Intro to Blockchain: Understanding Initial Coin Offerings
This post is part of a three part series on blockchain. In Part 1, I walked through the history of both the modern internet and blockchain technology. In Part 2, I’ve focused on explaining how the technology works, including articles on blockchain protocols, decentralized applications, and this post on initial coin offerings.
In Part 3, I plan to highlight a few of the most attractive areas for investment in the space. If you’ve enjoyed these posts and want to see more VC-related content, please follow my publication on twitter! Alright, enough of the overview, let’s dive in.
Initial Coin Offerings (aka ICOs)
I’m sure you’ve heard about the rise of the ICO and how it seems to be challenging the traditional venture capital model. I’m not going to comment on that debate in this post; however, I will try to provide a little clarity on how the ICO process works.
Question 1: What is an ICO?
Simply put, an ICO is a way to raise money. Specifically, it is a way to raise money by selling a coin or a token.
Question 2: What is a coin / token?
Before diving into the depths of how the ICO process works, it’s helpful to have a little bit of background on what exactly these investors are buying. As I discussed in my previous post, coins and tokens are the incentive mechanisms for blockchain protocols and decentralized applications. Coins / tokens are used to incentivize network participants to improve and maintain the network. Let’s look at two quick examples.
Example 1: Bitcoin
As I’m sure you’re aware, Bitcoin is a protocol that is maintained by a group of “miners” that process and validate transactions. Why do these miners waste their time and computational resources mining Bitcoin? They do this because they are incentivized by a block reward. If a miner successfully mines a block, he or she will earn 12.5 bitcoins, which is worth approximately $82,250 (on 11/2/18 for those of you who will undoubtedly fact check me). Without this incentive mechanism in place, it’s doubtful that anybody would take the time to process Bitcoin transactions.
Example 2: Filecoin
Filecoin is a decentralized application that allows somebody (let’s call him Joe) to store a file on somebody else’s computer (let’s call her Kim). Why the heck would Kim let Joe store his information on her computer? She’s incentivized because she will earn Filecoin by allowing him to do so. Without that token serving as a payment mechanism, she would not be willing to offer up her excess storage. This leads to our next question.
Question 3: Is there a difference between a “coin” and a “token”?
Short Answer: Yes.
Long Answer: Coins are cryptocurrencies that are meant to act as money. They are typically “native”, meaning that they run on their own blockchain and power the underlying blockchain protocols. Examples include Bitcoin, Litecoin, Dash, etc. Tokens, on the other hand, are typically used to facilitate decentralized applications that sit on top of existing blockchain networks. There are several types of tokens, including utility tokens, security tokens and equity tokens.
- Utility tokens are used to provide access to a specific service. For instance, in our example above, Filecoins were used to pay for file storage on the Filecoin network.
- Security tokens are tokens that “derive their value from an external, tradable asset”. An example of a security token is PropertyCoin. PropertyCoin’s parent company Aperture completed the PropertyCoin ICO in May 2018 and used the proceeds from the ICO to flip houses and provide loans to property investors. By buying a PropertyCoin, investors receive a fractional ownership of all of the assets that are owned by PropertyCoin. As you can imagine, security tokens are subject to much stricter regulations as they are officially considered a “security” by the SEC.
- Equity tokens, as the name implies, are tokens that represent equity in the company that issues it. However, there has been a general lack of regulatory guidance for equity tokens, leading to a limited number of equity ICOs to date.
While these descriptions seem relatively black and white, there are a few coins / tokens that fall into a gray area. Alright, now that we have a little context, let’s discuss the ICO process.
Question 4: So how do you actually sell these coins and tokens via an ICO?
The common perception is that it’s extremely easy to raise money through an ICO; however, there are actually a number of steps that need to be completed for an ICO to be successful. In his article, “How to Launch an ICO-Initial Coin Offering?”, Akash Takyar breaks the process down into four high-level stages: Preparation, Pre-ICO, ICO, and Post-ICO. I think this is a useful way to break up the process so I’m going to use the same broad stages to guide my explanation here. Also, just a heads up, I’m going to be discussing the process as if you are the one holding the ICO as I think that makes it easier to digest.
Stage 1: Preparation
The preparation stage is comprised of several tasks. First, and most notably, you need to come up with an idea. This probably seems like an obvious point but to be able to raise capital with nothing but a white paper, your idea better (i) solve a real world problem, (ii) be extremely well articulated, and (iii) be technically feasible.
