Short History of ICOs: From Crypto Experiment to Revolution in Startup Financing

2017 was indisputably the year of cryptocurrency boom, which was to large extent fuelled by a new type of startup financing, so-called initial coin offerings, also known as initial token offerings or token-generating events. Solely in the past year, ICO campaigns have raised almost $6 billion with some of the largest campaigns surpassing $200 million. To some it may seem as if ICOs appeared out of nowhere. However there is always a story behind everything and so there is one behind ICOs.

In 2008 an unknown developer or group of developers under alias Satoshi Nakamoto published a white paper introducing the first operating blockchain network developed for the purposes of digital currency, known as Bitcoin. Bitcoin became famous as a first commercially successful decentralized cryptocurrency, offering an alternative to traditional fiat currencies controlled by the governments. Bitcoin is undoubtedly a revolutionary concept by itself, but even more impressive is the underlying blockchain technology, which can serve many other purposes.

The Beginnings

In 2013, a developer J.R. Willet penned “The Second Bitcoin White Paper”, presenting his new project Mastercoin. In this document, Willet suggested to use Bitcoin blockchain as a base protocol layer, on top of which new protocols with new rules could be constructed. Simply put, J.R. Willet posited that building and testing of your own blockchain is a major bootstrapping exercise and thus it is economically more efficient to create a new application with own protocol rules on top of an existing blockchain. Mastercoin should serve as an interim layer between bitcoin blockchain and these new decentralized applications. The whole construct can be compared to an Android operating system, which creates a smartphone’s functional interface for downloading and running other applications for instance from Google Store. Willet further stated that new protocol layers on top of the Bitcoin blockchain will also increase Bitcoin value since they will expand its utilization. Furthermore, he suggested a new way of crypto community fundraising, which would later become known as the first Initial Coin Offering.

Interestingly, the governance of the project as well as aligning the incentives of coin-holders and developers played a crucial role in his early ICO model. He proposed to create a so-called “Trusted Entity”, an organization with a publicly known identity and location that would issue Mastercoins, coordinate the fundraising and distribute the funds for the protocol software development. From his other notes, it became obvious that this entity should not be controlled by developers and should have rather non-profit goals e.g. proliferation of the blockchain technology.

The first ICO turned out to be a success, when it raised around $500,000 worth of Bitcoin in August 2013. On paper, Mastercoin could have been the project that would have triggered the emergence of decentralized applications on top of the existing Bitcoin blockchain. This would have significantly lowered the barriers to entry into the decentralized application domain. However there were several technical drawbacks that made the original Bitcoin blockchain protocol too simple to accommodate more complex applications. One of the major limitations was the lack of Turing completeness of Bitcoin scripting language. Simply said, not all functions that these decentralized applications suggested could be programmed under Bitcoin script language, which was primarily developed to facilitate simple transfer of value from A to B.

Why Ethereum made possible what Bitcoin couldn’t

In 2014, a young programmer Vitalik Buterin published a white paper of Ethereum, an alternative blockchain protocol, built to serve as an ultimate foundational layer for programming of smart contracts. Ethereum contains several new features superior to Bitcoin blockchain. Most notably, its, scripting language is Turing-complete hence “allowing anyone to write smart contracts and decentralized applications where they can create their own arbitrary rules for ownership, transaction formats and state transition functions.”

Secondly, Ethereum’s scripting language as opposed to the Bitcoin is not value-blind. What does this mean? Bitcoin blockchain facilitates a ledger that records transactions that are sent and received by different blockchain participants, it does not work as simply as a bank account. Technically, your crypto wallet contains only outputs of received transactions. When you need to send 4 Bitcoins from your wallet you need to look at outputs of received transactions (for instance 2 & 7 & 8 Bitcoins) choose one (e.g. output with 7 bitcoins), send it to the a desired counterparty and revert the remaining amount back to yourself (e.g. 3 bitcoins). Such complexity would in case of multi-layered smart contracts significantly aggravate its inefficiency.

Thirdly, as a simple ledger, the coins (outputs) in the Bitcoin ecosystem can be either spent or unspent, either they exist as a received output in your wallet or they are recorded as sent to another user. Such binary existence of outputs does not support complexities of multi-stage smart contracts, in which parties often have to lock coins until the conditions of its release to the counterparty are met, hence coins can exist in sort of a limbo until the result of a transaction is determined.

