Karl Marx observed in Das Kapital,
“Money plays a key role in modern capitalism. The simple equation M — C — M’, where M is money initially exchanged, C is commodities or capital, and M’ is money after the second exchange. In other words, capitalism takes money (M) and invests into capital (C) to make more money (M’).”1
Marx is generally dismissed by modern capitalists, but his observation is an astute one. Individuals invest money in capital to make more money. Rarely does someone invest money without concerns about getting their principal back and generating a positive return. Hence, most investors assume M’ will be bigger than M, with the gain representing their investment return.
Initial Coin Offerings (ICO) have emerged as a new funding model where “tokens” are (pre-)sold in a crowd-funding project to raise capital for the development of new digital technologies. While token buyers may be excited about the market potential of the technology underlying the offering, the issuer often views the offering merely as a vehicle to raise capital independent of the ultimate value of the token. Unlike capital raised in more tradition deal structures [an IPO or private placement], projects raising ICO capital have no legal obligation to token holders, who, in turn, have no legal recourse if (when) things go wrong. Buyers might assume the issuer has accepted the responsibility of turning M into M’ when it sells tokens, but the reality is not so simple. Digital tokens are not equity and should not be confused as such.
Most digital tokens are simply vouchers for a (future) product or service and can be thought of as gift cards for a store prior to its grand opening. Their value will depend solely on the (ultimate) value of the underlying utility of the platform under development. Carrying the gift card analogy forward, the token’s value will be dependent on the platform being completed and deployed (store opening), which is by no means a foregone conclusion, and the utility/value of the services available on the platform (merchandise in the store). If token buyers assign a speculative value to the tokens in the meantime, then the heightened risk is of their own making. Buyers beware: ICOs and digital tokens are highly speculative investments.
The main argument used to justify token offerings is that the process democratizes fund raising for young startups developing exciting new digital technologies. The story goes that ICOs allow individual investors to participate in opportunities historically available only to VCs and institutional investors. Although the argument is weak on several fronts, it is important for individual investors to recognize that no venture capital firm or institutional investor would give a private enterprise the amount of capital being raised by ICOs without extensive due diligence that would include at a minimum comprehensive documentation, transparent governance, and professional accounting and legal advisors.
It is imperative to emphasize that a digital utility token is not equity and does not give the holder ownership in the entity or (traditional) shareholder rights found in a VC investment or Initial Public Offering (IPO). Although the deal-structures are often compared, the ICO investor has no more rights than a gift cardholder. Further to this point, VC and IPO investors demand access to vital information prior to investing, such as the entity’s operating performance, key business objectives, and comprehensive financial projections in the case of a VC investment and audited financial results in the case of an IPO. At a bare minimum, VCs get monthly operating reports and financial results after their investment is made, while publicly-owned companies are required to disclose quarterly financial and operating performance to their shareholders.
In stark contrast, there are no such disclosure practices with ICOs. Token issuers are under no regulatory obligation to report any information to buyers prior to the token offering and few issuers have provided the information voluntarily. Even fewer token issuers report basic information after completing the offering, let alone the kinds of information more sophisticated investors require. The ICO investor also has no rights related to corporate governance or access to the entity’s operating managers, which is standard with more traditional institutional deal structures.
As history shows, all early-stage investing involves significant risks. Most ICOs have raised capital for an unproven platform in its early stages of development, which is not dissimilar to early-stage venture capital. However, ICO investing adds another layer of complexity. A token’s (ultimate) value will be derived from the economic value of the utility offered from accessing the underlying platform, which is radically different than venture investing, where the investment’s value will be derived from the ultimate economic value of the enterprise. Paramount to investing in ICOs is the recognition that there is rarely enough publicly-available information to exercise proper diligence on the offering or determine the token’s value once it is trading. It should be obvious that without the proper information, token holders cannot monitor the project’s progress and evaluate the risks of their investment. Venture capitalists accept the risk of investing in early-stage companies by mitigating the risks through extensive due diligence. ICO buyers have no such process and essentially are flying blind by comparison.
Despite these concerns, the amount of capital raised in Initial Coin Offerings is staggering. Roughly $4.9 billion was raised from 145 ICOs2 in 2017 and nearly double that amount has been raised so far this year, with approximately $9.2 billion raised from 207 ICOs.
