the investor a right to vote on the direction of a project or DAO, with the rights of the investor embedded within the structure of the ICO, though generally the investor will have input throughout a project lifespan.
  • The majority of ICOs involve the creation of a defined number of coins or tokens prior to sale.
  • ICO prices are usually established by the creators of the economy, project or DAO.
  • ICOs may have multiple rounds of fund raising, with coins or tokens on offer, increasing in value until the release date, with early investors likely to have greater rewards embedded within their tokens as an incentive.
  • ICOs conclude once the coins or tokens are tradable in the open market.

If we were to compare the key features of ICOs and IPOs, some of the similarities and differences would be as follows:

  • An IPO gives you ownership of the company based on the number of shares acquired, whilst an ICO may only give you rights of a particular project, not the company launching the project.
  • Decision making in IPO companies are centralized with the CEO and the board involved in the day to day running of the business, whilst with ICO companies/projects, decision making is decentralized, giving the investor a material decision making position.
  • Financial data is released as per the rules of the exchange on which the IPO took place, whilst for ICOs, these will either be public by way of the blockchain or as outlined within the white paper and agreement with the investors.
  • Companies launched by way of an IPO must pay taxes, with investors having to pay capital gains tax, whilst for ICOs, the company may not be subject to direct tax, only the investor being required to pay capital gains tax.
  • An IPO is a onetime sale with multiple intermediaries involved in the process of determining the conditions, pricing, etc., whilst ICOs can have multiple rounds of fund raising, with few if any intermediaries, the white paper the blueprint.
  • And finally, stock exchanges and companies listed by IPO are heavily regulated, whilst the exchanges on which ICOs are launched are quite the opposite.

For companies raising capital through ICOs, the advantages include:

  • The project, DAO or economy is not necessarily subject to direct taxation, which in contrast to companies fund raising through IPOs.
  • Sales of coins or tokens are direct, including multiple rounds, with few if any intermediaries required in the process, investors basing investment decisions on the content of white papers prepared by the fund raising entity.

While ICOs are to mainly raise capital for a start up, they are also used to kick-start the sale of a service to be taken to market or the use of a new cryptocurrency.

On most occasions, the investor becomes the consumer of the service being offered by the company raising funds through an ICO, which allows investors to buy coins at a discount, though valuation will ultimately be dictated by supply and demand once released to market.

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In vetting ICOs, there is no guarantee or sure fire way of distinguishing the good from the bad, investors needing to avoid scammers who are using ICOs to dupe investors out of funds.

There’s plenty of interest at present from an investor perspective, attributed to sizeable returns that investors have enjoyed to date, demand driving prices, with large prices gains incentivising investors to lock in profits, which can lead to mass sell-offs that could ultimately wipe out investor money, not to mention the company.

History and Evolution of ICO

The first ICO was by Mastercoin back in 2013, which raised approximately US $600,000 for a project to create a Bitcoin exchange and platform for transactions, while Bitcoin led the way on Cryptocurrencies, becoming the first decentralized cryptocurrency back in 2009, other cryptocurrencies sometime referred to as Altcoins, essentially Bitcoin alternatives have hit the market.

The shift in focus away from the use of venture capitalists for fund raising has taken the market by storm and the numbers of ICOs continue to rise, with the liquidity associated with ICOs over VC funding driving investors into a frenzy.

Venture Capitalists have begun to take notice however and are looking for a way back into the segment, with Blockchain Capital having run its 3rd fund raising in what was to be the first liquidity enhanced venture capital fund, the VC taking out the incubation period for investors.

Unlike centralized electronic money / banking systems, cryptocurrencies are decentralized. Bitcoin and the early altcoins were launched without an ICO and with the market still considered relatively nascent, governments and central banks have been relatively slow in catching on to provide some formal legal framework to the cryptocurrencies and the ICOs that followed.

With VCs getting in on the act in fear of losing out on major fund raisings, news also hit the wires in April of this year of the first ever underwriter of initial coin offerings. First Bitcoin Capital sees itself as a gatekeeper and by acting as the underwriter, assists in separating the good with the bad in the interest of longevity within the segment, by way of sound due diligence on the underwritten ICOs.

