What is an ICO?

An initial coin offering (ICO) is a way to attract and raise investment for cryptocurrency-related projects. As part of the ICO, the team creates its tokens based on the blockchain in order to then distribute them to early investors. An initial coin offering acts as crowdfunding: users receive tokens that they can use (immediately or in the future), and the project receives development funding.

This model became popular in 2014, when it was used to finance the development of the Ethereum network. Since then, hundreds of projects have resorted to ICOs (especially during the 2017 boom) with varying degrees of success. Although the name of such crowdfunding resembles an initial public offering (IPO), the two methods are completely different ways of raising funding.

IPOs typically apply to existing businesses that sell their shares, representing partial ownership of the company, as a way to raise funds. In turn, ICOs are used as a fundraising mechanism that allows companies to attract investment for their project at the earliest stages. When investors in an ICO buy tokens, they are not purchasing an ownership interest in the company.

ICOs can become a viable alternative to traditional tech startup funding. Often new entrants struggle to get investment without any functioning product. In the world of blockchain technologies, well-known companies rarely invest in projects that have only one white paper. Moreover, the lack of cryptocurrency regulation prevents many investors from taking blockchain startups seriously.

However, this practice does not only apply to startups. Some already existing companies choose to launch a reverse ICO, which is functionally very similar to a regular one. In this case, the business already has a product or service and is offering tokens in order to decentralize its ecosystem. Alternatively, they can also use ICOs to attract a wider range of investors and capital to form a new blockchain-based product.


Differences between ICO and IEO

An initial coin offering is similar in many ways to an initial exchange offering (IEO). The key difference between the two is that the IEO is not hosted solely by the project team, but in collaboration with a cryptocurrency exchange.

Partnership with an exchange provides users with the opportunity to purchase tokens directly on the exchange platform. This can be beneficial for everyone involved in the process. When a reputable exchange supports an IEO, users can expect the project to be subject to strict scrutiny. The team behind the IEO benefits from a lot of attention, and the exchange benefits from the success of the project itself.


Differences between ICO and STO (security token offerings)

Security token offerings were once referred to as a “new type of ICO.” From a technological point of view, they are identical, tokens are created and distributed in the same way, but from a legal point of view, these are completely different approaches.

Due to some legal uncertainty, there is no consensus on how regulators should qualify ICOs (discussed in more detail below). As a result of this, the industry still does not experience any meaningful regulation.

Some companies decide to use STO as a way to offer shares in the form of tokens. Additionally, it can help them avoid some of the client uncertainty regarding the project's legal status. The issuer of tokens registers its offering as a securities offering with the relevant government agency, which equates this type of asset to traditional securities.


How ICO works

Initial coin offerings can be structured in different ways. Sometimes the project team has a functional blockchain that will be developed in the coming months and years. In this case, users can purchase tokens that are immediately sent to their blockchain addresses.

If the project does not have its own blockchain, tokens are issued on an existing network with a good reputation (for example, Ethereum). After the launch of the new chain, users will be able to exchange their tokens for new ones.

Most often, tokens are issued on a blockchain with support for smart contracts. Typically, the Ethereum network is used for this, since many solutions use the ERC-20 token standard. There are now over 200,000 different Ethereum tokens, although not all of them started as ICOs.

Besides Ethereum, there are other popular blockchains that can also be used for this purpose, such as: Waves, NEO, NEM or Stellar. Given the flexibility of these protocols, many organizations do not plan to migrate to another platform, preferring to continue working within the current one. This approach allows them to leverage the network effects of the existing ecosystem and gives developers access to tools that have already been tried and tested.

The rules for conducting an ICO are announced before the actual collection of investments. The team can determine the duration of the offer or set a hardcap - a limit on the number of tokens sold. The project may also introduce a whitelist in which users must register before participating in the ICO.

Users then send funds to the specified address, payments are mainly accepted in Bitcoin and Ethereum due to their popularity. Buyers either provide a new address to receive tokens, or tokens are automatically sent to the address from which payment was made.


Who can launch an ICO?

The technology for creating and distributing tokens is publicly available, but in practice there are many legal issues that must be taken into account before conducting an ICO.

In general, cryptocurrency is not regulated by regulations, and some important questions have yet to be answered by the relevant authorities. Some countries outright prohibit launching ICOs, even the most crypto-secure jurisdictions do not yet have a clear set of rules, so it is imperative that you familiarize yourself with the laws of your country before considering launching your ICO.


Due to the lack of a universal set of rules applicable to every cryptocurrency project, the relevant regulations vary between different jurisdictions, and in most cases, each project has its own nuances that may affect how its activities are interpreted by government agencies.

It should be noted that the lack of regulation in some countries does not provide the right to freely crowdfund a project through an ICO, so it is very important to obtain professional legal advice before using this form of financing your project.

Regulators have repeatedly sanctioned projects that raised investments in what were later identified as security token offerings (STOs). If authorities deem a token to be a security, the issuer must comply with the strict measures that apply to traditional assets of that class. This issue is being considered by the US Securities and Exchange Commission (SEC).

In general, the development of regulation in the blockchain space is slow, one of the main reasons for this is the rapid progress of technology, which is clearly outpacing the slow development of the legal system. However, many government organizations are discussing the introduction of a more flexible mechanism for the general regulation of activities related to blockchain technologies and cryptocurrencies.

While many crypto enthusiasts are wary of possible government overreach (which could hinder the industry's development), most recognize the need for investor protection mechanisms. Unlike traditional methods of financing, anyone can take part in such an event, but this in turn involves many risks.


Risks of conducting an ICO

The idea of ​​a new token with high returns is tempting, but it always comes with risks. As with any cryptocurrency investment, there is no guarantee that you will receive a positive return on investment (ROI).

Determining the prospects of a project is quite difficult, since it is necessary to take into account many factors. Potential investors should conduct due diligence and carefully study the project in which they plan to invest. This process involves careful fundamental analysis. Below we have provided a list of questions that may be useful when searching for a promising project, although there may, of course, be more of these questions:

  • Is the project concept viable? What problem does it solve?

  • What is the order of distribution of the total supply of assets?

  • Does the project need a blockchain/token or can it function without it?

  • Is the team authoritative? Do they have the right skills to make the project viable?

The most important rule is never invest more than you can afford to lose. Cryptocurrency markets are incredibly volatile and there is a high risk that your assets will drop significantly in value.


Summary

ICOs have been extremely effective as a source of funding for projects in the early stages of development. Following the success of Ethereum's initial coin offering in 2014, many organizations were able to obtain capital to develop new protocols and ecosystems.

An investor should always be aware of what he is investing money in, because there are no guarantees of income. Given the nature of cryptocurrencies, such investments are very risky, and if the project fails to provide a viable product, in an unregulated industry, most investors are left helpless.