An Initial Coin Offering (ICO) is a new fundraising mechanism where tech startups, mainly from inside the digital-currency sector, create a new virtual coin or token and offer it for public sale. ICOs are similar to an Initial Public Offering (IPO) and crowdfunding.
IPOs are a highly regulated capital-raising process where shares of a company are sold to public investors to raise money for operations. On the other hand, crowdfunding brings together various individuals who commit money to new projects and companies they want to support. Crowdfunding does not involve receiving shares of the company and is usually reward-based.
ICOs combine the two dealing with early-stage supporters also motivated by a potential return on their contribution. Current regulations, or lack thereof, make ICOs an attractive method of raising money.
How does an ICO work?
Typically a team announces a project for a blockchain related project on Bitcointalk. The announcement contains information about the project such as a whitepaper, roadmap, ICO guidelines, and team. ICOs involve a public address where contributors send their digital currencies (BTC, ETH, etc…) in return for a token.
Specific token function and initial price varies but can be compared to chips at a casino. In order to use the product being developed, you will need “chips” to pay for services. For example, Ethereum conducted an ICO in 2014 selling Ether tokens for Bitcoin. It is one of the most successful ICOs to date and is currently the most popular platform for conducting ICOs. (Find out why Ethereum has become the go-to blockchain for ICOs, here.)
Ether is simply a token used for paying transaction fees or building or purchasing decentralized application services on the Ethereum platform. The ICO ran for four weeks and raised $18 million making it the second largest ICO to date. This capital was used to fund development of services around the Ethereum blockchain. Ideally, after the initial crowdsale, a token will make its way onto exchanges. Exchanges allow tokens to be traded like stocks in the secondary-market giving early contributors the option to sell their tokens at a premium.
How much money are we talking about?
During Ethereum’s ICO one token was valued at $0.311. An investor who contributed $1,000 received 3,215.43 tokens. About 3.5 years since those same tokens would be valued near $2.73 million; around a 273,508% return!
Having already surpassed early-stage VC funding for internet companies, ICOs continue to be an attractive alternative for startups. Fred Wilson, a venture capitalist and early investor in Facebook and Twitter, stated ICOs “are a legitimate disruptive threat to the venture capital business.”
ICOs exploded in 2017 and companies are still raising a TON of cash. Total fundraising over the past four years is estimated at a staggering $6.4 billion dollars with $1.32 billion raised in Q3 2017 alone. Large rewards entail large risks and the excitement surrounding ICOs has not gone unnoticed by regulators.
Are ICOs Legal?
It depends. SEC rules state you cannot sell securities without proper compliance work. Lack of regulations means each token must be evaluated on an individual basis. Investors can evaluate if a token is a security using the Howey-Test.
Under the Howey Test, a transaction is a security (or investment contract) if:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
Many tokens fall under point 2, and SEC Chairman Jay Clayton remarked: “to date no initial coin offerings have been registered with the SEC.” Note that the organization investigated the infamous DAO. They concluded the ICO violated federal securities laws with unregistered offers and sales of DAO Tokens. The agency decided not to bring charges in this instance but cautioned investors.
Regulations vary by country and are evolving. ICOs are currently banned in China and South Korea. Click here to find more information on ICO regulations in your country.
A New Hybrid Asset Class
ICOs are a new and innovative way for startups to raise money using a cryptographic token. Billions of dollars have flowed into ICOs and the model poses a potential threat to the venture capital industry.
Regulations are uncertain and catching up with the market. The fate of ICOs may not be clear but the industry is rapidly developing a compliant framework for token sales with projects like SAFT. (Simple Agreement for Future Tokens)
Oliver Bussmann, a former chief information officer at UBS, and now head of a fintech advisory firm stated: “ICO as a new business model leveraging blockchain technology will sustain as the digital way, combining crowdfunding and (a) new hybrid asset class of equity ownership and currency.”
Some ICO Resources
Research and Communities: