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.
In an ICO, a project creates a certain amount of a digital token and sells it to the public, usually in exchange for other cryptocurrencies such as bitcoin or ether.
The public could be interested in the tokens on offer for either or both of the following reasons:
1) The token has an inherent benefit – it grants the holder access to a service, a say in an outcome or a share in the project’s earnings.
2) The benefit will be in increasing demand, which will push up the market price of the token.
Tokens, especially those of successful sales, are usually listed on exchanges, where initial buyers can sell their holdings and new buyers can come in at any time.
As a type of digital crowdfunding, token sales enable startups not only to raise funds without giving up equity, but also to bootstrap the project’s adoption by incentivizing its use by token holders.
Buyers can benefit from both the access to the service that the token confers, and from its success through appreciation of the token’s price. These gains can be realized at any time (usually) by selling the tokens on an exchange. Or, buyers can show their increasing enthusiasm for the idea by purchasing more tokens in the market.
The first token sales appeared in 2014, when seven projects raised a total of $30 million. The largest that year was ethereum – over 50 million ethers were created and sold to the public, raising over $18 million.
2015 was a quieter year: Seven sales raised a total of $9 million, with the largest – Augur – collecting just over $5 million.
Activity started to pick up in 2016, when 43 sales – including Waves, Iconomi, Golem and Lisk – raised $256 million. Included in that total is the infamous sale of tokens in The DAO, an autonomous investment fund that aimed to encourage ethereum ecosystem development by allowing investors to vote on which projects to fund. Not long after the sale raised over $150 million, a hacker siphoned off approximately $60 million worth of ether, leading to the project’s collapse (and a hard fork of the ethereum protocol).
The DAO’s failure did not deter the increasingly ebullient enthusiasm for the new asset type, and in December the first fund dedicated to token investment got significant backing from old-school venture capitalists.
2017 saw an explosion of activity – 342 token issuances raised almost $5.4 billion – and thrust the concept to the forefront of blockchain innovation. Sales selling out in increasingly shorter periods of time fuelled the frenzy, and in the haste to get “in on the action,” project fundamentals became less important to would-be investors.
Along with increased attention came increased scrutiny, and concern about the legality of token sales came to a head when the U.S. Securities and Exchange Commission (SEC) put out a statement saying that, if a digital asset sold to U.S. investors had the characteristics of a security (ownership rights, an income stream or even expectation of a profit from the efforts of others), it had to abide by U.S. securities laws.
By the middle of the year, ICOs had overtaken venture capital as the main source of funds for blockchain startups as they flocked to what appeared to be an easier and faster way to raise a huge amount of money without sacrificing equity in the company.
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.
To the issuer:
- Access to seed funding, much faster and with fewer restrictions than via the venture capital route
- The opportunity to create new, decentralized business models
- A base of participants incentivized to use and test the service, and a boot-strapped ecosystem
- No loss of equity in the project (unless the tokens stipulated ownership sharing)
- A faster funding process
- More arbitrary limits to the amounts collected
To the token holder:
- Access to an innovative service
- Possible gain through an increase in the token’s price
- Participation in a new concept, a role in developing a new technology
For the issuer:
- Uncertain regulation (possible post-issue clamp-down, fine or even sentencing)
- Unstable investment (a sell-off by disgruntled users could affect the token price and the viability of the project)
- Little idea of who the token holders are (unlike shareholders)
For the holder:
- No guarantee the project will get developed
- No regulatory protection (investment at risk)
- Often scant information about underlying fundamentals
- Little transparency on token holding structure
At time of writing, the growth in initial coin offerings looks set to continue. As the technology matures and the market gains more experience with the concept, and as investors become more sophisticated, the quality of the tokens and the viability of the business models are likely to improve.
Regulators will most likely pay more attention to token sales as the next few years unfold, perhaps even passing blanket laws – or amending existing ones – to protect investors from flimsy or fraudulent sales.
Meanwhile, new types of business models will continue to emerge, fuelled by a new funding system and operating structure. The infrastructure that supports token sales will also continue to grow, with reputable advisors morphing into the “investment banks” of the sector, and new dedicated platforms increasingly enhancing the user experience.
You can find updated ICO offering information at Cryptonim, here.