The above properties of the novel blockchain allowed for what we know now as decentralized blockchain applications (so-called Dapps) and Decentralized autonomous organizations (so-called DAOs). DApps are very similar to website applications, however instead of using APIs (application program interface) to connect to the database, they utilize smart contracts to communicate with the blockchain. DAOs are technically also Dapps that are designed to resemble real-life organizations in the digital space, such as corporations, with different stakeholders and adequate decision-making mechanisms. The underlying rationale of DAO is to create an organization, where decisions will be automatically enforced and hence agency problems between managers and shareholders (or potentially other stakeholders) will effectively cease to exist. Building the cornerstone for other blockchain applications has significantly reduced barriers to entry and fueled the efforts of blockchain projects around the world.

Ethereum’s path to success

Ethereum, similarly to its predecessor Mastercoin, has walked the path of initial coin offering, raising around $18,4 million worth of cryptocurrencies in September 2014. Since the ICO, Ethereum has been quickly gaining momentum. Its popularity is apparent also from growing number of decentralized applications based on the Ethereum foundation protocol.

Besides being a developer friendly cornerstone of many blockchain platforms, Ethereum has contributed to the democratization of ICOs also in another way. One critical innovation is their ERC20 protocol standard. This protocol standard serves as a template implementing all basic functions of a tradeable token, such as transferring tokens, inquiring the balance of tokens at a certain address, and the total supply of tokens. Using this template also guarantees the tradability of the token on the secondary exchanges since it can be easily traded with other tokens based on the same protocol. Currently, the blockchain applications are built on more than 90 different blockchains. Ethereum, however, has been dominating the blockchain application market with more than 70% of applications using it as a building protocol layer.

ICOs and traditional financing

The technological advancements, however crucial, weren’t arguably the only factors triggering the sudden boom of ICOs in the beginning of 2017. The expansion of ICOs had its roots already in 2016. In this year, the crypto community witnessed first offerings that introduced more articulated capital rights for the token holders. Such development enabled potential investors to calculate valuations of the given businesses. In 2016, the venture capital industry became increasingly aware, and towards the end of the year, also actively involved in cryptocurrencies.

ICOs have undoubtedly challenged the dominance of venture capital in the domain of startup funding. Many commentators claim that ICOs will significantly shift the power dynamics between VC investors and entrepreneurs with investors eventually losing the upper hand. Moreover, the traditional VC model will be enriched with token trading strategies. Due to the ease of token trading, VCs no longer need to have only long-term and very illiquid positions in their portfolio startups.

Besides VCs, hedge funds have also stepped into the crypto arena. More than 90 newly established hedge funds focused on cryptocurrencies began operating in 2017. While they do not always participate in the ICOs, their active trading on the secondary exchanges further perpetuates the hype and thus directly influences the primary market. Although VCs and hedge funds have been increasing their presence in the crypto space, the majority of ICOs in 2017 was still to large extent fueled by wider public, e.g. retail investors. The research of LBX, a London-based blockchain startup, has posited that particularly millennials are prone to investing in cryptocurrencies. The estimate shows that around 5% of millennials have already invested in and/or traded either cryptocurrencies or cryptotokens and up to 17% are seriously considering such investment. According to expectations, by the end of 2018, almost third of millennials will get involved in the crypto-investing. Although very volatile, this market attracts young adults, who feel left out of other more traditional investment markets, such as property or pensions.

ICOs what’s in it for (startup) founders?

Moving from the investor side, the ICOs offered undisputable advantages also for the founders. First of all, token offerings do not alter the ownership structure therefore founders are not faced with significant dilution. ICOs are arguably faster and the control rights remain fully in the domain of the founders. Furthermore, during the ICOs, between 5–20% of tokens are allocated directly to the development team. On the one hand, such allocation facilitates the aligning of the investors and founders interests, similarly to stock options, on the other hand, development team can trade tokens immediately after the lock-up period and thus realize the capital gains much sooner than in the traditional VC model. Most importantly, ICOs that have raised well above 100 million, such as Filecoin, Tezos, EOS, Bancor and The DAO introduced a new startup reality, in which subsequent rounds of financing may not be necessary.

Aforementioned developments in the past two years were instrumental in ICOs entrance to mainstream investment market. It is very difficult to predict the future of ICOs as they directly depend on the developments in value of major cryptocurrencies. However, it may be possible that ICOs as a method of financing would even survive crypto crash and emerge in a modified and more sustainable form. Only time will tell.

Ivona Skultetyova, Co-founder