Why you should not invest in ICOs

First of all, there are a lot of good reasons to invest in Initial Coin Offerings (ICOs). Many smart people have earned quite some money by investing in ICOs. However, they are associated with significant risks for investors. This is not unusual for investing: Without anyone bearing the risk, why should there be any profit? Nevertheless, the majority of ICOs have momentous weaknesses that should be kept in mind.

ICOs: Same same but different

To some extend ICOs are closely related to the well known Initial Public Offerings (IPOs). During an IPO shares of a company are admitted in an organised capital market. In both cases, investors exchange money for a more or less virtual asset that promises to increase in value. For an IPO, this asset is a stock. But what asset stands behind an ICO?

In many cases, investors receive a so called Utility Token from an ICO. The fact that this token is a cryptocurrency is secondary. Basically, Utility Tokens are nothing more than digital vouchers comparable to gift cards. However, gift cards are less common as an investment than ICOs. So, what distinguishes the Utility Token from a gift card?:

  1. Crowdfunding: The product or service for which the voucher can be redeemed does not yet exist in most cases.
  2. Tradeability: The voucher can be easily exchanged online for other vouchers or money.
  3. Programmability: The vouchers are programmable and set to increase in value if the underlying product is successful.

With the crowdfunding aspect of a Utility Token, investors have the opportunity to help young companies grow. This was previously a classic task for business angels and venture capital firms. Tradability allows price discovery within an exchange, which determines the value of a token at any time.

Programmability, on the other hand, is the most complex property of a Utility Token and it has a distinct advantage: In addition to the price being set by the underlying demand for the token, the company itself can influence the price by changing the amount of tokens offered. This is how it works: Each time tokens are exchanged for a service, some of them are rendered unusable. The tokens are “burned”. As a result, the supply of tokens decreases and given a constant demand, the price increases. The more customers using the company’s offer, the more tokens will be burned and the stronger the price will increase. The company can change the proportion of tokens that are burned at any time within a predetermined range. The result: If the price increase does not meet expectations, the company increases the proportion of burnt tokens.

Becoming a millionaire with a one page website

Despite all the criticisms, it is clear that if you invest early in a successful project, you benefit greatly from this lever. If the project flops, however, the tokens are worthless. However, with some projects, investors didn’t even get the chance to see the projects fail. Many projects have in the past collected money from investors and simply run away with it. One reason why this is so common is that anyone can create tokens without much effort. We tested it with CASHLINK and developed a working token within 30 minutes.

In addition, if you use a tool for creating a shiny website, such fraudulent activities are hard to distinguish from a legitimate ICO at first glance. Another reason for this is that it is in no way necessary to own a company or even to have an imprint. Anyone can create tokens and sell them online in exchange for other cryptocurrencies. In that way several millions have disappeared, leaving betrayed, disappointed investors behind. The problem is so massive that the SEC has created its own Fake ICO page to warn investors against such scammers. Extensive research helps to prevent such scams. However, there is no effective and bullet proof protection.

Evaluating a utility token is almost impossible

But let’s not start directly from the worst-case scenario: The world is largely made up of good people and many in the crypto community actually want to make the world a better place. These people start with great ideas. But how can I rate these ideas to find a reasonable price for a token? Company valuation really is rocket science. However, all methods share a common ground: Information. Fully-fledged shareholders therefore secure extensive information rights. In the case of joint-stock companies, the same is made possible by publication requirements. By contrast, projects that finance themselves through ICOs only publish a more or less meaningful white paper at the beginning. After that, you usually hear little about these companies. The result: tokens degenerate into pure speculative objects whose price is driven by manipulation and rumours instead of solid information. High price fluctuations are commonplace in the world of Utility Tokens.

Changing the business model leads to total loss

ICOs are often referred to as a method of financing companies. But that’s misleading. ICOs started as a way to fund open source projects. As described above, most tokens are just coupons. The revenues from the ICO also do not migrate to equity or debt capital. Revenues from ICOs are extraordinary returns. There is no obligation on the company with them.

However, a start-up is like a big experiment. Testing out is daily business and the results of these tests are measured and evaluated. The conversion of the business model or even of the whole product (a so-called pivot) is a normal part of the development with most Startups. Over time, you get to know your market and your customers better and, as a result, new opportunities necessarily arise whereas the old plans become obsolete. This is not an exception, but the rule in the start-up environment. But what happens to my token if the startup does a pivot which means that the advertised product is not built or the marketing is discontinued? The token becomes worthless while the money remains in the company and can be used for the new product.

Exit vs profitable business

You would not suspect that the founders are doing that? Then maybe the next scenario will convince you. Let’s say the start-up has raised two million dollars in a seed round of classic investors. They have been given shares for this purpose and can thus determine the company’s decisions. In most cases, such venture capitalists seek to sell the business because it is the best way for them to receive a return on their investment.

Let’s consider the following: After the seed round, the founders decide to make an ICO. Investors are going to buy the tokens because they believe in the product’s success. As described above, buyers of tokens are interested in having sold as many products as possible. This increases the value of the tokens. The venture capitalists, however, aim for a sale of the company. Even if the founders are still so honest and give everything for the success of the product, it is completely unclear what happens to the product after the sale of the company. Furthermore, the token holders do not see a penny from the sale of the company. Thus, the value of the tokens is at stake. In a nutshell, in this scenario, the interests of investors and token holders are not identical. While the Token-holders want a steady expansion of the product, the investors work towards a quick sale of the company. The disadvantage for you as an ICO investor: You have little influence on this strategic decision.

Innovation or Wild West?

ICOs have led to a democratization of start-up funding. Many people have the opportunity to profit from the high growth rates of young start-ups. The tradability of the tokens provides more liquidity and also the ability to get rid of tokens quickly. However, it is of concern that there are so few obligations for companies that finance themselves through an ICO. Rights and obligations between companies and investors are unevenly distributed.

The solution to this dilemma can be a token that is geared directly to enterprise value, allowing the flexibility of a Utility Token, unlike traditional corporate finance models. Such a model combines the best of both worlds and would help start-ups to get the much-needed capital.