As of today, there’s still a long way to go for the market and until there is a more robust framework, which is recognized by governments and regulators, investors can be left out in the cold with the lack of a legal framework for those who have been duped. Even Madoff’s Ponzi scheme, which lost investors billions, is returning some funds back to the investors, in the case of ICOs there’s no legal entity to which the investor can face off, let alone make claim to.

In terms of the numbers, ICOs have raised US$327m to date through fund raising, compared with US$295m raised by venture capitalists representing blockchain start ups, VCs falling behind this year for the first time as the numbers of ICOs continue to increase.

Since the Mastercoin’s ICO, it was estimated that ICOs raised a lowly US$25m in 2014, falling to US$10m in 2015 following Bitcoin’s price collapse of 2014. In 2016, the trend reversed, with ICOs raising an estimated US$225m, supported by a rally in the price of Bitcoin, which drove interest into both blockchains and Fintech.

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While there have been plenty of success stories, in the 2nd quarter of last year, an Ethereum based project named The DAO entered an ICO to launch an investment fund without a fund manager, with the investors being involved in all of the investment decisions upon launch. The ICO raised almost US$150m, almost 70% of 2016’s total capital raised through ICOs. By mid-2016, hackers managed to get away with more than US$40m from the DAO, bringing the project to a grinding halt and the value of Ether down with it, Ether’s price falling from US$19 to under $12 in just a matter of days. In the interest of market capitalizations and protecting the investors, Ethereum created a new blockchain and ultimately reversed the theft, leaving the original Ethereum blockchain, now known as Ethereum Classic behind, a small minority continuing to support and assign value to the old blockchain.

Despite the inherent risks, which are not just down to hacking, but also fraudsters and scammers, 2017 looks to be another stellar year, with ICOs raising in excess of $150m by mid-May of this year, based on numbers from Smith + Crown.

Concepts are getting more and more innovative and the speed with which capital is raised is getting faster by the day and, without the regulatory oversight things could burst before the likes of the SEC catch up.

How Does ICO Work and How to use ICO

Start ups kick start the ICO process by establishing the blockchain and set up of protocols and rules, at which point an ICO data is announced.

For the creator, the next step is to begin mining for coins that will sold during the ICO, with social media sites, Reddit and a rising number of cryptocurrency related website used as a marketing medium to attract investors ahead of the ICO data, creators looking to draw in as much interest as possible to not only raise the required funding, but also push demand and prices post ICO.

In the background, the creators will make their final checks and adjustments to ensure its smooth sailing by the time of the ICO.

For the cryptocurrency creators, they will need to join an exchange, the exchange similar to that of a stock exchange during an IPO, with investors needing to have an account with the exchange to be able to buy the new cryptocurrency with other cryptocurrencies or fiat money.

Active and up and coming ICOs can be found through various sites, with the purchase of cryptocurrencies being made through the selected exchange, with investors also able to buy directly through the creators official website.

Exchanges that are widely recommended for the purchase of new coins include Bittrex, Kraken, Poloniex, Livecoin, SpaceBTC, Bitlish, though there are many others.

Documentation requirements vary depending upon the investor domicile, with the requirements outlined on the respective exchange’s site and creator website.

A step by step of an ICO can be summarized as follows:

Pre-Announcement: This is the marketing stage of a future project through sites frequented by cryptocurrency investors, with the creators of the project preparing a white paper, essentially an investor presentation outlining the details of the project.

Once the white paper has been circulated, the company will get a sense of whether there is investor interest in the project proposed, with the company then addressing concerns and addressing risks raised by would be investors to reach a final business model and a final version of the white paper.

Offering: This is the final version of the white paper, setting out the terms of a contract for the benefit of the investors, made on behalf of the company entering into the ICO.

The offer will outline the project details, the total amount of capital required, together with project timelines. It will also indicate the financial instrument to be sold during the ICO, normally tokens. The financial instrument will have a value assigned to it, together with the rights of the investor along with the expected period after which the company will commence returning earnings to investors, traditionally by way of dividends.

Once the offer has been signed, the ICO start date is announced and the marketing campaign moves into overdrive.

Marketing Campaign: This is a pivotal component of the ICO, with the marketing campaign key to the company being able to raise the necessary capital. Companies are generally nascent and unknown, bringing marketing agencies into the frame to make the necessary presentations, etc. The campaign will tend to last up to a month on average, target audience being institutional and some smaller investors. Participants of crowdfunding programs tend to be the main segment, investors generally more willing to back projects, with their involvement in the project considered a positive for both the investor and the company.

