ICOs — Initial Coin Offerings — have continued to gain momentum since 2017. In spite of their inherent risks, they are growing in popularity as a method of fundraising. But what are the intricacies behind ICOs? How do startups and investors utilise them to raise funds and expand their portfolios? What do you need to start your own ICO?
These are some of the questions that this article will address.
What is an ICO?
An ICO is a fundraising method through which startups can raise capital for their ventures. One of the primary reasons for it becoming such a popular method of fundraising is that there is almost no restriction on the type of investors who can participate in an ICO. This opens the ICO up to a group of global investors, allowing the amount of funding raised to be very high.
However, a lot of ICOs are launched prior to a product launch or update. As a result, investors are putting their money more into a concept than a ready product. Although not always the case, when this does happen, it makes the investment highly speculative.
The whitepaper is the solution to this problem while also being the go-to resource on the ICO itself. In fact, a startup can run an ICO only after first publishing a whitepaper that details their business, goals, plans, and intended use of the funds raised. It also needs to mention how the people investing in the ICO can utilise the benefit they obtain through their investment. This benefit is called a token. There are three types of tokens, each of which offer the investor specific benefits and rights. This is explained in more detail in the section Types of Tokens. Investors can buy this benefit or token by paying in Bitcoin, Ether, or even Fiat currencies.
However, unlike traditional fundraising and IPOs, the investors of an ICO do not receive a share in the company, unless specifically pre-determined. They only receive certain rights and benefits as determined by the type of token the startup is offering for sale. Broadly speaking, these benefits are divided into two categories:
- benefits inherent to the token that gives the holder access to a service or outcome
- benefits that face increased demand with time, raising the value of the token held by the investor
In many cases, tokens are listed on exchanges where holders can sell their tokens when the price rises, and other buyers can step in at any time. This gives startups who run ICOs the benefit of raising funds without losing equity. Additionally, the tokens can also work to incentivise the use of the related product, which leads to improved adoption of the project.
Investors and startups both seem to remain positive towards ICOs. But where did this phenomenon begin?
A brief history of ICOs
In 2014, seven projects raised a total of $30 million through ICOs. More than half of this ($18 million) was raised by Ethereum when 50 million ethers were created and sold publicly. Augur was the largest fundraiser of 2015, having raised $5 million of the total $9 million raised that year through a total of seven sales. 43 sales happened in 2016, raising $256 million. However, the year also witnessed the first ICO scam.
The DAO, which was a decentralised organisation operating like a VC fund that empowered its members to fund projects based on Ethereum, lost $3.6 million to hackers (from the approximate $150 million worth of Ether it had raised). Investors were purchasing DAO tokens with Ether to become members who could vote on Ethereum projects. A measure was built into the code resulting in the development of “child DOAs” to which the stolen funds got transferred, leaving them frozen in a separate wallet.
However, this scam did almost nothing to reduce startup and investor interest in ICOs. In December of 2016, Polychain Capital, a startup that specialises in blockchain-based asset trading raised funds from traditional venture capitalists. Coinbase led the funding round, which raised $10 million from venture capital firms Andreessen Horowitz (A16z), Boost VC, and Union Square Ventures, among other investors.
This popularity only gained momentum in 2017 during which around 342 ICOs raised approximately $5.4 billion. ICOs became the biggest result of the innovation of blockchain, and a popular fundraising method.
Why did ICOs become popular?
There are a lot of factors that contributed to the popularity of ICOs, especially as a fundraising method over VC funding and other traditional options. These include:
- Competition in traditional funding methods — Traditional funding methods tend to be highly competitive with hundreds of thousands of startups trying to bite into the limited-size pie of funding available from venture capitalists, angel investors, and other similar investors. ICOs offered a new method that, although popular, was not nearly as crowded as traditional funding.
- Larger investor pool — Traditional fundraising methods limit the potential funders to the VCs and other individuals that a startup can approach. However, ICOs are open to everybody, including retail investors who purchase tokens in smaller amounts. This opens up a much larger investor market for startups, allowing them to raise funds without having to rely on the inclination of just a few large parties.
- Overcoming geographical boundaries — Since ICOs are run online and all related material is also available on the web, startups are no longer restricted to the investors in the region. Furthermore, they do not have to spend seed money on traveling halfway across the world to meet with potential investors. This adds to the growth of the investor pool.
