An initial coin offering (ICO) is a method of crowdfunding from the general public or a select group of participants, using a digital currency. Instead of being rewarded with equity stake or debt in the new company, these investors are awarded cryptocurrency tokens, backed by a distributed ledger, in direct exchange for their investment. If you don’t yet understand cryptocurrencies you can learn more about them in our What is Cryptocurrency guide. Through the advent of ICOs, blockchain-based companies can create tokens that not only have intrinsic value and/or utility, but also help raise funds for the team behind the project.
Historically, if a new company wanted to raise funds it would first go to venture capitalists who would fund the project in the early stages, and then issue a public offering to take their company to the next level. This model has grown to be the norm over the past several decades and hasn’t evolved in any major way. Until now.
Let’s take a look at the meaning of ICOs and how ICOs work, to better understand these new fundraising tools.
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ICO scams and how to avoid them
How ICOs work
An initial coin offering (ICO) is a method of fundraising using cryptocurrencies. However, instead of selling shares of stock like with an initial public offering (IPO), an ICO exchanges funds for cryptocurrency.
As an example, let’s say a blockchain company is looking to raise money to start a new game called Blockchain Chess. (Note: if you want to learn more about blockchain check out our blockchain guide) This company could raise money via an ICO in exchange for its chess token, which is used to power the new game on the blockchain. Funders would send the company funds in exchange for this new token, which could be used to play Blockchain Chess or exchanged for other cryptocurrency as needed.
Here is how an ICO might look from start to finish:
- A company creates an idea for a blockchain-based product or service.
- Plans for the ICO are outlined in a whitepaper or similar document. This includes how much money will be raised, how many tokens will be issued, who can invest, how the tokens will be distributed, etc.
- The ICO is marketed via the company website and appropriate social media channels to raise its visibility and public interest.
- Investors send funds on or after the date of the ICO in exchange for tokens.
- The new funds are used to grow the business and create or build upon an already existing product.
A history of ICOs
The first initial coin offering on record was completed by Mastercoin in 2013. While Mastercoin got the ball rolling, it wasn’t until Ethereum raised funds via its own ICO in 2014 that the industry started to take notice. Ethereum was able to raise 3,700 bitcoin — equivalent to $2.3 million at the time — in just 12 hours. The Ethereum ICO experiment proved that this new fundraising path was here to stay and paved the way for what was to come.
During the late 2017-2018 bull run, ICOs were en fuego. It seemed that any blockchain project with a halfway decent idea was able to raise funds through coin offerings. There were plenty of high-profile ICOs that turned heads during this period.
Some notable ICOs during the time included:
- Brave – Raised $36 million in just 30 seconds
- Kik – Investors poured $100 million for the KIN token to be used in conjunction with the Kik messaging app
- Filecoin – The distributed file storage project raised $257 million in its ICO
- Tezos – Raised $232 million, pricing its token at $0.50
- Block.one – The company behind EOS raised $4 billion and immediately became the fifth largest cryptocurrency in the industry
The post-ICO bubble
In 2018, ICOs raised a staggering $7.8 billion. But this fundraising boom didn’t last. As the entire cryptocurrency industry faded from the public eye, so did this fundraising strategy. In 2019, it’s estimated that ICO fundraising fell by 95% to a total of $371 million.
One potential reason for the downswing was the failure of the vast majority of cryptocurrencies that were born out of the 2017-2018 frenzy. The list of Dead Crypto Coins (as defined by being abandoned, scams, and/or no activity on the blockchain) is in the hundreds and counting. This has not just weeded out bad projects, but made it harder for good ICO projects to raise funds from investors.
Are ICOs legal?
The legality of this new fundraising method has raised eyebrows from regulators. Some believe that even though ICOs tout themselves as raising funds in exchange for fully functioning cryptocurrencies, they are really just skirting securities laws through this technicality. Countries such as China and South Korea have gone so far as to build a regulatory framework that ban ICOs altogether in an attempt to not deal with this issue.
In the United States, the Securities and Exchange Commission (SEC) has provided potential investors with guidelines as to when an ICO needs to be registered as a security. These guidelines generally follow the Howey Test, which is used to determine whether a transaction should be defined as an investment contract.
In the case of digital assets, the relevant questions may be:
- Is there an investment of money?
- Is there an expectation of profits from the investment?
- Is there common enterprise? (defined by when the profits of an investor are tied with the success of the company)
- Is the profit dependent on the efforts of the issuing company?
There is no standard, one-size-fits-all template for ICOs. As a result, the design of an ICO can directly affect the ability for investors to be a part of the token sale.
In an attempt to comply with local regulators, ICO projects may attempt to restrict themselves to investors from a select group of countries. And because the law in the United States is murky, many ICOs don’t allow US citizens to invest in their projects. Therefore, US investors shouldn’t get too excited when they see a new ICO because it’s possible they won’t have the ability to invest in the first place.
To incentivize fundraising, companies look to reward the first funders who put up their capital before anyone else. In the case of an ICO, this can take the form of a tiered sale, where tokens are sold for various prices at different points of the sale. For instance, the first $1 million funded in an ICO might receive tokens at a price of $1 per token. The next $1 million raised at a price of $1.50 per token, and the last $1 million at $2 per token. This incentivizes investors to get in early, and helps the company raise more funds right off the bat.