Once the marketing campaign comes to an end, the buying and selling of tokens commences, with the company having established an exchange for investors to acquire tokens.

The ICO: Companies generally release tokens on blockchain in two ways:

  • Collect the specific capital, outlined within the offer, and then divide and distribute the tokens to the investors based on initial investment made.
  • Alternatively, tokens are sold on cryptocurrency exchanges, which means that the tokens need to be released on a number of exchanges in advance for trading.

Once the sale has ended, the company commences on its obligations.

For the investor, it’s a case of exploring the various exchanges or social media sites that publish active and up and coming ICOs and then opening an account, acquiring the tokens, having completed the necessary due diligence on the company or project  in question.

The New Way of Tech Companies to Raise Money

Start up companies are generally some form of an entrepreneurial venture, which will take the form of a new, rapidly expanding business targeting the needs of a marketplace by way of innovative products, processes and services.

While historically, start ups would have raised capital through venture capitalists, the advancement of fund raising through ICOs has been almost spectacular. While venture capitalists tie up investor money for lengthy periods of time that can extend to years, ICO money is far more liquid and with value easily assigned, traded within a very short period of time. The liquidity associated with ICOs is certainly a contributory factor to the increasing number of ICOs, with the lack of cumbersome documentation and unjustified demands and requirements of the VC also avoided.

Adding to the upside for start ups is the involvement of the investor in the decision making process, whether it is an actual business or a project, providing the investor a say, many of the initial investors in start ups being entrepreneurs and experts in their respective fields.

Blockchain technology and cryptocurrencies have certainly paved away for the more innovation, with the lack of regulatory oversight allowing start ups to push the boundaries created by those before them.

Successes from ICOs are well publicised, with some of the most well-known ICOs including, but certainly not limited to:

  • Ethereum (ETHER-ETH): US$18.5m raised in capital. At ICO investors paid US$0.4 per Ether back in 2014. The value of an Ether hit a high of US$14 per Ether in 2016. Ether is certainly one of the more well-known early success stories. Year-to-date, Ether’s market cap has surged in excess of 500%.
  • ICONOMI (ICN): US$9.1m in capital raised.
  • Maidsafe Coin (MAID): US$7m raised in just 5-hours, which had been the record for the most amount of capital raised in the shortest period of time.
  • Golem Project: The Company’s goal is to build a P2P global computer network, with blockchain data handling payments in GNT tokens. US$8.6m in capital raised in just a matter of hours.

To be honest, these ICOs pale into insignificance by today’s standards, Bancor Foundation raising a whopping US$153m of Ether through the sale of its tokens in just 3 hours in mid-June.

Post ICO, there are some great returns for investors that continue to grab the headlines, Ether not alone.

Ripple’s XRP springs to mind, up 10x to dwarf Bitcoin’s 150% year-to-date return.

Ripples XRP Price Rise
Ripples XRP Price Rise

If there were any doubts of Ripple, 10 financial institutions signing up to send real time payments internationally was certainly a plus for the creators and angel investors, with banks including Bank of America and Royal Bank of Canada signing on.

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And in May, there were more than 80 companies including Toyota and Merck joining a group called the Enterprise Ethereum Alliance (EEA) to create standards for smart contracts, large corporations taking the initiative to bring some order to the market.

How to Join Initial Coin Offering?

There are a number of sites that list current and up and coming initial coin offerings including Reddit, Cyber Fund and even social media sites such as Facebook.

To invest, the first step of the process is to identify which project or company launch is of most interest and while searching through the ever increasing number of ICOs hitting the worldwide web, set up a cryptocurrency wallet.

With a lack of formal structure, each ICO will likely have a different set of requirements, though ultimately it’s a simple process of sending tokens upon payment by cryptocurrency to the blockchain identified and listed on the ICO website, which will also provide the investor a step-by-step guide into the investment process.

Public sites, such as Blockchainhub, advise that before investing it is important not to use any kind of an online wallet or exchange. Backers are generally required to export their private keys into another wallet in order to access their new coins, so it is vital to ensure that the wallet’s private keys are exportable.

