ICOs — the Good, the Bad, and the Ugly

What is an ICO?

Initial Coin Offerings (ICOs)/Token Sales/Token Swaps are a way to raise capital for a business or open source project. They are arguably the hottest trend in blockchain and cryptocurrencies. It all started in 2016, with the now famous ERC20, which is an open source model for how any developer can create their own tokens/coins/cryptocurrencies on top of Ethereum. Some call ICOs the new Kickstarter for startups. For years, the market was longing for the “killer app” for Ethereum and cryptocurrencies. Wallets, new blockchains, IOT, exchanges, derivatives and international remittances were all important innovations but, in early 2017, it became clear that ICOs would constitute the basis of the “hockey stick” growth in the market.

While ICOs are not user facing, they make it extremely easy for any company/organization to raise capital for their businesses/non-profits. In other words, it’s a middleware layer which accelerated the advent of new blockchain startups, and helped attract new capital (market capitalization of $15B in January vs $90B in July). Presumably, after some of these startups show concrete advancements and user base growth, even more capital will flow into the blockchain space, creating even more opportunities for developing applications and infrastructure protocols.

Due to their rapid growth and novelty, ICOs come in many flavors depending on the underlying product/business, the capital raise/token sale process, and legislation/regulatory context. The goal of this article is to analyze some of these variables, identify the innovative elements of ICOs and describe some of the problems in the space. Part 2 (How to Fix ICOs) will discuss possible solutions.

Disclaimer: none of the content in this article should be considered legal advice. This is purely a personal opinion. Many of these opinions are rooted in ICOs I’ve seen in the space. The point of this article is not to influence buyers/investors of tokens in regards to specific ICOs. It is to depict a general landscape and offer general insights for everyone to use personally.

ICOs: The Good

Problem: “Investors need a chance to get in early but also to get liquidity. By the time most investors get a chance at IPO (when they have liquidity), the best returns have often already been taken by private investors. Yet, if they try to get into private rounds, most investors are at a disadvantage to the top tier VC funds and they have to accept their capital being locked up with no control over liquidity. This is hard for even the HNWI and UHNWI investors, but it is doubly hard for smaller investors who are sometimes legally prohibited or have to pay a big % in legal expenses.” (Bernard Lunn, Blockchain Bitcoin & Crypto Weekly CXO Briefing for week starting 22 May 2017)

ICOs are undoubtedly a revolution in the space, making it much easier to raise capital across the globe, while creating a new business model for open source software. In simple terms, they provide:

Global Reach

A company/foundation can now easily raise capital from investors across the world. Similarly, investors can now easily invest in companies located in any country in the world, whether it’s the US, Switzerland, France, Romania, China, Turkey or Russia. Compare this to the existing traditional funding route, in which international founders had to travel and incorporate in US in order to raise capital. This is not necessary anymore. Another way to put this is that it disrupts the traditional venture funding process.

Less Friction

The process of buying a token is several orders of magnitude easier than investing as an angel investor, or buying into a venture capital fund.

As an ICO investor, one does not need to be an accredited investor in the US. Even ICO tokens that are only available for purchase by accredited investors eventually launch on exchanges, being tradeable by anyone.

Investing in an ICO merely takes wiring ETH or BTC to an account or smart contract, and receiving tokens in return. It is a 5-minute process.

Little to no Investor/Buyer Discrimination

ICOs are available to almost anyone, regardless of where they come from, their network, their income or net worth. This also poses an additional risk to buyers who are not able to correctly appraise the opportunity of ICOs, and the lack of regulation makes it easier for companies to purposefully attract investors via unethical/illegal means. However, the foundation/infrastructure of this new system is much cleaner and efficient than that found in the traditional venture space, and the additional future layers of regulation/buy/investor protection have a large chance of being much more efficient and easier to comply with.

Close to Instant Liquidity

Unlike angel investing/venture capital, where funds are locked in for 3–10 years until a liquidity event takes place (i.e. acquisition, IPO), ICOs offer close to instant liquidity. This means that, once tokens are bought, they can be traded much faster. The exact timeframe depends on the token sale terms, but it usually ranges from 0 to 12 months.

