5 years ago, hardly anyone had ever heard of cryptocurrency, or ICOs. Today, everyone from your boss to your best friend is debating the merits of digital currency, and talking about whether it’s worth investing in Bitcoin and ICOs.
Now, if you’re not 100% sure what an ICO entails, you’re not alone. In this article, we break down exactly what an ICO is, and tell you all about how ICOs work. Read on to find out more!
Initial Coin Offering (ICOs), defined.
In a nutshell, an ICO is an alternative fundraising mechanism whereby a company issues digital tokens to individuals; they do this to raise the capital necessary to bring their product to market.
In other words, a company sells its tokens to individuals in exchange for Bitcoin (BTC) or Ethereum (ETH). Individuals buy these tokens either to use, or to sell them on coin exchanges at a profit.
ICOs: from then till now
One of the first instances of a cryptocurrency being distributed via an ICO was Ripple. Back in 2013, Ripple Labs started to develop a digital currency called Ripple; all in all, they created 100 billion Ripple (XRP) tokens. These tokens were sold to the public, and the funds were put together the development of the Ripple platform, which the company billed as an open payment network that operated based on a real-time gross settlement system.
Ripple aside, there have been several other cryptocurrencies which have been funded with ICO, with one of the most prolific examples being Ethereum. In 2014, the Ethereum Foundation sold ETH against 0.0005 Bitcoin each. The foundation reaped almost $20mio, and Ethereum went on to become one of the most popular coins of all time.
How does an ICO work?
Say you’ve just founded a startup with the goal of developing a new blockchain-based social network called BlockWork. You could go the traditional route and meet with venture capitalists in the hopes that they’ll invest in your social network… or you could simply launch an ICO to crowdfund your project instead.
Assuming you decide to go with the latter option, one of the first things you’ll have to do is decide how much you want to raise to fund the development of your platform (and how many tokens you want to issue). The math is pretty simple: if you need approximately 2,000 bitcoins to fund your platform, and you’ve pegged your “exchange rate” to be 5,000 BlockWork tokens per bitcoin, this means you’ll have to issue a total of 10 million BlockWork tokens.
Once you’ve got your numbers worked out, the next step is to create a whitepaper detailing how your platform will work. You might also set up a website, create a Telegram group, and do whatever else you can to build and nurture a community of potential investors. The more time and energy you invest into promoting your platform and answering enquiries, the more people will hear about your ICO (and hopefully invest when you launch).
Finally, when you launch your token sale, consumers will be able to purchase BlockWork tokens using BTC or ETH. You’ll probably put the bulk of the funds you raise from your sale to develop your platform, but you might also withhold some tokens in order to capitalize upon future price increases.
For buyers, it’s crucial to note that buying BlockWork tokens (or any other tokens) isn’t quite the same as buying shares in a company when it IPOs. When you own a company’s tokens, you don’t actually own any equity in that company; you simply hold their tokens in the speculation that their value will increase.
What’s the difference between ICOs and IPOs?
We’ve just discussed how owning a company’s tokens doesn’t mean that you own equity in that particular company — that’s one key factor that differentiates ICOs from IPOs. Read on to find out about the other areas in which ICOs and IPOs aren’t the same!
Companies that want to launch an IPO have to meet stringent requirements; on the other hand, virtually any company can launch an ICO.
Let’s talk about the NASDAQ and the S&P 500, for example. If a company wants to get listed on the NASDAQ stock exchange, it needs to “have aggregate pre-tax earnings in the prior three years of at least $11 million, in the prior two years at least $2.2 million, and no one year in the prior three years can have a net loss”.
What about companies who want to be on the S&P 500? Among other things, these companies need to achieve and maintain a market capitalization of $6.1 billion and over. Back in 2013, JC Penney was kicked off the S&P 500 when its market cap fell below the then-limit of $5.3 billion.
Now, as compared to IPOs, ICOs are ridiculously easy to launch. There are no hard and fast rules or requirements that companies who want to launch ICOs have to meet; this makes it easy for any Tom, Dick or Harry to launch an ICO.
Requirements aside, IPOs are also strictly regulated. When it comes to corporate governance, for example, both Nasdaq and the New York Stock Exchange (NYSE) requires that a company’s board of directors include at least two “disinterested, non-insider members”, and that the company establish an audit committee of the board composed primarily of disinterested directors. Ideally, companies who are looking to launch IPOs should also establish a compensation committee, although this isn’t strictly enforced.
On a separate note, it’s also mandatory for consumers investing in IPOs to go through a Know Your Customer (KYC). This check verifies each consumer’s identity, and prevent situations such as money laundering from happening.
Now, moving onto ICOs: these alternative fundraising methods were initially completely unregulated, but governments are increasingly moving to regulate or even ban ICOs in their countries. For instance, the Australian Securities and Investment Commission (ASIC) has stated that the “legal status” of an ICO depends on its structure, operation, and the rights attached to the token.
According to ASIC, tokens which carry rights with regard to ownership in or entitlement to future profits of the issuing company do fall within the definition of a share (ie: a financial product). Under these circumstances, it will be mandatory for the company that’s conducting the ICO to comply with disclosure requirements, including the preparation of a prospectus.
3. Point of issuance
Generally speaking, only reputable, long-standing companies with fully developed products or services launch IPOs. In most cases, these companies will have already taken on some sort of private investment, and their IPO will then serve as a liquidity event for their early investors.
On the flip side, companies who launch ICOs typically do this at the start of their lifetime. Some companies may have a working prototype to show their consumers; other companies may simply have an idea and a blueprint of how they intend to execute that idea. From the perspective of a consumer, investing in ICOs definitely carries more inherent risk.
Why are ICOs popular?
Here are the statistics: there were a total of 875 ICOs launched in 2017; companies across the globe collectively raised $6B++ through these ICOs. Despite the increased regulation and scrutiny on the cryptocurrency space, demand for ICOs have grown even more: in the first three months of 2018 alone, companies raised a whopping $6.3 billion from digital coin offerings, which is more than the total amount raised in 2017.
So, here’s the question: why are ICOs so popular? On the supply side, launching an ICO makes sense because this allows companies to bypass the venture-capital process (and do away with the paperwork and red tape that this process involves). ICOs essentially allows companies to bring a product/service to fruition using the power of crowdfunding, like how platforms such as Kickstarter and Indiegogo do.
On the demand side, ICOs allow the average man on the street to make early investments in companies with high potential. Traditionally speaking, these investments are restricted to venture capitalists who have stacks of cash sitting around, but with ICOs, consumers can now part with as little as a few tens or hundreds of dollars, and still be able to invest in a company that they deem worthwhile.
A final word on ICOs
ICOs are an exciting space to be in — there are new ICOs being launched everyday, and if you put your money into the right platforms, you could potentially get up to a 100x return on your initial investment.
That said, it’s important for folks who are thinking of investing in ICOs to do their due diligence before taking the leap. At the end of the day, there’s still very little regulation on ICOs, and there are plenty of reported cases of people getting swindled by ICO scams. (In fact, a recent study says that up to 80% of ICOs conducted in 2017 were scams.) Make sure you proceed with caution!