- Incorporating new technology — Another reason that contributed greatly to the popularity of ICOs is that this fundraising method allows startups to implement blockchain into its product portfolio. A disruptive innovation that is changing the state of numerous industries, blockchain helps startups build a completely new and different type of offering. This is an intrinsic benefit of ICOs, which may take time to implement, but does play a role in a startup’s decision to go down the ICO path.
- Additional benefits — There are various other benefits, received by the investors and founders of ICOs, that have contributed to their popularity. For a buyer/investor, these include the chance to be part of the development of an innovative technology, the potential of gains through token price increase, and the accessibility to a new technology or innovation. Other benefits that startups obtain include:
- Easier and faster access to seed funding
- Creation of decentralised business models
- Participants willing to test a new service and a ready customer base
- Full control over the equity of the company (unless otherwise specified)
The popularity of ICOs, however, means that more and more startups are choosing to turn to this fundraising method over more traditional funding avenues. There are new ICOs being launched every day, making it a buyer’s market. Furthermore, with blockchain being incorporated into so many different sectors, ICOs are driven by new ideas, innovation, and technology. So how does an investor choose the right ICO to invest in?
Evaluating ICOs
Every ICO begins with a whitepaper that details the specifics of the fundraising and its purposes. This whitepaper tells potential investors everything they need to know about the startup, its vision, its product and product applications, future plans, and even application of the funds raised. The whitepaper includes those elements that essentially give prospective investors insight into the startup.
Components of a whitepaper
Project vision:
This depicts the longevity of the project as well as its uniqueness. Reviewing the vision allows investors to identify if the offering bridges existing market gaps or not. A project vision that highlights innovative USPs (that are achievable) will have greater potential of success.
Team:
The team is the body that can turn the vision into a success or a failure. Insight into the team allows investors the opportunity to discover the professional successes of the individual members. This enables the development of trust in the core team, which is an essential influencer in the investment decision.
Strategic gap being filled:
The project vision lays out how the ICO will enable the development of an offering that will bridges a certain market or strategic gap. While this information is very useful, it is also incomplete without a deep dive into this gap itself. Focusing on why the gap occurs, why it needs to be filled, and how the product or offering will do so allows investors to get a better and clearer understanding of the viability and market-attractiveness of the product and the project.
Token distribution method:
The whitepaper also focuses on the benefit of the ICO itself — the token. Investors need to review the type of token they will receive, what its intrinsic benefit is, how these tokens will be distributed, as well as any associated equity or share receivable. This tells investors what they’re really buying with their investment, enabling them to determine the personal value-addition that this purchase provides.
Timelines:
While the above mentioned elements are crucial to an investment decision, they remain incomplete without timelines. A vision has no value unless it is viable and eventually achieved. A whitepaper will specify the deadlines and schedules according to which the startup aims to achieve the mentioned goals. This gives investors an indication of the actual achievability of the goals, as well as indicates the expected period in which they will see returns.
These are the primary factors that a whitepaper will cover. In other words, the whitepaper is the equivalent of a funding pitch that startups give to investors. Understanding and reviewing these factors allow investors to take informed decisions about whether to invest in the ICO or not. However, to truly be able to evaluate an ICO by its whitepaper, investors need to also focus on the basic take-away.
FOMO or Excitement over an innovation?
There is no dearth of ICOs that are little more than scams. The above factors will play a crucial role in developing an interest in a specific ICO. But investors also need to focus on the feeling they get from the whitepaper as a whole to correctly evaluate an ICO.
Many ICOs earn by instilling FOMO — the Fear Of Missing Out — in prospective investors. They do so because the underlying project or offering does not have any real value to add. Using language that instils the fear of losing out enables them to cover this weakness and still obtain investors. In too many cases, these end up being scams that leave investors burned.
On the other hand, a whitepaper that focuses on the USPs of the product and the specifics of the innovation itself is more likely to be genuine. These whitepapers focus on the product because that is the strength and eventual goal of the ICO. These whitepapers rely on the innovation to drive excitement in, and interest from, prospective investors.
The language and overall feel of the whitepaper will determine which of the two emotions a potential investor will feel — FOMO or excitement about the innovation. The feeling that a whitepaper evokes should not be discounted and, instead, should be instrumental in the investment decision. All these factors together enable the successful evaluation of an ICO; which brings to the forefront another question — what benefit does an investor really get when buying into an ICO?