Companies have looked to facilitate the process by making available functioning online wallets for their ICOs, where the investor can send the money directly to the wallet established, the funds exchanged for tokens using the exchange rate at the time of purchase, with the tokens deposited into the wallet. Others remit the purchased tokens to the address from which the funds were sent.

Investors will also need to be aware that certain wallets may be incompatible with the tokens and are therefore not visible following purchase and receipt. For this reason it’s essential to have a wallet which permits the export of private keys, so that it is permissible to transfer the tokens to a new compatible wallet.

It’s become far simpler since the launch of Ethereum, with creators setting up user-friendly campaigns, with Ethereum’s wallet supporting multiple tokens, making access to purchase tokens far easier than before.

Outside of identifying the ICO itself, due diligence is also recommended in the interest of avoiding scams and Ponzi schemes, with ICORating providing would be investors with a full assessment of the project or company in question and other companies providing some additional background should more details be needed.

The Gold Rush Go Through Regulation

While cryptocurrencies have seen advancements in the regulatory landscape with countries such as Japan and Russia recognizing cryptocurrencies as legal tender, ICOs have yet to fall under the cloak of regulators.

The SEC has publicly announced that ICOs need to protect the investor and, with the size of the market, has certainly caught their attention, with certain regulators and governments now having caught up on blockchains and the likes of Bitcoin and Ether.

Regulators have a responsibility to even the most foolhardy investor and in the interests of avoiding another Dot.Com bubble eruption, some oversight would certainly save a lot of pain down the road, particularly should fraudulent cases begin to rise alongside the ever increasing number of ICOs.

While the SEC is looking into the latest fund raising FAD, it has also come out and announced that they will begin to focus in ICOs should they become a significant component of the market for investments and a triggering event takes place, with companies looking to raise capital by way of ICOs becoming subject to both regulatory and enforcement action.

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The lack of transparency remains an issue and there have also been reports that the sale of tokens to U.S citizens is in fact deemed illegal, though whether exemptions will be permitted remains to be seen, uncertainty certainly there for investors consider down the road.

In the end, it is hard to imagine regulators sitting on the side lines when considering cryptocurrency valuations, the rising number of ICOs and the inherent risks associated with investing in start ups in this manner and how both investors and the companies respond to the magnifying glass of regulators will likely decide the fate of ICOs, which for now are able to raise sizeable sums as a result of the inflated valuation of cryptocurrencies such as Bitcoin and Ether.

One thing is certain, legal recourse to start ups with enforcement agencies able to take action against scammers and fraudsters would be a great start, the less savvy investor certainly there for the taking by the few who are so inclined.

ICO or Not?

Investors will be wowed by the returns and the surge in market cap of cryptocurrencies over the last year and, while there are certainly some tremendous opportunities and sound investment opportunities to be had, there are risks that need to be considered before entering the blockchain world.

So, as is always with the case with any investment and never more so than those that can give investors returns in excess of 100% in a matter of months, there are pros and cons for the investor to consider.

Starting with the positives

  • Despite the number of ICOs hitting the market, as many as a 100 every few weeks, there have been a large number of companies that have become incredibly successful, having raised capital through ICOs.
  • The high ROI (Return on Investment) story certainly provides an opportunity for the yield hungry, though where returns are on the higher side, there is a higher level of risk associated with investing.
  • Perhaps the greatest feature of an ICO is that the tokens are considered liquid, unlike investing in traditional start ups, where investor money can be tied in for years. ICO investors can cash in and out at any time, converting ICO tokens into Bitcoin or other cryptocurrencies with ease, assuming the demand is there.
  • There are also no fees similar to those that investors face with IPOs and then there are VCs, who like to run the show and make unnecessary demands, which could devalue the investment on occasion, companies losing their identity in search of the Dollar.

Where there are positives, there are also negatives to consider and some of the more negative elements to investing in an ICO include:

  • Well-known for failures, with too many projects being alike or with projects failing to reach expected levels, driving the value of initial coins to zero.
  • A lack of governance can lead investors down the garden path, with a lack of appropriate due diligence leaving investors open to Ponzi schemes and more.
  • While the upside can be sizeable, it’s ultimately not something to bet your shirt on and any investments lost as a result of scams and frauds are unlikely to be recovered.

