What is ICO?
An initial coin offering (or ICO) is a method for project teams to raise capital in the cryptocurrency world. During an ICO, project teams create tokens on the blockchain to sell to early backers. This is the crowdfunding phase – users receive tokens that they can use (immediately or in the future) and the project receives funds for development.
This method became popular in 2014 when it was used to raise capital for the development of Ethereum. Since then, hundreds of blockchain projects have adopted it (especially in 2017), with varying degrees of success. Although from the name, ICO may seem similar to Initial Public Offering (IPO), essentially, both are very different methods of raising capital.
IPOs often apply to businesses that are already operating and doing business, they sell shares as a way to raise capital. In contrast, ICOs are used as a fundraising mechanism that allows companies to raise capital for their projects at a very early stage. When ICO investors buy tokens, they do not buy any ownership in the company.
ICOs can be a viable alternative to traditional fundraising for tech startups. Usually, it is difficult to raise capital without forming a functional product. In the blockchain space, established companies rarely invest in projects based on the value from the white paper. Furthermore, the lack of cryptocurrency regulations prevents many people from considering blockchain startups.
However, this method is not only used by new startups. Established businesses sometimes choose to launch a reverse ICO, which functions very similarly to a regular ICO. In this case, a business already has a product or service and issues tokens to decentralize its ecosystem. Additionally, they can organize an ICO to expose more investors and raise capital for a new product built on blockchain.
Compare ICO with IEO (Initial Exchange Offering)
Initial Coin Offering and Initial Exchange Exchange have many similarities. The main difference is that the IEO is not only organized by the project team, but also together with a cryptocurrency exchange.
The exchange works with the project team to allow users to directly purchase project tokens on their platform. This benefits all parties involved. When a reputable exchange supports an IEO, the project will typically be closely examined. The project team benefits from the exchange's user base and the exchange profits from the success of the project.
Compare ICO with STO (Security Token Issuance)
Issuing security tokens has been called a “new ICO”. From a technological standpoint, they are identical – tokens are created and distributed in the same way. However, legally, they are completely different.
Due to some legal ambiguities, there is no consensus among regulators on what qualifies for an ICO (discussed in more detail below). As a result, there is still no meaningful regulation of this industry.
Some companies decide to use the STO route as a way to offer equity in the form of tokens. Additionally, this can help them avoid any uncertainty. Issuers register their offering as an offering of securities with the relevant government agency, which subjects them to the same regulations as traditional securities.
How do ICOs work?
There are many forms of ICO. Sometimes, the project team will use a functional blockchain that they will continue to develop over the coming months and years. In this case, users can purchase tokens sent from their addresses on that chain.
Additionally, if the blockchain has not yet been launched, in that case the tokens will be issued on an established platform (such as Ethereum). Once the new chain is live, holders can swap their tokens for newly issued tokens on the project's chain.
However, the most common practice is to issue tokens on a chain with smart contracts. Again, this is done primarily on Ethereum – many applications use the ERC-20 token standard. While not all originated from ICOs, it is estimated that today there are up to 200,000 different tokens on Ethereum.
Besides Ethereum, there are other chains that can be used – Waves, NEO, NEM or Stellar are some popular examples. Given how flexible these protocols are, many organizations do not plan to relocate but instead choose to build on new foundations. This approach allows them to exploit the network effects of an established ecosystem and gives developers access to tried and tested tools.
ICOs are often announced early and have pre-specified operating rules. An ICO will provide information about the time frame in which it will operate, a hard limit on the number of tokens that will be sold, or a combination of both. It may also include a whitelist to which participants must register in advance.
The user then sends funds to a specified address – usually Bitcoin or Ethereum because of their popularity. The buyer provides a new address to receive the tokens, or the tokens are automatically sent to the address the user used to pay.
Who can organize an ICO?
Token creation and distribution technology is now widely accessible to everyone. But in reality, there are many legal issues to consider before organizing an ICO.
Overall, the cryptocurrency space is lacking in guidelines and regulations, and several important legal questions remain unanswered. Some countries outright ban ICOs, and even the most crypto-friendly jurisdictions have yet to introduce clear laws. Therefore, it is imperative that you understand your country's laws before considering holding an ICO.
What regulations are there regarding ICOs?
It's difficult to come up with a one-size-fits-all answer because there are so many variables to consider. Regulations vary between jurisdictions, and each project may have unique nuances that can affect how government agencies view that project.
It should be noted that the lack of regulation in some places does not mean that the project is free to raise capital from the community through ICO. Therefore, it is important to seek professional legal advice before choosing this form of crowdfunding.
In some cases, regulators have sanctioned industry fundraising groups because lawmakers later deemed them securities offerings. If the authorities find that the token is a security, then the issuer must comply with the strict measures applicable to traditional assets of this type. In this regard, the US Securities and Exchange Commission (SEC) has provided some insight.
In general, regulatory development often happens more slowly than the pace of blockchain development, and that is also the general situation of the technology industry and the legal system. However, many government organizations have been discussing implementing a more transparent framework for blockchain technology and cryptocurrencies.
Although many blockchain enthusiasts are wary of the possibility of government overreach (which could hinder development), most of them recognize the need for investor protection. Unlike traditional finance, raising capital from anyone globally will always present significant challenges.
What are the risks with ICOs?
The prospect of a new token offering huge returns is no small draw. But not all cryptocurrencies can meet this expectation. As with any cryptocurrency investment, there is no guarantee that you will have a positive return on investment (ROI).
It is difficult to determine whether a project is feasible or not, as there are many factors to evaluate. Investors should do their due diligence and conduct extensive research on the tokens they are considering. This process should include thorough fundamental analysis. Below is a list of some questions to ask investors for reference:
Is this model feasible? What problems does the project solve?
How is the token supply distributed?
Does the project need blockchain/token to implement?
Is the team reputable? Do they have the skills to bring the project to fruition?
The most important rule is to never invest more than you can afford to lose. The cryptocurrency market is extremely volatile and there is a significant risk that your holdings will plummet in value.
summary
ICOs have been very effective as a means for early-stage projects to obtain funding. After the success of Ethereum's ICO in 2014, many organizations were able to obtain capital to develop new protocols and ecosystems.
However, buyers should be conscious of what they are investing in. No profit is 100% guaranteed. Given the newness of the cryptocurrency space, investments in ICOs are high risk and there is little protection for investors if the project fails to deliver a viable product.
