Road Less Ventured
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Road Less Ventured

I See You ICO — A Beginner’s Guide to the Wild West of Initial Coin Offerings

Last week I wrote about investing in crypto currencies and gave some advice to those who are looking to enter the market. What I left out of that post was the topic of ICOs, which has been generating a huge amount of buzz recently. While the mass-market awareness of cryptocurrencies is rising faster than the general public’s understanding of cryptocurrencies, ICOs seem to be gaining a lot of momentum with even less understanding. So I wanted to follow up my last post with a quick primer on ICOs.

Before I go on, it’s probably a good idea that you’re familiar with the basic mechanics of a blockchain system. This discussion depends on an understanding of the technology (a fact that demonstrates that buying into an ICO without knowing about the blockchain is essentially gambling, which is totally cool as long as you know that’s what you’re doing). Go ahead, I’ll be here when you get back.

Back to the topic at hand: if you aren’t familiar with ICOs, which stands for Initial Coin Offering, it’s probably because they are relatively new. Whereas the blockchain and Bitcoin have been around since 2009, the first ICO was Mastercoin in 2013 and the first to garner serious attention was Ethereum in 2014.

ICOs are akin to IPOs in that they are a fundraising event for a company and are the first time the general public has a chance to “invest.” But that’s where the similarities end. Instead of selling equity in the company as in an IPO, these companies sell digital tokens built on top of an existing blockchain (usually Ethereum via the ERC-20 standard), to network participants. These participants can then use these tokens to run the service, hold them in hopes they appreciate in value, or sell them for profit.

I know that sounds confusing, so lets talk about these tokens for a second.

These tokens are essentially cryptocurriencies native only to that product or service. They are used to fuel the product or service as well as compensate all participants in the network. A great example is Steemit, which is a social media platform where everyone gets paid for creating and curating content. The service runs on a token called STEEM, which can be earned by writing a blog post or by up voting content. The amount earned is based on the number of up votes an individual receives, which also determines the curation reward. If a post does well, you earn more than if a post doesn’t do well, thus incentivizing you to only produce and/or vote for content that you believe is high quality.

In theory, tokens may be used for just about anything from sharing unused storage space (Filecoin), to advertisers paying users for their engagement (Brave), to data scientists contributing algorithms to a trading platform (Numerai), to running a network that other applications are built on top of (Ethereum).

Unlike an IPO, these tokens aren’t equity because you don’t have any ownership rights in the company like you would with a stock. They aren’t exactly currency either in that they can’t be exchanged for physical goods like a carton of milk in the same way Bitcoin can (assuming the grocery store accepts Bitcoin). In fact, the only way to buy these tokens is with another cryptocurriency, which means if you want to cash out, you have to convert your tokens to a cryptocurrency (typically Ether, Bitcoin, or NXT) and then to dollars, Euro, or your fiat currency of choice. These tokens themselves aren’t products either, instead they are used to fuel and reinforce the use of the product or the service. So although these tokens have properties of stock and money, they aren’t equity or currency (at least not in the way fiat currency is). Tokens are an entirely new asset class.

So what? What is the big deal about tokens?

The token system is all about aligning incentives and creating a network effect. A company can create a new, decentralized product or service and use these tokens to create value for itself (by retaining some of the tokens), its investors (selling tokens in an ICO), its contributors (issuing tokens for work done) and its customers (rewarding users). If the protocol becomes widely used, the value of the tokens will increase and everyone benefits. So instead of selling equity stakes, ICOs allow a company to give the people who will be participating and creating value in the network a financial stake in the project. This way, every participant is incentivized — especially, those who bought early — to increase the project’s value. In other words, these tokens represent a brand new business model for the decentralized web. If you want more detail about this new business model and the network effects these tokens create, I suggest you read here, here, here and here.

And these ICOs have boomed as of late.

As of June 2017, ICOs surpassed venture capital funding as a means for raising cash for blockchain based startups this year. Entrepreneurs raised $327 million from ICOs during the first half of this year and there are currently around 20 or more offerings every month. Brave’s ICO generated $35m in under 30 seconds and Bancor recently completed the largest ICO to date, raising $153m in a few hours.

Wait, that’s insane. Is this for real?

Yes, but hang on a second. For every good project out there are lots of scams too. Remember how tokens aren’t stocks? Because they aren’t securities and because this whole thing is so new, ICOs are currently unregulated. And as with any gold rush, there are bad actors committing outright fraud in hopes of cashing in on a get rich quick scheme. The SEC is currently examining this financing method but until something is decided, participants cannot enjoy any protection on their investment in ICOs.

But not everyone is ill intentioned and yet, even in those instances, we still have seen some bad outcomes. There are some projects that were good conceptually but not fully secure (the DAO hack) and projects in which the incentives have gotten out of whack (Bancor raising $153m with no working product yet).

Even among the best ICOs, there is still a lot of experimentation going on trying to figure out standards and best practices. In fact, one could argue that the lack of regulatory oversight is actually good in the short term, as it allows the ICO market to experiment quickly. This will hopefully lead to learnings, new structures, and best practices. One of the best posts to read on how these ICOs could or should be structured is from Vitalik Buterin, founder of Ethereum.

And yet, despite all the uncertainty surrounding ICOs, there is real innovation being developed from companies with very interesting and potentially disruptive ideas. There are companies with real products that many consumers already use that are now being monetized through the use of tokens. Below is a list of projects that I believe are doing really exciting and innovative stuff. Time will tell how successful they all are but I think they are worth following and possibly participating in. I encourage you to do some more research on any one of these (or any other ICO for that matter) if you are interested.

· Brave: I am a big fan, and daily user of Brave. Brave is a new, open source web browser started by the co-founder of Mozilla and creator of JavaScript Brendan Eich. The idea is that instead of advertisers paying platforms such as Google or Facebook for the ability to market to you, users will get rewarded with their native tokens (BATs) for their attention.

· Kik: The social media company, which has millions of daily active users, is experimenting with a new token based business model. Will be very interesting to see how successful they are and if other social networks copy suit.

· Protocol Labs and Filecoin: The idea that you could be getting paid for letting others piggyback off your unused storage has far reaching implications.

· Civic: Identity management is going to be extremely important in a decentralized web. Imagine a world where you have passwordless entry to websites, apps, bank accounts, and everything else but its totally secure because none of your personal information is actually stored on the blockchain or any server. I am very much rooting for Civic to become that platform.

· Numerai: The company is building a hedge fund powered by crowdsourced trading algorithms. The company did an ICO but didn’t raise any money, instead electing to issue tokens to those that contribute the best performing algorithms.

I’m sure there will be plenty more innovative token based companies to come and I’m excited to watch this space unfold.

Also check these additional resources out to learn more about ICOs…

Great post by Fred Wilson on ICO activity

A16Z Podcast

Good Post by William Mougayar on evaluating ICOs

Jordon Cooper on what he looks for in ICOs

William Mougayar: Unpacking Initial Coin Offerings (ICO) and Token Sales

Token Summit: Fireside Chat with Fred Wilson and William Mougayar

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Brett Munster

entrepreneur turned fledgling investor. baseball player turned aspiring golfer. wine, food and venture enthusiast.