With the lack of regulatory oversight, investors do need to do a decent amount of due diligence and repeating this view is reflective of the need, with the number of fraudulent ICOs likely to be on the rise as regulators lag behind the segment.

Due diligence tends to be expensive and when it comes to cryptocurrency economies and ICOs, the market is beginning to see the presence of rating agencies, who conduct the due diligence, carrying out the necessary analysis of the information at hand, with the rating agencies publishing their research reducing some of the risks associated with investing in ICOs, self-policing coming in ahead of any more formal regulatory oversight.

ICORating is one of the agencies undertaking the task of providing some cover for investors and the analysis will certainly be a starting point to drive the ICO market to the next level, though even rating agencies have been known to get it wrong from time to time.

On top of the ratings, investors can also look out for ICOs that include independent escrow agents, so that the capital raised does not reach the company entering an ICO, but a 3rd party.

Multi-Sig is an example of such an escrow agent, with the agent essentially funding the project on an ongoing basis, funds released from an escrow as needed, the agent ensuring that project targets are being met along with the company’s pre-determined obligations to the investor.

So, while some level of control is entering the market, the question remains on whether this is another dot.com. The skeptics have been out in force since the Global Financial Crisis, with every investment opportunity being labelled as economic bubble, included Bitcoin.

The similarity is the fact that its digital and more importantly, lacking of physicality and investors don’t have to think too far back, when companies were selling concepts for millions of Dollars.

For now, ICO fund raising falls well short of the levels seen during dot.com era, which should provide some level of comfort, the only concern being a collapse in the market should the volume of fraudsters surge over the near-term, or there be a collapse in the valuation of cryptocurrencies.

The association is ultimately coming off the back of the surge in valuations and market cap of the sector, but the surge in market cap is not isolated to blockchains and start ups hitting the market looking to take advantage of the yield hungry investor, so calling a bubble for now is certainly a more pessimistic view point. You only need to go back to the early days of tech stocks such as Intel, Apple, Microsoft and Alphabet to consider how the industry can be reshaped in the years ahead.
Regulatory oversight of some sort will certainly provide it will longevity, though the attractiveness of ICOs could be lost should the minimum requirements become as intensive, such an outcome not killing off the industry, but just the medium through which capital is raised. It’s pretty easy for creators right now…

For now it’s a phenomenon, but tomorrow it could be yet another cautionary tale, joining the dot.com and MBS (Mortgage backed security) stories of yesteryear. It will boil down to the integrity of the sector and the success of companies raising capital, mindful that not all will deliver, but at least a majority.

The numbers certainly point to a bubble, with ICOs in the 2nd quarter of this year each raising in excess of US$10 in a single day and the sizes are rising as investors look to cash in on the trend before the bubble bursts. If you can get in and get out with your tidy profit before doomsday, then it’s the investment for you, but as with any bubble, few can predict the day of the crash.

Investors are throwing money ICOs and in certain cases, the business models or scope of projects are shady at best, but with cryptocurrency valuations on the rise, the investment may be justified, a crash in the value of Ether or Bitcoin could be a different story altogether, such an event not a completely farfetched consideration for investors looking to convert relatively stable currencies into tokens, the success of the business itself not the only consideration, the value and stability of the cryptocurrency also needing to be considered.

Does that sound like the Dot.Com bubble, where valuations grew exponentially, with the NASDAQ surging from under 1,000 to over 5,000? How did it happen? Cheap money, market over confidence and investors on the hunt for the next big thing after mortgage backed securities… Current surges in post ICO valuations are certainly not based on anything tangible, with projects or businesses in their early stages, so 10x increases in a matter of months sounds somewhat extreme, the appetite for cryptocurrencies perhaps masking the business or project the coins are actually investing into…  When you consider the regulatory oversight of the NASDAQ, that’s quite a run and quite a fall from grace. The gains in Bitcoin alone have been striking, bringing new investors into the market, but how long before the wool is pulled from the eyes and the smart money walks out door leaving the last person to turn out the lights. These things tend to end in tears after all…

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About the Author

Bob Masonauthor

With over 20 years of experience in the finance industry, Bob has been managing regional teams across Europe and Asia and focusing on analytics across both corporate and financial institutions. Currently he is covering developments relating to the financial markets, including currencies, commodities, alternative asset classes, and global equities.

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