Public vs. private
Some ICOs are open to the public, where anyone can be a part of the fundraising campaign. But other ICOs are conducted as private sales, and only open to a select group of early investors. Private sales are more akin to venture capital or institutional investing as only pre-vetted investors are allowed into the sale. As an individual, it’s highly unlikely you will ever get a chance to invest in a private ICO sale.
Fiat vs. crypto fundraising
Some initial coin offerings allow funders to send fiat currency directly to the company, while others only allow cryptocurrencies like bitcoin or ethereum to be sent. Make sure to know ahead of time what type of currency you can use in an ICO sale. You may have to convert your fiat currency into bitcoin, ethereum, or another cryptocurrency to take part in a token sale.
Major ICO networks
For those companies looking to keep it simple and not reinvent the wheel, already existing blockchain technology provides an outlet for setting up an ICO. Instead of creating a new blockchain network, ICOs can utilize the infrastructure of secure, well-developed blockchains without having to manage their own network.
Many projects utilize these blockchains for their ICO capabilities. If you want to better understand what is blockchain you can refer to our Blockchain Guide:
|Ethereum||Bancor, Sirin Labs, Polkadot|
IPO vs. ICO vs. STO vs. IEO
As the idea of IPOs gave way to ICOs, there are now further evolutions of fundraising that provide different benefits and drawbacks. IEOs (initial exchange offering) are most similar to ICOs in the sense that a company is still selling a utility token in exchange for funds. However, an IEO is conducted directly via a digital asset exchange, which comes with its own advantages and drawbacks. Then there are STOs (security token offering), which are a new way to sell securities via digital assets.
Now that there are new acronyms in the mix, it’s important to distinguish between these fundraising offerings.
ICO scams and how to avoid them
Let’s pump the brakes for just a moment. Just because a few ICO opportunities might net you a good rate of return doesn’t mean this industry is all that meets the eye. It can’t be overstated that whenever you see a good ICO investment opportunity you should do your homework, because there is a chance it’s nothing more than a fraudulent scheme. ICOs have been the subject of a multitude of fraudulent activity where scammers have taken advantage of unsuspecting investors and taken them for millions of dollars.
ICO scams show no bounds:
- Pincoin (April, 2018) – After raising $660 million in an ICO, the Pincoin team vanished. The project which started in Vietnam took money from 32,000 investors who were promised large returns on their investment.
- Onecoin (March, 2016) – It took 18 months for the OneCoin scandal to finally come to a close. The project touted more than a currency, but a revolutionary movement. Unfortunately, $4 billion was invested into a project that never had any plans of producing a viable product. The scam was so intriguing that the BBC made a documentary chronicling its events.
- Bitconnect (January, 2018) – Nothing to see here, but your run-of-the-mill ponzi scheme. Bitconnect promised its investors huge returns, and for a while that seemed to be happening. The price of BitConnect hit a high near $500 before plummeting below $1 when the scheme was finally uncovered.
- Centra Tech (December, 2017) – Investors were duped out of $25 million through a project that exploited unsuspecting investors through their marketing tactics. At one point the project was endorsed by celebrities like boxer Floyd Mayweather and music artist DJ Khaled.
A few things to look out for when determining if an ICO is a scam:
- False promises – The ICO promises a guaranteed return on your investment.
- Little-to-no technology – The project has no technological backbone. Check the company’s technology on GitHub or other open-source repository, and comb through their whitepaper to make sure it is thorough and covers everything necessary to make the company successful.
- Extreme marketing tactics – The company is aggressively targeting unsuspecting investors. This could include promising high returns on investment or touting high-profile investors and supporters.
Why invest in an ICO
Investors turn toward alternative assets in search of asymmetric returns on a small portion of their portfolio. An asymmetric return is one in which the upside is so high that it outweighs the risks of losing everything.
For instance, say you invested $100 in 10 different initial coin offerings. Now, let’s imagine that nine of these companies failed and went to $0, while the other ICO was successful and gave you a 50x return on your investment. In this scenario, even though 9-out-of-10 ICOs went bust, you still would profit $4,000 from your ICO investments as a whole ([$100 x 50 return on successful ICO] – $1,000 original investment). As you can see, even if 90% of ICO investments fail, you can still have success investing in ICOs in a major way. Compliance Note: No investment is guaranteed to give you a profitable return, and this is not investment advice.
Investing in an ICO lets you get in on the ground floor of a potentially groundbreaking new technology. Imagine investing in Apple or Amazon before they were public companies, or when their stock price was in the single digits. In fact, a study was released in May 2018 that examined the price of ICOs. The study found that ICOs returned 179% from the time of fundraising to the time of trading on the open market. If that doesn’t get you excited, we don’t know what will!
Any good idea can be used in a negative way. This is the story of ICOs. As a good fundraising concept they have often been co-opted for nefarious purposes. Still, this doesn’t mean ICOs are all bad. In fact, some of the most successful cryptocurrencies started out using this very method, and can lead to huge returns for investors in the process. Just be careful to fully understand how an ICO works before you invest your hard-earned money.
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