What is an ICO?
An Initial Coin Offering (ICO) is a method of raising funds for a project in the cryptocurrency sector. In an ICO, the team generates tokens on the blockchain to sell to the project's early supporters. It serves as a crowdfunding phase – users receive tokens that they can use (immediately or in the future) and the project raises money to finance its development.
This practice became popular in 2014 when it was used to finance the development of Ethereum. Since then, it has been adopted by hundreds of businesses (mainly during the 2017 boom), with varying degrees of success. Although the name is similar to an Initial Public Offering (IPO), they are fundamentally very different methods of raising funds.
IPOs generally apply to established companies that sell a portion of their shares to raise funds. ICOs, on the other hand, are used as a fundraising mechanism that allows companies to raise funds for projects in the early stages. When investors purchase tokens in an ICO, they are not purchasing any shares or property in the company.
ICOs can be a viable alternative to traditional financing for technology startups. New organizations that do not yet offer a working product often have difficulty raising capital. In the blockchain sector, well-established companies rarely invest in projects based on the merits of a whitepaper. Furthermore, the lack of regulation of cryptocurrencies causes many to disregard blockchain startups.
However, this practice is not only used by new startups. Some established companies choose to do a reverse ICO, which is functionally very similar to a regular ICO. In this case, the company already has a product or service and issues a token with the aim of decentralizing its ecosystem. Alternatively, they can host an ICO to expand their pool of investors and raise capital for a new product based on blockchain technology.
ICOs vs. IEOs (Initial Exchange Offerings)
Initial Coin Offerings and Initial Exchange Offerings are similar in many ways. The main difference is that an IEO is not hosted solely by the project team, but in partnership with a cryptocurrency broker.
The exchange partners with the team to allow users to purchase tokens directly on its platform. This can be beneficial for all parties involved. When a reputable exchange supports an IEO, users typically assume that the respective project has been rigorously audited. The team responsible for the IEO benefits from the publicity and exposure and the broker benefits from the success of the project.
ICOs vs. STOs (Security Token Offerings)
Security Token Offerings used to be called “new ICOs.” From a technological point of view, they are identical – the tokens are created and distributed in the same way. Considering the legal aspect, however, they are completely different.
There is a certain legal ambiguity, so there is no consensus on how regulators should qualify ICOs (more details below). Therefore, there is still no definitive regulation.
Some companies use STOs to offer securities in the form of tokens. Furthermore, it is an option that helps to avoid uncertainty. The issuer registers its offering as a securities offering with the competent government body, which subjects it to the same treatment as traditional securities.
How does an ICO work?
An ICO can take many forms. Sometimes the team hosting it has a working blockchain that continues to develop in the months and years that follow. In this case, users can purchase tokens that are sent to their addresses on the blockchain.
Alternatively, the blockchain may not have been launched yet. In this case, the tokens will be issued on another already established platform (such as Ethereum).
The most common practice, however, is issuing tokens on a blockchain with smart contract capabilities. This process is predominantly done on Ethereum – many applications use the ERC-20 token standard. While not all originate from ICOs, it is estimated that there are currently over 200,000 different tokens on Ethereum.
In addition to Ethereum, there are other blockchains that can be used – Waves, NEO, NEM or Stellar are popular examples. Given the flexibility of these protocols, many organizations do not plan to migrate, but choose to build on the existing foundations. This approach allows them to leverage the network effects of an established ecosystem and gives developers access to tools that have already been tried and tested.
An ICO is announced in advance and specifies the rules for how it will be executed. It can set an operating deadline, implement a maximum limit on the number of tokens sold, or combine both strategies. Some also have a special whitelist, to which participants must sign up in advance to gain early access or other benefits.
Users send funds to a specific address – generally, Bitcoin and Ethereum are accepted due to their popularity. Buyers provide a new address to receive project tokens or they are automatically sent to the address that made the payment.
Who can carry out an ICO?
The technology for creating and distributing tokens is quite accessible. But in practice, there are many legal specifications to consider before carrying out an ICO.
Overall, the cryptocurrency sector lacks regulatory guidelines and some crucial questions still need to be answered. ICOs are banned in some countries, but even in more cryptocurrency-friendly jurisdictions, legislation still lacks clarity. Therefore, it is critical that you understand the laws in your country before considering conducting an ICO.
What are the regulations regarding ICOs?
It is difficult to give a single answer as there are many variables to consider. Regulations vary for each jurisdiction and each project has its own specificities, which can affect the way government bodies operate.
It is worth remembering that the absence of regulation in some countries does not represent a free pass to finance a project through an ICO. Therefore, it is important to seek professional legal advice before using this type of financing (crowdfunding).
On several occasions, regulators have sanctioned teams that raised funds in what they later considered to be securities offerings. If authorities consider a token to be a security, the issuer must comply with the strict measures that apply to traditional assets of this class. On this front, the United States Securities and Exchange Commission (SEC) has provided some good insights.
Generally, the development of regulation is a slow process in the blockchain sector, mainly because technology overcomes the slowness of the legal system. Still, several government entities have been discussing the implementation of a more transparent structure for blockchain technology and cryptocurrencies.
Although many blockchain enthusiasts are concerned about possible government overreach (which could hamper development), most recognize the need for investor protection. Unlike traditional financial classes, the ability for anyone from anywhere in the world to participate presents significant challenges.
What are the risks associated with ICOs?
The expectation of a new token that can offer huge returns is attractive. But not all currencies are created equal. Like any cryptocurrency investment, there are no guarantees that you will have a positive return on investment (ROI) value.
Determining whether a project is viable is not an easy task, as there are many factors to be evaluated. Investors must do due diligence and research the tokens in question very well. This process must include thorough fundamental analysis. Below is a (non-exhaustive) list of some questions that should be asked:
Is the concept viable? Does it solve what problems?
How is token supply allocated?
Does the project need a blockchain/token or does it operate independently?
Does the team involved have a good reputation? Do the members have the capacity to bring the project to life?
The most important rule is to never invest more than you can afford to lose. Cryptocurrency markets are highly volatile and there is a high risk that your holdings will lose value.
Final considerations
Initial Coin Offerings (ICOs) have been very effective as a form of financing for early-stage projects. Following the success of the Ethereum ICO in 2014, many other organizations secured investment to develop new protocols and ecosystems.
However, investors must be well informed about the project they are investing in. There is no guarantee of income. With the growth of the cryptocurrency sector, these investments present many risks and there are few protective measures in case the project does not deliver a viable product.