Little to no Transaction Fees

Since most ICO logic is written in code (code is law), the marginal cost of buying a token is close to 0, which makes the transacting of tokens almost free.

New Business Model for Open Source Code

Perhaps the biggest revolution introduced by ICOs is a new business model for open source code. Non-profit foundations can now finance their open source projects by creating and selling tokens, which are needed to utilize the platform. As the usage and popularity of the platforms increases, so will the value of the tokens. Compared to the traditional open source business models, which focus on services and value-added features, this new model is much more direct and rewarding for developers of open source code. The same concept could be thought of for academic research. Tokens could be a real way for academics to raise funds for projects that move humanity forward.

ICOs: The Bad

a) Structural Problems

When it comes to structural issues of the existing ICO process, some of the main issues are:

Unclear what you’re buying/investing in. Most projects are highly technical, which make them very difficult for most buyers/investors to understand well.

Most ICOs Do Not Need Their Own Token. Many ICOs claim they will revolutionize certain industries/processes by using blockchain, without firmly describing (1) how blockchain is necessary to their product, (2) why they need to create a new token or currency, and (3) how their product will result in much better efficiencies when compared to the status quo.

Zero Accountability to Investors: There is absolutely no legal mechanism that prevents an ICO entrepreneur from cashing out all of the money raised and delivering nothing in return. What is preventing ICO entrepreneurs from cashing out their ICO profits and taking an extended vacation? What is preventing them from working no more than a 3–4h/day on the project while paying themselves $1M per year? Personal reputation and moral compass are arguably the main deterrents of ICO entrepreneurs to continue working intensely on their projects, as the ICO entrepreneur has no fiduciary accountability to the investors whatsoever. We will almost surely see many ICO equivalents of the Fyre Festival in the next two years and millions of hard earned dollars wasted.

Difficulty of performing future raises. While the typical fundraising model (angel → Series A → Series B → … > Acquisition/IPO) is gradual and based at each step on the current performance, team, product and vision of the company, the typical ICO process is a one-step-process, and does not offer a clear path on how future fundraising can be performed. Some of the ICOs which have achieved sky high valuations are closer to Series E rounds than pre-product startups.

b) Security Problems

Typical crowdfunding (Reg D, Reg CF, Reg A+) and venture capital raising methods lack the automation of ICOs, but perform better from a security perspective. It is much more difficult to “hack” a crowdfunding initiative, or VC round, largely because it is manual and based on signed contractual obligations. Many companies have been sued by their institutional investors for misrepresenting information, while others issued more equity to their investors to avoid lawsuits. ICOs, on the other hand, are notorious for getting hacked. Recent examples are DOA’s $50M loss, Coindash’s $7M in funding getting stolen and Verisateum’s loss of $2.5M.

ICOs: The Ugly

Despite the great benefits that ICOs are introducing into the market, there are also, unfortunately, many ways that this new process is being corrupted and misused. The blockchain/cryptocurrency space is notorious for its scams and ways to avoid regulations. This section will discuss some of these issues.

What does a coin/token represent?

Some tokens are being used to pay for the utilization of the underlying platform or processing of transactions (Utility Tokens). Others are being used to represent a share of the profits of the underlying company (Security Tokens). Others are considered to be replacements of traditional fiat currencies (Currency Tokens). Others have fixed income products behind them (Fixed Income Tokens). And others have real assets behind them like gold, zirconium and real estate (Asset Tokens). The vast diversity of tokens makes it very difficult to create regulations around them.

One of the clearest ways people are pushing the legal limits of ICOs is that of issuing security tokens that do not comply with the typical regulatory/legal constraints. While these constraints might not be optimal, their intent to protect the investor and assure certain fundraising characteristics is very important to a healthy growth of the blockchain landscape. Without this, investors will lose confidence in the blockchain space, which will dramatically slow down the pace of its evolution.

