What are ICOs?
Capital markets have time and again devised new ways of providing financial catalysts to growing enterprises of all sizes. The world of cryptocurrencies has grown to a massive and matured state wherein existing currencies have grown to an 8-figure standing and new entrants are emerging at an accelerated pace. In this rapid rate of growth, the cryptocurrency-world has come up with a novel method to fundraise means, in which a company attracts investors looking for the next big crypto score by releasing its own digital currency in exchange, typically, for bitcoin. Considered to be in the middle of initial public stock offerings and crowdfunding, ICOs or initial coin offerings have claimed to raise a record $1.32 billion for firms in the third quarter of 2017 alone.
What are ICOs?
An ICO can be thought of as a crowdfunding platform to develop blockchain-based applications, with the fundraising process taking place on a blockchain. It is widely used by start-ups to circumvent the rigorous and regulated capital-raising process demanded by venture capitalists or banks. Initial Coin Offerings are both a novel technology and, for some others, a means to democratize corporate fundraising. J.R. Willett, a Seattle-based software engineer launched the first ICO, Mastercoin (now called Omni), back in 2013. He calls the concept of ICOs, “the perfect token sale” and is currently backing it with more than $1 million of his own money. An ICO is said to be akin to an Initial Public Offering, but only in the digital world sans the regulations . Although the concept needs one to get used to it before utilization, it has recently acquired prominence as a popular means to launch a new cryptocurrency.
For instance, in 2014, the Ethereum ICO crowdfunded an amount of $18 million in bitcoin. This would then be the equivalent of 40 cents per ether. Ethereum is now trading above $200 with a market cap approaching $19 billion after a massive spike. Statistics from the Smith and Crown data show that the number of ICO sales concluding each week has shown an 80% increase from an average of 1.5 sales a week in 2016 to over 2.75 sales a week for the first four months of 2017. ICOs have gained a flourishing popularity as they facilitate crowdfunding through a larger group of people or entities who can purchase as many, or as few, tokens as they wish,instead of seeking investment from venture capital or angel investors.
The Economist describes the ICO financing mechanism by stating the following:
“ICO ‘coins’ are essentially digital coupons, tokens issued on an indelible distributed ledger, or blockchain, of the kind that underpins bitcoin, a cryptocurrency. That means they can easily be traded, although unlike shares they do not confer ownership rights.” A series of successful ICOs in the recent past has led to a popular sentiment among investors who enter the digital fundraising space hoping to profit from getting in early on a promising platform. A few of the early numbers obtained from the spring and early summer of 2017 reports reflect tremendous gains in this space.
Breaking ICOs down for you…
The process of raising capital by a cryptocurrency startup firm through an Initial Coin Offering usually starts with the creation of a plan on a white-paper. This document states what the project is about, what functions the project will fulfill on completion, how long the ICO campaign will run for, what amount of money is needed to undertake the venture, what fraction of the virtual tokens will be kept by the pioneers of the project for themselves, and what type of money is accepted in the campaign.
While the ICO campaign is on, enthusiasts and supporters of the firm’s initiative buy some of the distributed cryptocoins with fiat or virtual currency. If the money raised in this step, does not meet the minimum funds required by the firm, the money is returned to the backers and the ICO is called unsuccessful. However, if the funds requirement is met within the specified timeframe, the money raised is used to either initiate the new scheme or to take it to completion. All early investors in any operation hope that the plan becomes successful after the launch. This could translate to a higher crypto-coin value than the purchase value before the project was initiated.
