As the dream of launching your own start-up becomes aspirational for ever more people, new methods of fundraising are popping up. From Shark Tank to Kickstarter, entrepreneurs are finding creative ways to get their businesses off the ground.
Over the last few years, Initial Coin Offerings (ICOs) have become a popular crowdfunding method. Instead of looking for a large investment from a venture capital firm, startups raise small amounts of money from large numbers of people.
But misunderstandings are rife and regulation is minimal.
ICOs offer a quick and easy route to fundraising without the need to jump through any regulatory hoops.
A lot of projects have taken advantage of that and given the whole industry a bad name with their poorly planned projects or outright scams.
Are ICOs a shortcut to a success, or a loophole for fraudsters? In this story, we’re looking at the advantages and disadvantages of ICOs and how you can avoid scams.
What is an ICO?
Initial Coin Offerings are a new fundraising method involving the sale of digital tokens, piggybacking on the success of cryptocurrencies. A start-up launches an ICO by creating tokens which they sell to investors who hope they will gain value and can be sold at a profit. To make the tokens, they use platforms like Ethereum which simplify the process. Tokens designed only for the Ethereum platform are called ERC-20 tokens.
On the launch date, the company performs a public ICO and anyone can purchase their tokens, usually in exchange for a popular cryptocurrency like Bitcoin or Ethereum. In theory, this is similar to an Initial Public Offering (IPO), when a company goes public and offers up their stock. In practice, the two are wildly dissimilar. Instead of receiving a stake in the company which entitles them to a share of future earnings, purchasing ICO tokens does not give you equity and simply means you may be able to sell them for more in the future. The ICO gets to keep all its future earnings and, if they want to, the investors can sell at a profit.
So, a win-win, right? Not necessarily.
To go public, a company needs to first have a reasonable valuation and be well known enough for people to buy its stock. This means it’s already established and presumably has a working product. ICOs, meanwhile, represent little more than an idea which makes even the serious projects risky.
That idea is laid out in a white paper: a document describing the purpose of the project, the compensation scheme for investors, and the end goal. Prospective buyers use this to inform their decisions and it’s likely to be their main source of information.
At an agreed upon date, the tokens are launched, provided enough money is raised. If you want to learn more about investing in ICOs, we previously took a look at how you can assess the quality of the teams behind them.
Ethereum launched through an ICO
Good-news stories like Ethereum show us that it can work. As the second largest cryptocurrency launched via a wildly successful ICO, it started attracting interest in the concept. Before long, new ICOs were launching every single day, hoping to capitalise on Ethereum’s success. A small number have led to big profits and produced meaningful, or at least functional, products. But that came down to the companies themselves — ICOs are not inherently a source of wealth and there are a lot of scammers willing to capitalise on the misconception that they are.
Launching an ICO takes little planning or effort, and has proved extremely profitable for many scammers.
All it really takes is a website and tokens which can be generated online with no technical knowledge. During the heights of cryptocurrency mania, many people were so eager to buy into the hype that they willingly gave money to basic ruses like that. Easy pickings for scammers.
Only a few countries, notably China and South Korea, have outright banned ICOs. But many others are beginning to enforce regulations and to persecute ICOs that violate existing securities rulings.
Most ICOs fail
Most ICOs are short-lived, either failing to reach their funding goals or collapsing within a few months of launching. Some are outright scams, where the organisers simply take people’s money without any intention of producing a product. Unsurprisingly, this has drawn comparisons to the dot-com boom of the early 2000s, when funding was poured into internet businesses with no product of profitability, only an idea.
A report found that 86% of ICO tokens were trading below their listing price, with nearly a third worth close to nothing. Nearly three-quarters of projects still lacked a usable project. Around half survive less than 4 months. To date, over 1000 have failed. By some estimates, 80% of ICOs are scams.
As a crowdfunding model, ICOs hold a lot of promise. But their strengths — simplicity, ease of access, speed to set up, freedom from cumbersome regulations — are also their downsides.
The world of ICOs is full of fraud, scams, legal violations, or efforts that are simply pointless. All the regulatory requirements and complexity surrounding IPOs, venture capital funding and the like exist for a reason. Without strict controls, ICOs have become the favourite tool of cryptocurrency scammers.
The UK’s financial regulator, the FCA, warns that ICOs are very high-risk, speculative investments. They encourage prospective investors to ensure they’re confident in the quality of the underlying project and have enough experience to make good decisions.
ICOs do show potential as a new funding model
ICOs could have tremendous potential to change the way businesses access finance, making the process more accessible and democratic. A few promising projects have already emerged from the hype and some serious companies with genuine products are leveraging crowdfunding through tokens.
At Luno, we always caution our customers to be wary of investing in ICO tokens.
As the FCA explains:
‘You should only invest in an ICO project if you are an experienced investor, confident in the quality of the ICO project itself (e.g. business plan, technology, people involved) and prepared to lose your entire stake.’
Most ICOs to date have not been subject to regulatory oversight; so there’s absolutely no protection for investors and no recourse if it proves to be a scam. Considering how many have proven to be fraudulent or simply not to have viable solutions, it’s certainly worth being very careful.
We’d encourage new investors to invest their time in understanding the fundamentals of this new technology before investing. We thoroughly vet any cryptocurrencies we decide to support and would only move forward with ones we believe are safe and secure for our customers.
Don’t get caught up by FOMO
If you’re adamant that investing in ICOs is right for you, remember that there are hundreds of them happening at the moment. You don’t need to jump on the first one you see.
It’s fine to take some time to research, watch a few crowd sales happen to test your intuition, then start small. Find out more about our thoughts on altcoins and the questions we ask when assessing new coins.
Do you have any ICO stories you’d like to share with us? We always like hearing about your experience in the crypto space, so let us know how you do your homework on ICOs.