ICO Basics:  How Does It Really Work?

Have you ever wondered what exactly is ICO?

The financial world keeps evolving with new technologies, products and terminologies.  One of the freshest terms that we keep hearing about of  is Initial Coin Offering or ICO.  Experts consider it an alternative form of crowdfunding (another new term) that happens outside the traditional financial system.

Crowdfunding is the process of raising a large amount of money through small amounts from a multitude of people.  The ICO model has successfully provided numerous projects and companies the funds needed to start a business.

What Is ICO?

An Initial Coin Offering is the unregulated system of crowdfunding using cryptocurrencies. In an ICO, the company sells a percentage of the new cryptocurrencies to willing investors in exchange for legal tender.  Sometimes, they exchange them for other cryptocurrencies such as Bitcoin.

It works much like a ‘token sale’ or crowdsale where investors buy participation in an economy.  It gives them access to a particular project set to start at a future date.  Investors of an ICO can choose to buy a right of ownership or royalties to a project.

In an article written by Amy Wan of law firm Trowbridge Sidoti LLP on Crowdfundinsider.com, she commented on ICOs. She said, “The coin…is a symbol of ownership interest in an enterprise—a digital stock certificate if you will.”[i]  In an IPO, the investors buy stocks and gain shares of the company.  In an ICO, the transaction is somewhat dissimilar.  The investors are buying the coins of the company and are hoping that their value would appreciate later.

ICOs Evolvement

The earliest documented ICO or token sale happened in July 2013. Mastercoin hosted the sale and reportedly managed to raise over 5,000 bitcoin over the ICO phase. Ethereum followed suit in 2014 and raised some $18 M during their ICO.  Also in 2014, Karmacoin became the first cryptocurrency to issue shares to fund their goodwill projects.

Fast forward to 2017, ICOs and token sales are trending in the financial world. For September 2017 alone, investors had the option to select from not less than 30 active ICOs in the market. New web browser Brave’s ICO raised around $35 M in just a little over 30 seconds.  There are now more than 20 websites that track ICOs.  As of October 2, 2017, ICOs have raised more than $2.37 B in sales.[ii] This has already surpassed the whole of 2016 in terms of value and number of ICOs.

Most ICOs made use of Ethereum

As of October 2017, the Ethereum Blockchain has been most popular with ICO projects. An estimated 56.83% of the 400+ ICOs made use of Ethereum.[iii]  However, cyber criminals have taken advantage of Ethereum-based ICOs to victimize unsuspecting investors.  There has been a rise in phishing, Ponzi Schemes and other scams associated with these ICOs. Fortune reports that thieves have already stolen more than $225 M as of August this year.[iv]  Analysts estimate that more than 10% of the coins from ICOs are already in the possession of thieves.

Last July, the Securities and Exchange Commission indicated that they could step in to regulate these ICOs.  The SEC determined that some ‘coins’ can be considered securities. However, they might apply federal securities law to ICOs on a case-to-case basis.  This move could actually prompt more mainstream investors to participate in ICOs.  However, the SEC pronouncement only covers investors from the US.  This is why most ICOs do not typically allow US investors to participate in them.

Are ICOs The Real Deal?

As of 2018, investors have sunk in more than $4B in ICOs.  You might say that they have invested millions of dollars into something they cannot hold or see.  All they got were a white paper and a bunch of cryptocoins.  Those cryptocoins are depending on a small network of terminals running their blockchains to keep all the financial records. Add to this the seemingly irrational choice of mode of exchange.  Last year, Bitcoin was the dominant choice, accounting for about 80% of the cryptocurrency capital.  But now, despite Bitcoin’s phenomenal rise in value, it can only boast of a 50% share

As we mentioned before, ICOs already raised some $2.37 B in the first 10 months of 2017 over 140 sales. This has silenced pundits who believe that ICOs will come and go pretty soon – then the new fad comes along. Looking at the averages, ICOs are all over the place and at least two begins everyday.

Ico – Is It Legit Investment?

As of now, we can say that many aspects about ICOs are legally undefined. By design, a token is a digital good similar to other products; they are not financial assets. This why legalists claim the correct term for ICOs is ‘crowd sale’. In many states and jurisdictions, ICOs remain unregulated and financial statutes are still silent about them.  This allows companies to conduct them with ease and minimal documentation especially with an expert lawyer to give them guidance.

Not Everyone Agree

However, some jurisdictions are already paying attention to ICOs. The common view is that they are similar to sale of shares and securities.  They argue that regulations regarding sale of shares should also apply to them.  The sensational implosion of the DAO hastened to ignite the interest of the regulators.  While today, most ICOs fall in the gray areas of the law, they will most likely be fully regulated in the near future.

This would add a new dimension to investing in ICOs.  Investors might have to bear more financial or legal risks and costs. Also, the cost to comply with regulations might negate the advantages of an ICO.  Companies and investors might just opt to go back to the old school way of funding and investing.

Do ICOs Make Money For Investors?

Many ICOs have given investors a windfall.  Here are some examples:

  • ETH was sold at 0.005 Bitcoin each; today it’s valued at 0.05 BTC (profit: 10,000 percent)
  • Augur token (PEP) was sold at 0.005 each; today it’s traded at 0.01 (or 2x the original value)

Successful ICOs commonly report a rise in value of 100 to 500 percent.

Remember:

However, many ICOs ended up disappointingly bad, as well.  We have a long list that includes Omni, Lisk and IOTA-token.  They lost the value of the Bitcoin assigned to them or at best, are struggling to maintain their original level. Scammers also took advantage of the ICO craze to skim millions of dollar off investors. They built nice websites and filled them with promises of the ultimate cryptocurrency with sweet mumbo-jumbos.  In the end, they all ran away with the people’s money.

 

[i] ‘Why Your Initial Coin Offering Is Probably Regulated By Law’, Amy Wan, www.crowdfundinsider.com, March 6, 2017, retrieved October 6, 2017

[ii] ‘Cryptocurrency ICO Stats 2017’, www.coinschedule.com, retrieved Oct. 6, 2017

[iii] ‘The ICO Market Research:  The Leading Blockchain Platforms of 2017’, Emmanuel Darko, www.icowatchlist.com, retrieved Oct. 6, 2017

[iv] ‘The Rise Of Cybercrime In Ethereum’, www.blog.chainalysis.com, retrieved Oct. 6, 2017

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Baruch Silvermann

Investment research writer, business journalism, and financial analyst. Covers the vast spectrum of the financial topics in investments, real estate, equities, fixed income and personal finance. Twitter: https://twitter.com/BSilvermann

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