What is an ICO?
Initial Coin Offerings or ICOs's are an increasingly popular method to raise capital. Investors can participate in a token offering by exchanging fiat currencies, such as USD or EUR, or cryptocurrencies, such as BTC or ETH, to the token issuer in exchange for digital tokens ("Tokens"). Tokens represent a holder’s right of benefit or performance vis-à-vis the issuer. Tokens may also be used (exclusively) for payment to the issuing company for its services or products. Contrary to a traditional initial public offering ("IPO"), Tokens typically do not represent an ownership interest or dividend right in an entity. ICO investors seek to directly benefit from the issuing company’s future business, while investors in IPOs tend to pursue a long-term interest in the value-creation of the IPO entity.
The underlying technology of the Tokens is based on blockchain. Using cryptography to record transactions in a distributed ledger, blockchains such as Bitcoin and Ethereum process, verify and track the trade of the relevant virtual currency (Bitcoin or Ether) securely across independent network components.
Similarly to IPOs, the issuer can use the proceeds of the ICO to finance its business operations and future growth. In the event that Tokens are exchanged for other cryptocurrencies, the issuing company can exchange them for fiat currencies like US dollar, Euro or Renminbi, as required. Tokens are typically tradable on virtual currency exchanges, creating a secondary Token market, which makes them fungible in the same way as shares.
This significant growth of the ICO market and the fact that ICOs offer limited investor protection have caught the attention of regulators all over the world. Although an ICO-specific regulatory framework does not yet exist, this does not mean that the market for ICOs is entirely unregulated. Regulators are progressively applying existing securities and financial market regulations to ICOs. Regulators in some jurisdictions, such as France, are in the process of drafting specific ICO regulation on the basis of a public consultation paper. An effort is being made to provide regulatory guidance to issuers, investors and financial markets as a whole.
For an ICO to be in compliance with regulatory requirements, potential ICO issuers should seek qualified securities’ counsel advice to conclusively analyse the applicable legal framework.
How does an ICO work?
To market an ICO, it is currently market practice that the issuing company publishes a whitepaper ("Whitepaper") on its website and certain virtual platforms. In the Whitepaper, the issuing company typically describes its business operations as well as the structure and features of the Tokens. The ICO documentation may also include a Token purchase agreement stipulating the terms and conditions pursuant to which investors can purchase the Tokens.
Some companies opt to have a pre-sale ICO (either publicly or privately) in which digital tokens are sold (often at a discount) to test market appetite and raise funding for the ICO.
During the ICO itself, digital tokens are then sold in exchange for either crypto or fiat currency. If the firm fails to raise the minimum funding target in its Whitepaper, the ICO is deemed to have failed and investor funds are returned.
The rights behind the digital tokens can vary considerably and many tokens are not intended to grant the investor an ownership stake in the business (unlike shares, for example). Instead, many ICOs offer 'utility tokens' to investors, which allow buyers to use (and pay for usage of) a service backed by blockchain.
Once an investor has acquired their digital token, they are the beneficiaries of the token's underlying rights. In practice, many investors will, at a later stage, look to trade their token on a digital exchange once the project has increased in value.
Benefits of an ICO
ICO’s have been toutes as a disruption of traditional VC funding, because these offerings have a number of attractive properties:
ICOs have quickly become popular with start-ups, as an alternative to venture capital funding. The benefits of ICOs for start-ups include:
- Wider reach: ICO's offer start-ups and companies the opportunity of bypassing VC's by approaching a wider pool of potential investors on more preferable terms.
- Speed: ICO's can be set up quickly and, in some cases, avoid more cumbersome regulations for traditional public offerings.
- Marketing: The ICO can be an extremely effective marketing tool by raising the company's profile with investors across the globe at the same time as it receives investment. Some ICOs issue utility tokens, which can then be used to acquire products or services offered by the company.
An increasing numbers of investors see ICO's as an opportunity to profit from the opportunities presented by blockchain infrastructure. Some of the reasons for the popularity of ICO's with investors include:
- Wider reach: Previously, investment in start-up was almost entirely reserved to a limited number of Venture Capitalists and accredited investors. Many investors which are interested in taking a share in the innovative projects proposed by token issuers see ICOs as an effective way to do so.
- Profit potential: The volatility of cryptocurrencies means that there are significant gains (and losses) to be made. A well chosen investment in a digital token can exceed the return of more traditional financial instruments.
- Liquidity: As is the case with public companies, tokens can be traded on virtual exchanges allowing investors to liquidate their investments quickly (if there is market demand). Unlike traditional VC investments, investors do not need to be locked into a project for a prescribed number of years.
- Diversification: ICO's present a new asset class, which will increasingly become part of traditional investors' portfolio's. Because ICO's allow investors to take smaller stakes compared to typical amounts invested in traditional Series A or B rounds, VC's are enabled to invest smaller amounts in a larger number of projects.
Risks associated with ICO's
Regulators globally have raised concerns around ICO's, many of which are taking place overseas or outside of regulations. Some of the risks that regulatory agencies have been warning about include:
- New, unregulated space: many ICOs are not regulated by local regulatory agencies (such as the SEC) and many are launched overseas, which may make it hard to seek compensation when things go wrong.
- No investor protection: investors in ICOs may be unable to benefit from regulatory protections, such as those offered by the SEC.
- Price volatility: the value of tokens can be very volatile, which can result in considerable losses to investors. Never invest more than you are willing to lose.
- Fraud: there have been documented cases of fraudulent use of ICOs to raise funds to be used in ways which were not originally marketed to investors.
- Limited documentation: Whitepapers are not regulated and consequently may be incomplete or misleading in comparison to regulated prospectuses for IPOs.
- Early stage products: many start-ups which undertake ICOs are in the early stages of development with experimental business models. This poses greater risk to investors who could potentially lose their entire investment.