What is an ICO?
An ICO, or Initial Coin Offering, is a way of raising money by selling cryptocurrency tokens. The process is like an IPO – Initial Public Offering – in which a company issues shares to raise capital.
Instead of buying shares, however, ICO investors buy tokens, some of which are designed to be traded, like a currency or a security, while others are a digital representation of a physical entity, such as a share of a diamond. Still others are utility tokens, that allow owners to use a product or service.
Another crucial difference is that ICOs are, like cryptocurrencies themselves, decentralised and still unregulated in many jurisdictions. The benefit of this is less red tape and none of the delays caused by meeting the rules of a central body. However, as we will see below, there are downsides of this too, such as the growth of scam ICOs that can lead to investors losing their money with little chance of getting it back.
The history of ICOs
ICOs are a recent concept, taking the idea of crowdfunding, or a public share offering, and applying it to the cryptocurrency world. The first one was launched in August 2013, following a white paper by a developer named JR Willet, which proposed a ‘Trusted Entity’ that would operate as a layer on top of Bitcoin and issue ‘Mastercoins’ to allow decentralised applications. It raised $500,000 in Bitcoin but its effectiveness was limited by the Bitcoin script language, which could not provide all the features necessary for Willet’s vision.
A year later, Vitalik Buterin published a white paper proposing Ethereum, an alternative blockchain protocol that was designed specifically to deal with this problem and work as a foundation layer for decentralised applications. Ethereum raised more than $18 million in 42 days, beginning in September 2014.
Ethereum has been a popular platform for ICOs because it provides foundations and capabilities that the developers do not have to then build themselves. The ERC20 token standard, for example, encourages developers who are creating Ethereum tokens to follow certain rules to make sure that those tokens can interact properly with wallets, exchanges and smart contracts.
The number of ICOs began to grow in 2016 before mushrooming in 2017, a year in which $3.8bn was raised.
How ICOs work
The rise of ICOs has opened a revenue stream to startups that has never been available before. They can raise incredible amounts of money in very short periods of time. The Basic Attention Token, a blockchain-based ad platform, raised $30m in just 30 seconds, while Aragon, a platform for managing decentralised organisations, took 15 minutes to raise $25m.
The organisers of the ICO set out their plans in a white paper, which explains in detail what the project is, how it works and what buyers will get if they invest. They will specify when the ICO will happen and the price for those who want to buy in.
Buyers, after scrutinising the white paper and assessing the credentials of the ICO organisers, can join the project by sending Ether, Bitcoin, or other cryptocurrency to the creators of the ICO, who will often use a smart contract to manage the receipt of funds. The smart contract will store the funds and issue the new tokens once the terms of the smart contract are met.
What happens next depends on the nature of the ICO. Some are designed to raise funds for projects that have not yet been built, so investors will have to wait for that to happen. In the meantime, however, the value of their coins may rise if more people decide that the project is an interesting one.
Since the tokens purchased in an ICO can be traded, the most successful ICOs have been popular with investors. Finding the right ICO can be an incredibly lucrative investment but, since many ICOs are about raising money for a product, they can also be very risky.
The downsides of ICOs
Not all ICOs are successful. The State of the Token Market report for 2017, from Fabric Ventures, found that 48% of ICOs failed to reach their target. Worse, many are outright scams, with ICO fundraisers disappearing without issuing anything to investors.
This is one of the reasons why the response to ICOs from regulators has been mixed. In the US, the Securities and Exchange Commission has moved towards regulating ICOs, arguing that they are effectively securities. Those ICOs that promise voting rights to investors or make guarantees based on future company earnings do indeed look like securities and this has made regulators take notice.
Regulators argue that they are protecting investors from scams. ICO supporters worry that regulators could stifle a creative new investment route by overzealous legislation. ICOs are already banned in China and South Korea. Switzerland, however, has adopted a positive stance towards cryptocurrencies in general.
Some other ICOs have effectively become a gimmick, with companies giving tokens away as a marketing exercise. Others sell them as a way to buy the right to use a service.
Do your research first
For all these reasons, it’s sensible for a potential ICO investor to do some research first. This is where CoinSchedule’s resources come into play. We have developed an algorithm that assigns a Trust Score to ICOs based on the information they provide. The Trust Score uses dozens of inputs, including KYC (Know Your Customer) information such as copies of the passport of every member of the ICO team. We also investigate the company issuing the tokens, check the company documentation, conduct interviews with the ICO team, check the quality of the information they have provided and more. All of this is then compiled into the CoinSchedule Trust Score.
Names, photos, biographies and even ID verification for team members can help to show a trustworthy ICO, as can appropriate links to supporting material and websites. But at CoinSchedule, we go beyond what can typically be found using a search engine and ask each project to provide additional information to ensure that we can identify the best ICOs in which to invest.
Nowadays, almost all ICOs add measures to help protect investors, such as holding funds in an Escrow account until the terms of the ICO are met, preventing the organisers from simply disappearing with the money.
The unregulated nature of ICOs does increase the risk involved in investing in them. However, it’s also the thing that has made them so agile and flexible. Done right, a good ICO can be a much better way to raise money compared to classic methods, such as VC, Angel or loans, because the projects get an instant group of people who have not only invested but are also willing to test the project before launch and give it the best chance of success.