ICOs — how did we get here?
Over the last six months startups have raised $1.3B in capital through anonymous crowdfunding.
That’s a big number. The most valuable raise this year (Tezos — $232M) accomplished this with zero product and zero traction. Venture capitalists and entrepreneurs around the world are left scratching their heads. Media agencies are balking at the numbers and calling all ICOs ‘scams’. This is all happening in the ever-evolving world of crypto-currencies. I’m sure you’ve heard of Bitcoin before, but did you know that we now have 1,000+ other assets and currencies in this marketplace? The crypto-world has grown in the last year from a humble $4B market cap to now a whopping $95B+. Many of these assets were launched within the last year, through a new instrument known as an ICO.
What is an ICO?
ICO (“Initial Coin Offering”) is a term coined from IPO in traditional markets and adopted for the crypto-world. In short — an ICO is a fundraising tool built on top of blockchain protocols such as Bitcoin and Ethereum. Through this tool you can exchange bitcoin, ethereum and other cryptocurrencies for the newly created token or future cryptocurrency. This created token or cryptocurrency is then publicly listed on exchanges — freely available to be bought and sold. The tokens are scarcely distributed and as such hold value.
This popular fundraising tool is used to build blockchain companies and projects. It allows entrepreneurs to raise funds for their project through true crowdfunding — open, distributed and liquid.
Why partake in ICOs?
As a purchaser, primarily — speculation for potential returns. Technology investment at the early stages usually has restricted participation. With the tech sector constantly growing, getting involved at the early stages has potential for tremendous returns. Peter Thiel’s initial seed investment in Facebook saw him receive >10,000X in returns. However, Thiel is a well-connected, high net worth individual which brought him restricted access to this investment. The average person can only get involved once these companies file to go public, which is usually quite late in their stage of growth and development. ICOs open this potential opportunity up for everyone and at all investment levels.
The most successful ICO (for purchasers) to date was the Ethereum ICO. On July 22, 2014 — Vitalik Buterin (a 19 year-old Waterloo drop-out and developer) and his team launched an ICO for their project — Ethereum. Ethereum was built to proliferate the usage of smart contracts in the blockchain. The initial price for this raise was $0.30 USD per ETH unit. The team raised $15M from this round to boost their project. These funds were used to grow the development team and build out use cases for their product. As of today, Ethereum (“ETH”) is the second largest crypto-currency in the world valued at $25B.
If you purchased $1,000 in ETH during the ICO, at its peak you would have had 3,333 ETH worth $1,233,210. Take that Peter Thiel.
Ethereum’s ICO is the most important use case in the development of the ICO for two reasons:
- It showed the world the power of crowdfunding at a global scale as the team built a robust and widely used worldwide product.
- One of the by-products of the Ethereum project was an easier solution to launch ICOs by creating tokens (via Ethereum smart contracts) — a process which countless others followed and use today.
Ethereum brought crowdfunding to the masses through ERC20 tokens (on their smart contract) and showed the world why it was such an important tool. Furthermore, it’s headline grabbing growth drew a significant amount of new purchasers into this marketplace. The increase in users also brought change to important infrastructure in the form of improved exchanges and public information databases for would-be purchasers.
Ethereum brought the ICO model front and center for the masses, and is now widely used. It is important to understand what the advantages this system brings over traditional markets.
Advantages for purchasers:
In addition to the potential returns, purchasers receive:
- Liquidity: Traditional seed investments that are privately held can rarely be sold in the early stages. Most investors must wait for triggering events such as an IPO or sale of the company in order to liquidate. On the other hand, tokens can be sold instantly on international exchanges shortly after the raises are closed.
- Zero fees: As there are no intermediaries needed in the process, token holders pay zero fees on their purchases.
- Instant custody: Token holders only need private keys to guarantee custody. As a purchaser, you do not need to rely on expensive lawyers, the court system or a piece of paper. The international blockchain protects your ownership rights.
Advantages for issuers:
In addition to the substantial capital that can be raised for projects very early, issuers receive:
- Non-dilutive properties: Tokens aren’t equity (usually) and as a result are non-dilutive to the company’s cap table.
- Low up-front costs: Token’s don’t require significant use of lawyers, bankers and other intermediaries to launch. This destroys cost barriers for early entrepreneurs.
- International: Historically the majority of technology capital has been limited to large raises out of Sillicon Valley. Entrepreneurs outside of this territory usually have a hard time raising substantial capital. Tokens can be issued internationally over the internet. There are no floors on the amount of investment from individuals. This opens up the capital available to all issuers worldwide.
The above factors have lead to tremendous growth in this space:
So is this legal? Truth is — many countries still see this model as “unregulated territory” as they scramble to fit ICOs into existing but dated regulations. Some countries, such as the US, have taken the stance that tokens may be perceived as securities (in fact the SEC recently ruled the DAO ICO to be a security). This can cause issuers to get into a lot of trouble due to strict requirements set out by government parties when issuing perceived securities to the public. Even worse — due to the anonymity upon sale, tokens may be used by purchasers to launder money internationally as they purchase and sell on exchanges.
The road to hell is paved with good intentions
Unfortunately, due to the unregulated nature of this model, bad players have been abusing this system for personal financial gain. Misleading projects have been posted online with repeat offenders taking advantage of uneducated purchasers. ICO projects have more recently become hacker targets with millions in funding stolen. With so much attention on this model and the amount of capital being raised increasing daily — this was expected.
Fortunately — as this model matures, we can expect the infrastructure surrounding it to improve. Three key elements continue to develop to improve this system:
- Market Research— reliable knowledge is critical for making the right purchase decisions. Further, it ensures you are not buying into an unreliable project or ‘scams’. ICORating, TokenMarket and Smith + Crown are examples of agencies tracking ICO projects and vetting the team and other details for purchasers.
- Market Data — reliable data to track the performance of holdings is required by purchasers to determine what the opportune times are to purchase or sell their tokens. Coinmarketcap.com is a popular tool to track this data as an aggregator of information pulled from exchanges.
- Exchanges — appropriate exchange listings around the world allow the tokens to be liquid. The number of exchanges operating reliably around the world is constantly growing as well. Some of the largest players include: Poloneix, Bittrex and Kraken.
This disruptive model continues to pick up momentum from both issuers and purchasers. More importantly however, this model represents a significant improvement from the current method of raising capital. It is borderless, liquid, more efficient and open to all. There is an opportunity to open up this model up to companies of all types across the world. However, it is still early days and due to some bad seeds taking advantage of this system — it is still considered the ‘wild west’.
Purchasers should attempt to perform full due diligence before making their decisions. However, with limited reliable information available and the markets operating 24/7 — there is a huge risk of loss. It is best to speak with someone experienced in this space if you are looking to get involved in the early stages. A und with experience purchasing and selling these instruments is your best bet. They are best equipped to provide the right security (for hacking threats), information and opportunities available for interested purchasers. Prominent venture capitalists such as Andreessen Horowitz and Naval Ravikant use this route in this space as well.
At the end of the day, this model represents a drastic improvement over the current traditional models for financing a startup. It improves the structure for both the issuers and the purchasers in a disruptive way.
The ICO model is evolving the financial industry and has massive potential to change the way we raise capital forever.
(Purchasers: this is not financial advice. Please speak to your personal financial advisor before making any decisions. Issuers: it is always best to seek legal counsel before pursuing an ICO opportunity for your project.)