This issue has been recently identified by the US Securities and Exchange Commission (SEC), with its labelling of the DAO token sale as a security sale. The press release can be found here: https://www.sec.gov/news/press-release/2017-131 and full report here: https://www.sec.gov/litigation/investreport/34-81207.pdf

Get-rich-quick schemes. Fake it all.

The newest joke among entrepreneurs in Silicon Valley is that ICOs mean free money. Thousands of entrepreneurs now want to do an ICO to raise huge sums of money that no sane venture capitalist or institutional investor would invest in. For once, THERE IS FREE LUNCH!

• Fake it till you make it. Many ICOs have raised tens of millions of dollars without even having a product roadmap (not to mention the product itself). They use fake profit promises, fake marketing and fake industry “experts”. The goal of these schemes is to create fake traction, attract buyers/investors by creating a false sense of urgency and a fear of missing out on the next opportunity to make millions. Atlantic has a good piece outlining the rise of ICO Ponzi schemes.
• Use of Pre-ICOs. Most of the ICOs we have seen do what is called a pre-ICO: a private and heavily discounted sale of their token before the ICO, in order to attract influencers and gather funds to build and market the ICO. This is a no-brainer sell to the buyers of a pre-sale, as they can immediately cash out during the ICO and make up to 100% returns. Start-ups do this to get influencers to promote the startup and for family/friends to make money (i.e. nepotism). This is naturally very unfair to the average ICO investor, who is taking as much risk but getting less in return. Some startups started to add vesting schedules to pre-ICO investors to address this issue, so they wouldn’t be able to cash out immediately.
• Marketing bounties which incentivize people to like or provide great comments on social media pages are notorious for creating “fake traction”. Plenty of these campaigns can be found on BitcoinTalk, where people receive tokens into an ICO by sharing/commenting/liking social media pages. This is arguably wrong, since it sends a fake message to regular investors, who believe the product/company is much more popular than it actually is.

• Paid Influencer Marketing: Industry “expert” advisors, who are renowned for unrelated accomplishments are receiving tens of thousands of dollars or heavy discounts in pre-ICO sales to just appear on the websites’ “Advisors” lists or post on social media to promote the ICO. This reminds us of how the Fyre Festival — a scam that collected millions of dollars for a luxury festival in the Bahamas that never transpired — paid Kendall Jenner $250K to post a single Instagram photo promoting the festival. Below is Kendall’s post side by side with similar influencer marketing done by a startup trying to raise its ICO.

We gradually see the rise of a PR industry forming around ICOs, and will likely see paid influencer marketing being institutionalized to beguile investors into investing in ICOs whose underlying technology they do not understand. This massive problem will likely have a legal repercussion as well, as the Federal Trade Commission requires a sponsored brand campaign to be disclosed to consumers. Giving someone free or discounted tokens could and should end up counting as paid influencer marketing.

• Uncapped raises. Several ICOs have tried to maximize the amount of funds raised by using an “uncapped raise” model, which means that there’s no limit to the amount of capital that would be raised. Instead, the raise is time bound, and there is often an exact conversion from the new cryptocurrency to existing cryptocurrencies (e.g. XBT, ETH). While there are exceptions where this may be argued to be OK, in many cases it opens the door to greedy entrepreneurs who are trying to raise tens/hundreds of millions of $ on just a plan to build a product.
• Pump and dump. This occurs when people unnaturally inflate the price of the coins by placing large buy orders in order to create “FOMO” in the market and attract other investors. As soon as the prices increase significantly, they start cashing out, leaving regular investors with loss positions.
• Money laundering, illicit operations. Routing money through ICOs and cryptocurrencies in order to lose track of the origin of funds and their usage. The most recent example is here.
• ICOs hurt Ether’s price. Over the past few months, the price of ETH has decreased considerably from its ~$400 high to under $150, before recovering to around $200. One hypothesis on the downward trend is the large amount of funds raised from Ethereum-based ICOs, which are then selling their positions in order to convert it to fiat currencies. A related problem is that of incentive structure post-ICO.
• Investor protection vs. Buyer protection. In the previous section, we discussed the difference between Security Tokens (STs) and Utility Tokens (UTs). While STs need to follow regulations that ensure investor protection, we believe that UTs should not be considered a “paradise for everything is OK” and create false expectations in the minds of the buyers. We have seen many ICOs use the UT argument as a way to create fake traction and fake messages, relying on the lack of regulation in the UT space. For example, imagine a Kickstarter campaign which promised the creation of an advertising platform that would take over Google in 2 years. Or flying cars mass adoption in 2 years. While these examples are clearly unfeasible, one can easily obfuscate the message by introducing highly technical terms, which are misunderstood. For example, “The goal of this product is to create a distributed delegated Proof of Stake blockchain, which uses the latest Blake2b hashing algorithm, to reward end users for each advertisement shown to them via a proprietary cryptocurrency. This would ensure high degrees of scalability and viral mass adoption, challenging the status quo of companies like Google and Facebook.”