ICOs are a global phenomenon. Over the past two years, 54 countries have hosted ICOs with greater than $10M+ raised in the offering. The United States (73), Singapore (51), Switzerland (33), United Kingdom (26), and Gibraltar (17) represent the top five countries ranked by the number of offerings and account for more than half of the ICOs completed.
It is interesting to note that there has been a recent shift away from ICOs in the United States to Asian and European nations, as regulatory scrutiny in the US has intensified significantly. Most observers believe the SEC will require issuers to register their ICOs, which has dissuaded many potential token offerings from launching in the US.
For instance, Jay Clayton, Securities and Exchange Commission (SEC) Chairman, stated on June 13, 2018:
“Much of what I have seen in the ICO or token or ICO space, is a security offering… I don’t know how much more clear I can be about it.”3
Almost 90% of ICOs have used the Ethereum ERC-20 smart contract token standard for their offering (Charts 3 and 4). The Ethereum platform is easy for anyone to use when launching an ICO. According to a Medium Article written by a blockchain enthusiast4, the technical aspects of an ICO on Ethereum can be completed in less than 20 minutes.
Roughly 48% of the 354 ICOs discussed above are trading below their initial offering price and another 15% are not currently trading (Chart 5). Although some ICOs have been profitable investments (so far), ICOs also are not without significant short-term trading risks.
Back to the gift-card analogy. There have been many instances when the project funded by an ICO was never completed or the organization collapsed before the technology was finished, which is equivalent to the store not being built or the organization going bankrupt before the store’s grand opening. In either case, the gift card and token holders are left with nothing of value. For what it is worth, TokenData (www.tokendata.io) reports that 46% of 902 ICOs in 2017 have already failed5. It may be interesting to note that because of the way ICOs are structured, token holders have no legal recourse in these situations and, at least so far, there are no clear paths for retribution.
As an example of the short-term trading risks, IUNGO (ING), a project attempting to build a decentralized global wireless Internet provider raised $46 million in a February 2018 ICO. Participants in the ICO have lost 95% of their initial investment as the ICO token price was $1.15 and the ING token is currently trading at roughly $0.06. IUNGO is an example of an ICO that raised a large sum of money, certainly by traditional VC standards, without having an alpha version of the product. It is highly unlikely that a traditional VC would have funded the project with anywhere near the amount of capital raised in the ICO, particularly at its stage of development.
This discussion raises an interesting paradox. In reality, investing in an ICO is riskier than venture investing for the reasons outlined above, yet the amount of capital raised by each individual project is significantly larger than could be raised from more traditional venture capital, which is clearly one of the primary attractions an ICO for the token issuers. In light of these risks, it should not surprise anyone that many of the tokens have lost most of their value.
Most of the projects will fail to deliver value for the token holders, which is to be expected from early-stage investing. However, because very few ICOs provide enough information to properly evaluate the project’s potential and assess its risks, the token buyer is speculating on the future value of a poorly defined asset based on an undeveloped and unproven technology.
It is assumed that if you want to participate in an ICO, your goal is to invest M to generate M’. It is your responsibility, therefore, to invest only in projects that provide the necessary information to assess the project’s potential as well as its risks, and demand updates on the project’s progress and the entity’s financial performance, including reports on how capital is being deployed.
On the other hand, if you bought an ICO with no intention of getting M’, you are a philanthropist, not a capitalist.
Don’t invest your money for nothing.
(1) Marx, Karl, 1818–1883. Das Kapital, a Critique of Political Economy. Chicago. :H. Regnery, 1959.
(2) With greater than $10M raised in the offering.
(3) Mathis, Jack. ICOs are Securities, ‘Don’t Know How Much More Clear I Can Be’: SEC Chairman. CCN. Published 6/14/18 — https://www.ccn.com/icos-are-securites-dont-know-how-much-more-clear-i-can-be-sec-chairman/
(4) Neto, Moritz. How to Issue Your Own Token on Ethereum in Less Than 20 Minutes. Medium. Published 12/25/17 — https://medium.com/bitfwd/how-to-issue-your-own-token-on-ethereum-in-less-than-20-minutes-ac1f8f022793
(5) Sedgwick, Kai. 46% of Last Year’s ICOs Have Failed Already. Bitcoin.com. Published 2/23/18 — https://news.bitcoin.com/46-last-years-icos-failed-already/