Initial Coin Offerings (ICOs) are increasingly becoming important fund-raising means for cryptocurrency and blockchain projects. The first ICO was in 2014, for Ethereum project, which had raised US $ 18 million. In June 2017, for the first time in the history of blockchain entrepreneurship, blockchain and cryptocurrency entrepreneurs raised more money through ICOs than traditional venture capital (VC) investment.
While ICOs do offer a stake of the project to public, and are like Initial Public Offerings (IPOs) in that aspect, there are crucial differences over what an ICO is, how the investors and the entrepreneurs benefit from it, the risks, and method of conducting an ICO.
What is an ICO?
ICO is an unregulated means of raising funds for a new blockchain-cryptocurrency venture. Start-ups increasingly use it to raise funds for the development of their product or service, without having to go through the rigorous process of raising funds from VCs or banks. The cryptocurrency entrepreneur also avoids the stringent regulatory requirements by going the ICO route. A percentage of the total cryptocurrency planned for the project is sold to early supporters, and the fund is raised in the form of fiat currency, or prominent cryptocurrencies, for e.g. Bitcoin or Ether.
A cryptocurrency entrepreneur looking to raise fund through ICO creates a whitepaper, which is a plan describing what the project is about and what need will it meet. The whitepaper also explains the technical solution, specifies how much money is required to complete the project, what percentage of the digital currency the project team will keep for their use, which currencies (fiat or digital) will be accepted for the ICO, and the timeline for the ICO. Sometimes, an ICO may be preceded by a private sale, where a few select investors are invited to buy cryptocurrency tokens at a price less than what’s planned for the ICO. During the open public sale, i.e. ICO phase, enthusiasts buy crypto tokens for a predetermined price using fiat or digital currencies. If the required fund can’t be raised, the ICO is considered unsuccessful, and the funds are returned to the investors. In case of a successful ICO, the project is taken to completion utilizing the fund raised.
Pros and cons of ICO
The entrepreneurs have several advantages if they go the ICO route, and these are following:
- Positive network effects: Cryptocurrency projects are often decentralized apps (DApps), and many DApps provide greater benefits to the users if more users join, and the ICO campaign can generate a large user base.
- Ability to raise fund quickly and easily: There is really no entry barrier, and anyone can run an ICO campaign, with customized tokens, with the help of platforms like Ethereum, Stellar, Waves. Besides, marketing and settlement costs are less.
- Online marketing: The entire marketing is done via company website, social media, messaging apps, and online forums.
- Settlements over the blockchain: The blockchain used by the entrepreneur, along with smart contracts, significantly reduce effort to manage contribution of funds and distribution of tokens.
ICOs offer the following advantages to the investors and consumers:
- Liquidity: If the crypto token is a popular one, then most crypto exchanges will have markets for them with enough liquidity.
- Democratization of investment: Unlike VC funds, which are geographically concentrated in financial hubs, for e.g. Silicon Valley, New York City, and London, anyone can participate in an ICO and buy token.
- Potential for making profit: As we have seen in 2017, cryptocurrencies have experienced a significant gain in their price. Since tokens are bought at low price during ICO, if the token is well-received by the market, the investor can make a good profit in quick time.
ICOs are also associated with the following risks:
- Lack of due diligence: Very often, the start-up trying to raise fund through ICO doesn’t have a product or service ready. While the whitepaper describes the business plan and technology, there’s no guaranty that it can be built, and the flaws in the business plan or technology may only be known after significant funds have been invested. This represents uncertainty for the consumers.
- Lack of a sound basis for token valuation: While the entrepreneur is offering a product or service, the token price may not be based on how fundamentally sound the business plan is, rather it may be based on an expectation of a resale profit. This may cause a bubble, and gains may be temporary due to inflow of newer investor, instead of fundamental economic utility of the crypto token.
- Extreme price volatility of cryptocurrencies is now very well known, and this represents significant risks for the investors.
- Instances of market manipulation through ‘pumping and dumping’, and manipulations by ‘whales’, i.e. people who hold extremely large amounts of cryptocurrencies and are therefore able to decisively influence the market, are common in the crypto market, and are risks for the investors.
- Crypto market is unregulated, and so are the ICOs, making it risky for investors who may stand to lose large part of their investment in case of market manipulation, and have no redressal mechanism.
- While many cryptocurrencies value anonymity, it can also pose a problem in general, because it’s hard to know if criminals are routing their ill-gotten money into crypto projects. Anonymity makes it hard to implement ‘know-your-customer’ (KYC) and anti-money laundering (AML) mechanisms, and there’s a real possibility that the ICO may end up financing a terrorist group. These can pose significant risk to the civil society.
- Regulatory uncertainties: ICOs may be treated completely differently from one country to another, or even from one state to another within a country. There is also considerable confusion whether crypto tokens are securities, and the US Securities and Exchange Commission (SEC) is yet to provide clear guidance on legality of tokens and what regulatory framework they will be included under. China has banned ICOs completely.
How to launch an ICO campaign?
Assuming the start-up already has their management team, business plan, and a technology solution in place, the following broad steps are needed to launch a successful ICO campaign:
- Assemble a competent legal team to ascertain legal requirements and take appropriate actions. This step will include reviewing legal status of ICOs in their jurisdiction, determining whether the crypto token is a security, the KYC and AML requirements etc. The legal team should be experienced with blockchain start-ups and cryptocurrencies.
- Customize the token: This can be done in 3 different ways.
- The first option is to develop and launch own token completely from scratch. Every aspect of creating the platform and the crypto token is the responsibility of the start-up team.
- The second option is to build a crypto token on top of an existing platform. Many ICOs use the Ethereum platform and ERC20 standard for customizing their token. The token can be built using Ethereum’s proprietary language, i.e. Solidity, however, the development work must be undertaken by the start-up team completely.
- The third option, also quite popular, is to use purpose-built ICO platforms such as Waves or ICONOMI, which significantly ease the process of launching ICO. Not only these platforms make it very easy for the users to launch an ICO, they also aggregate many ICO campaigns at the same time, creating a larger audience for all the crypto projects.
- Assemble a competent marketing team: this team will need to use all possible online marketing techniques to create a buzz about the ICO. The whitepaper, which must be of a very good quality, should be publicized adequately, because investors experienced with crypto projects will first understand the value the project brings to the table, and the whitepaper is an important tool for this. With crypto projects depending heavily on social media platforms, messaging apps like Telegram, and online forums like Reddit, and expert investors enjoying high reputation, positive views held by them will go a long way in marketing the ICO. The marketing team needs to aggressively use the company website, social media, messaging apps and online forums for marketing activities.