The second task is to build out a team around you. Similar to any startup, you’re going to need a team of highly qualified individuals to develop and scale the product. In addition to that, it is helpful to have a group of senior advisors to guide you through the various legal, technical and operational challenges. Why does it matter if you have a team at this stage? Because you need potential investors to believe that you can actually do what you say you’re going to do. Even with the best idea in the world, if potential investors don’t think that you have the technical chops to build and scale the product you’re describing, they won’t give you a cent.
The third task is to write a white paper. As far as I know, there is not an “official” way to write a white paper; however, most white papers include a few key components. The best white papers I’ve seen have included detailed descriptions of (i) how the technology and business model is going to work, (ii) what market the product is expected to address, (iii) what the expected timeline for development is, (iv) the mechanics of the token sale, and (v) the team’s backgrounds. After creating the white paper, you should consult a legal advisor to confirm that you are adhering to all laws and regulations (especially if your ICO will be considered a security token!). One final step that is helpful in launching an ICO is to create a website that describes the project and provides links to both the white paper and the team’s bios. This provides additional resources for those that are trying to learn about your project.
Stage 2: Pre-ICO
So now that you have a general plan in place, what comes next? The next step is to announce the ICO and begin to generate excitement around it. One way to do this is to list it on a website that covers ICOs. Another way to do this is to spread the word via blogs, Twitter, LinkedIn or whatever other distribution platforms you have access to.
As you begin to spread the word, it is often helpful to provide additional detail around how the product is going to work from a technical standpoint. You can do this through a detailed wireframe; however, it is particularly helpful if you can create a prototype or a minimal viable product that serves as a proof-of-concept for the product.
The final step at the Pre-ICO stage is to actually write the smart contract that controls the creation and sale of the tokens. To do this, you can build on top of other blockchain networks or create your own. Currently, the most popular way to create a smart contract for your ICO is to use Ethereum’s Solidity programming language and ERC20 token. However, you can also use the Bitcoin or NEO blockchains. At this stage, you should determine how many tokens you are planning to create, how many you are planning to sell, and at what price. Additionally, you should determine when the ICO period will start, when it will end, and whether any discounts will be given to early investors. Finally, you need to clarify which currencies you are willing to accept in the ICO. Once you decide on these various factors, you can program them into the smart contract. There are a number of tutorials online that demonstrate how to do this on the various ICO platforms. After creating the smart contract, it is best practice to consult a security expert to make sure that the smart contract is secure. Once this is confirmed, you can test the contract on a testnet and then execute it on the mainnet.
Stage 3: ICO
Boom. The contract has been created. The token has been marketed. The story is over right? Not quite. You still need to set up the means for people to actually purchase the token within the pre-defined ICO date. This typically requires two steps. First, if you didn’t do this before, you should set up a website where people can learn about the project, learn about the team, and register to participate in the ICO. Once you create the website, you need to set up a crypto wallet that will receive the bitcoin / ethereum / whatever currency you’ve decided to accept, and distribute your newly created tokens to investors. After these steps are completed, congratulations, you’re all set to raise the money within the pre-defined ICO time period. One thing to keep in mind is that, similar to crowdfunding, ICOs are typically all or nothing endeavors. If you do not raise the full amount that you set out to, all of the money will be refunded to investors.
Stage 4: Post-ICO
Okay, hopefully at this point you’ve successfully raised the funds that you set out to. The final step is to use those funds to actually build the proposed product. Investors have given you a considerable amount of money and they’re going to expect you to build out the product in line with the development timeline that you initially proposed in your white paper. If you raised money to develop a new base protocol, this means that you need to bootstrap a community, build out the appropriate consensus mechanisms / scaling solutions, etc. If you raised money to build out a decentralized application that runs on a token, you need to develop the application and bring people onto the platform through an effective marketing campaign.
One question you might be asking after reading this is: at what point do coins / tokens get listed on exchanges? I’m not sure there is a “correct” answer here as each exchange has different standards for adding tokens. However, projects typically try to get listed as early as possible because the listing provides additional liquidity for token holders and brings an element of legitimacy to the project. While listing on an exchange often comes with a fee, the benefits of listing often outweigh the cost of the fee.
That wraps up part two in my series on blockchain, I hope you found it interesting and feel like you have a better understanding of how the technology works! If you enjoyed this post and would like future posts sent directly to your email, please subscribe to my distribution list or reach out to me at firstname.lastname@example.org.
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