An ICO does not buy you ownership or security
Investing in an ICO does not get you equity in the company. It provides ownership of a full or partial share of the token that is for sale. It isn’t a debt instrument, as the company that sold the token owes nothing to its owner other than the use of platform services equal to its value. Adding to it, an SEC announcement stated that not all ICOs are securities offerings. This would be determined depending on the facts and circumstances of each transaction. The Howey test determines if or not a particular token meets this definition. The Howey test defines three requirements to determine whether an asset is a security offering:
1. There is a financial investment,
2. The investment is in a common enterprise, and
3. Buyers expect to profit from the efforts of others.
While ICOs meet the first two requirements, a lot of companies issuing tokens notice an exemption in the third criterion. It is believed that if the tokens being issued perform a function, then the investors are buying their token not out of an expectation of profit, but to utilize the application that is being developed. Let us take the example of ownership in a co-op apartment in New York City that is structured as shares in a corporation. These shares, however are not considered securities, because they have a usage value that translated to the right to live in the apartment. Hence, tokens which confer usage rights to their owners may not be considered securities.
If not ownership, then what?
Barring ownership and securities, there are several other things one could get if he/ she has bought a token. The intent behind the purchase of a token often determines the satisfaction gained from the investment. Mark Williams, a master lecturer at Boston University, says, “Usually, a token gives the owner the access or right to participate in specific activities inside the platform. If the underlying demand or value of these activities increases, the token usually increases in value. Sometimes tokens are purchased as a bet that underlying value of such access and blockchain related activities will increase in value. It is also possible for platforms to become adopted without the token gaining much value.” He also said that the potential for a tokens’ appreciation depends on the specifics of the economic design of the application in question.
For instance, an ICO-funded company Storj describes its product to be a “distributed cloud storage.” Its function is to link available data storage space through a blockchain connection, running an open-source software that Storj developed. Storj first raised capital in 2014 through an ICO measured by 910 bitcoins supplied by its investors. At that moment, digital currency information and news provider CoinDesk valued the money raised at about $460,000. Thus, the buyers in that auction did not get equity in Storj. On the other hand, they procured Storjcoin, a digital currency linked to the Storj platform. In another scenario, a buyer may also be looking at ICOs as a means to participate in any upside or notional capital value growth from that token, which would convert back into more bitcoins, ethers, or even U.S. dollars. This would indicate that ICOs can be used as a method of gaining quick profits and investment returns.
What is the downside?
ICOs differ from crowdfunding in the sense that the supporters of Initial Coin Offerings are motivated by a prospective return in their investments. On the other hand, funds raised in the crowdfunding campaign are basically a form of donations. Owing to these reasons, ICOs are referred to as crowd-sales. Despite there being a lot of successful ICO transactions on record, investors are cautioned to be wary as some ICO or crowdsale campaigns might actually be fraudulent. While ICOs are poised to be disruptive innovative tools in the digital era, they are not regulated by financial authorities such as the Securities Exchange Commission (SEC). Hence, funds that are lost due to fraudulent initiatives may never be recovered.
In late August 2017, the SEC froze the shares of four companies on suspicion of hyping upcoming ICOs in order to conduct pump-and-dump scams. While ICOs have been questioned time and again, a lot of attention has been garnered by big controversies in the recent past. In July 2017, the Securities and Exchange Commission (SEC) issued a statement, following a report of investigation, on the regulatory significance of offers and sales of digital assets carried out using distributed ledger or blockchain technology. The SEC’s Report of Investigation discovered that tokens offered and sold by a “virtual” organization known as “The DAO” were actually securities and hence, subject to the federal securities laws. The Report confirms that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities with the agency, unless a valid exemption applies. The DAO raised more than $100 million in a crowdsale in 2016, before a hacker managed to steal tens of millions of dollars worth of digital currency. This led to the virtual organization’s collapse.
While the controversy around the ICO scams drew skepticism, the popularity of the concept still grew. The SEC has issued a list of red-flags that would help investors identify possible scams are fraudulent cases. Stephanie Avakian, co-director of the SEC’s enforcement division said, “The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets.”
The cryptocurrency market is hot and blooming again and is set to achieve higher records. Players in the same are advised to be cautious, abide by regulations and then deal with the technology niches being created in this sphere.