Types of tokens
When an investor buys into an ICO, he is essentially purchasing a token. That is why ICOs are also called token sales. Each type of token holds a different type of value or benefit. As at the time of writing this article, there were numerous names gives to the different types of tokens one could buy in an ICO. However, these fall broadly into two categories.
Types of tokens
Equity tokens:
Equity tokens are exactly what they seem — tokens that offer equity rights. Sometimes referred to as Securities Tokens, these tokens provide investors/holders with a share in the company on completion of the ICO. They are very similar to stock and have recently been classified as securities under the securities law. However, with their legality and categorisation still slightly unclear and numerous laws to be complied with for their issuance, equity tokens are rarely issued in ICOs. This may not be the case for long though as laws are being amended to cover such equity tokens, and the process of running ICOs with equity tokens is becoming simpler.
Utility tokens:
Utility tokens give investors access to the product or service of the startup running the ICO. It is not an investment in the traditional sense, but more of a pre-purchase of the rights to use the startup’s product, serving, or offering. Most ICOs offer utility tokens, and their supply remains fixed. As a result, their value can appreciate over time in the event of the demand for the product/service increasing. Since utility tokens are not investments, investors need to be wary of ICOs where the whitepaper markets them as such.
Utility tokens and equity tokens are primarily distinguished on the basis of the benefit they offer as well as the Howey test. In brief, the Howey test can be understood as a test created by the Supreme Court to identify if specific transactions fall under the ‘investment contract’ category. If found to do so, these transactions get categorised as securities and are subject to registration and disclosure requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934.
The Howey test determines whether a transaction is an investment contract by identifying if:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
When tokens are considered securities, as determined by the Howey test, they can only be issued after successfully complying with certain laws and requirements. That is one of the main reasons that ICOs rarely tend to issue equity tokens. Even with equity tokens having recently been more clearly classified, there still remains some opacity on the legality of ICOs and the safety of investing in them.
Are ICOs really safe or legal?
Although immensely popular, ICOs are not without risk or problems. There have been numerous hacks where perpetrators have gotten away without a trace and ICO funds have been lost. Even in the event of an ICO being safe from external hackers, the fundraising methods have some inherent risks that affect both investors and startups.
Some of the primary concerns for startups running an ICO include:
- Uncertainty about regulations which can cause errors that have adverse effects once the ICO goes live, possibly leading to fines or shut-downs
- Instability in investment received caused due to an abrupt selling-off of purchased tokens, which can affect the token price as well as project viability
- Lack of control over who can invest and complication caused by investors voicing opinions and criticism on public forums regarding the ICO, token, or even method of business operation
The primary concerns for investors of a startup include:
- Lack of guarantee that the project will actually go into development and get completed as planned
- Lack of clarity in regulations and lack of regulatory protection which makes the investment riskier
- Limited information about project details due to selective information sharing, which can affect the outcome of the project
- Influence of biased sources of information that aren’t moderated and that may be false or misleading
The recent decision to use the Howey test as a tool to better categorise ICO tokens does, to some extent, shed light on the legal stand of these assets. With time, the categorisation of tokens and the process of issuing equity tokens are being made simpler. This takes away some of the legal risks involved in ICOs.
Investing in ICOs can also be made safer through personal efforts and accurate evaluation of the startup, the whitepaper, and other details. However, the ICO space is still quite opaque. This is due to varying regulations and stands on the topic, as well as the sheer number of ICOs, which creates too many variables. The ICO space, without a doubt, needs more clarity.
Oddup’s contribution to making the ICO space clearer
In an attempt to reduce ICO space opacity, Oddup recently launched ICO and cryptocurrency listings.
The Oddup platform now covers an extensive list of curated and analysed ICOs — active, upcoming, and past — and also delves deeper into individual ICOs.
It also hosts live streaming, market capitalisation, and performance analysis of all active cryptocurrencies from across the globe. This addition aims to satisfy the investor need of greater clarity on ICOs and cryptocurrencies, through a single, comprehensive solution.
ICOs make for a very vast discussion topic with numerous views both contradictory and complementary. In the coming weeks, Oddup will shed even more light on this phenomenon through a detailed look at all aspects of ICOs. Stay tuned to learn about the types of ICO investors, running an ICO, and other ICO-related topics.
In the meanwhile, you can visit Oddup by clicking here to read more about startup investment, ICOs, and cryptocurrencies.