Legal paradises — Singapore, Switzerland, Estonia and other unregulated environments

Given the issues listed above, many companies have decided to create their ICOs in legal/regulatory “paradises”, to limit their potential legal issues. The benefit for these countries is that they are attracting new business, capital, people and building their brands. While some of the ICOs are trustworthy and have solid businesses behind them, others are abusing the system and are in a rush for quick money.

• Singapore. It has arguably the most lenient legal/regulatory environment. There’s no legal/regulatory separation between ICOs, regardless of their category: security, utility, bond, asset, currency. Many companies are incorporating in Singapore, and blocking investors from regulated countries, such as the US.
• Switzerland. Also called the “crypto-valley”, the Zug area in Switzerland is renowned for the large number of crypto start-ups. The most popular model used here is that of a non-profit organization, which is raising donations in order to meet its goal of supporting an open source project.
• Estonia. A pioneer with its “E-Residency Program”, Estonia is also a popular destination for crypto start-ups, following a model similar to that in Switzerland.

Inevitable Government Oversight

When buyers/investors start losing money from these ICOs, they will ultimately sue the companies. Our belief is that the waves created by these losses will reach the political level, which will be forced to regulate ICOs and will punish ICOs which did not act ethically and fairly. Ultimately, ICOs will be regulated, as they should be. Hopefully, these regulations will be easier to comply with, cheaper and faster than the existing ones.

All of these issues are constantly eroding the confidence in the system. The speed of development of the blockchain/cryptocurrency market will largely depend on the success of companies ICO-ing in 2016/2017. While many of these will fail, hopefully, a few large, solid businesses will emerge.

The Future

Like many industry leaders, such as Balaji Srinivasan in his blog post, we believe many companies which raised capital through ICOs will fail within the next year due to all of the problems we outlined and massive valuations that give little room for hiccups or setbacks.

We still believe ICOs’ strengths could mean a future where crowdfunding displaces venture capital and institutional funding as the main medium of raising money for start-ups, IF their structural problems are fixed. We are on the watch out for start-ups that devote themselves to fixing ICOs, and believe that there are billion dollar infrastructure opportunities that solve the bad and the ugly of ICOs. Part 2 of this article (How to Fix ICOs) will discuss challenges and possible solutions.

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Who are we?

Deniz Kahramaner is an Advisor at Accompany and StackShare. He previously led data, growth and analytics at big data startup Accompany($20M Series B). BS in Electrical Engineering & MS in Computer Science at Stanford University.

Vlad Andrei is working on a stealth blockchain/crypto startup, and has a fintech software development consulting firm. He previously led the Product team at RealtyShares, and as a Product Manager at Motif Investing, launched an award winning financial advisor product. Vlad started his career at Goldman Sachs, and worked in Product Management and Product Marketing roles at Clearwell Systems (acquired by Symantec) and Ravello Systems (acquired by Oracle). BS in Computer Science & MS in Management Science & Engineering at Stanford University.

Vlad’s and Deniz’s interests include fintech, blockchain, real estate, cryptocurrency and artificial intelligence. They have been active investors in cryptocurrency since 2011 and real estate since 2008.