Why most ICOs are Scams
The Environment
This year alone over $1.6B have been raised through ICOs.
ICOs — Initial Coin Offerings are a type of crowdfunding that enables companies to bypass current regulations on raising money by selling crypto-tokens to individuals and investors. These tokens may have some utility (purchasing in-app goods or allowing users to vote on company decisions) but mostly provide speculative value to investors who assume the price will increase as the company becomes more successful .
Some of the biggest ICOs have raised over $230M with little more than a team and an idea and massive lawsuits are arising as a result. ICOs barrier of entry is so low that the market has already started seeing terribly misleading and outright fraudulent business practices.
“We will see people go to jail” — Austin Hill, BrudderVentures
Here are 5 reasons why many ICOs are scams.
1. Money Raised vs Traction
Traditionally raising capital for your company requires your team and product to be vetted by a group of venture capitalists or angel investors. Investors heavily weigh factors such as prior experience, traction in the market, and achieving product market fit, before deciding to invest. For many companies raising venture capital is a hurdle they can’t overcome.
ICOs are a solution for this problem. They provide an unprecedented ability to raise funds without traction. With a nice website, and a brief description of their vision companies can raise millions of dollars from anyone with a computer and access to cryptocurrency. ICOs have exploded in fundraising in the last year; eclipsing Kickstarter with no signs of slowing down.
Some ICOs involve hundred of millions of dollars before anything has been built. This is orders of magnitude higher than the average seed round of 1 million dollars.
We are already seeing the problems that such huge injections of cash bring to premature companies. Tezos, which raised $230 million USD in an ICO earlier this year is plagued with lawsuits and team infighting. Despite it’s influx of capital it remains little more than vaporware.
2. Barrier of entry: Whitepapers
If someone wanted to raise $100M through traditional investment channels, you would expect months of due diligence regarding the team,use of funds, technology and intellectual property. Even Kickstarter projects require at least a video and timeline of their goals to be accepted into the platform.
Currently, startups looking to ICO are writing whitepapers, which are documents of approximately 20 pages describing the use of the token. There are currently no audits by a seasoned set of investors that can attest to the veracity of these documents.This means that currently there are people making tens of millions of dollars by essentially writing an essay and making a promise, very much like a large-scale confidence scam.
3. The Blockchain Test
Most companies do not need to be part of the blockchain. There are a large number of startups trying to force their companies into having some decentralized element. In reality many companies that ICO do not require a token. They introduce a token solely to participate in ICO fundraising. The problem with this is that non-essential tokens could be used to create an ICO and later on discarded by the company, allowing them to keep the money without giving any real value to the user.
Austin Hill from BrudderVentures calls this his ‘Why Blockchain?’ test. If a company can’t explain how a token adds value to their system they fail the test.
Augur’s REP token — which allows holders to report the outcome of events and rewards users for reporting correctly is a great example of tokens used correctly. By using tokens Augur avoids having a corruptible and fallible centralized authority to report events to.
Hydrominer — Exchanges mining time on a rented computer for tokens. It could use traditional fiat or existing cryptocurrencies to achieve the same result (Just like AWS). Hydrominer fails the ‘Why Bitcoin’ test.
4. Misleading Token practices
Tokens in ICOs are often seen as analogous to shares in IPOs, however contrary to behaviour of shares there is a lot of concern regarding the behavior of the tokens themselves. There have been multiple cases where founders give themselves up to 90% of the token, and only sell 10%.
Once you own a token, there no accountability that it will do what was promised, or that the company will use the money to create a product.
In order to fix this, escrows could be generated and tied to the token to hold companies accountable.
5. Legality
To make things more complicated, tokens can be classified as utilities or securities. Since the SEC has said very few things about the legality of cryptocurrencies, primarily that certain tokens are considered securities, a vast majority of ICOs are operating in an extralegal or even a blatantly illegal domain.
The offer and sale of securities is subject to applicable securities laws. While some companies have tried to limit the scope of their legal complications by proposing their tokens are SAFTs, or Simple Agreement for Future Tokens. SAFTs generally enable accredit investors to buy securities today, in order to receive tokens in the future. It remains to be seen whether the tokens are treated as non-securities.
“SAFTs are very clearly a security” — Ross McKee, Blakes
Since most investors in these ICOs expect their tokens to grow in value, a large majority can be considered securities, which immediately subjects the capital raised to broad legal consequences.
Conclusion: There’s hope
That said, we do believe that the current system for raising money is broken. Startups need money to build a product and attract users. In order to get this money, they typically have to go to wealthy individuals that select which companies survive. These people may not necessarily even be interested in using the product themselves, and have an incredible amount of power to create (or destroy) companies / ideas.
As a result, many companies have to create companies that look attractive to investors, sometimes at the expense of creating a product people want. And many believes that investors heavily prefer founders that look like them.
Startups struggle heavily to raise money to build a product.
For example: Social networks require users to gather investment, and they require investment to build a product that attracts users. This is perfect for ICOs, as they can benefit early users through discounts on the token, and continue raising the product through the microeconomics benefit of producing their own currency.
We firmly believe that ICOs are here to stay, but the startup community needs to produce and support companies that truly use the decentralized nature of the blockchain to create tokens that are purposeful, innovative and empower the owner of the token in ways that would not have been possible before. Otherwise, no one will trust ICOs, and rather than helping create products used by billions, they will be a technology used to deceive thousands.
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