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What is an ICO (Initial Coin Offering) and How Does it Work?
History and Evolution of ICO
The first ICO was by Mastercoin back in 2013, which raised approximately US $600,000 for a project to create a Bitcoin exchange and platform for transactions, while Bitcoin led the way on Cryptocurrencies, becoming the first decentralized cryptocurrency back in 2009, other cryptocurrencies sometime referred to as Altcoins, essentially Bitcoin alternatives have hit the market.
The shift in focus away from the use of venture capitalists for fund raising has taken the market by storm and the numbers of ICOs continue to rise, with the liquidity associated with ICOs over VC funding driving investors into a frenzy.
Venture Capitalists have begun to take notice however and are looking for a way back into the segment, with Blockchain Capital having run its 3rd fund raising in what was to be the first liquidity enhanced venture capital fund, the VC taking out the incubation period for investors.
Unlike centralized electronic money / banking systems, cryptocurrencies are decentralized. Bitcoin and the early altcoins were launched without an ICO and with the market still considered relatively nascent, governments and central banks have been relatively slow in catching on to provide some formal legal framework to the cryptocurrencies and the ICOs that followed.
With VCs getting in on the act in fear of losing out on major fund raisings, news also hit the wires in April of this year of the first ever underwriter of initial coin offerings. First Bitcoin Capital sees itself as a gatekeeper and by acting as the underwriter, assists in separating the good with the bad in the interest of longevity within the segment, by way of sound due diligence on the underwritten ICOs.
As of today, there’s still a long way to go for the market and until there is a more robust framework, which is recognized by governments and regulators, investors can be left out in the cold with the lack of a legal framework for those who have been duped. Even Madoff’s Ponzi scheme, which lost investors billions, is returning some funds back to the investors, in the case of ICOs there’s no legal entity to which the investor can face off, let alone make claim to.
In terms of the numbers, ICOs have raised US$327m to date through fund raising, compared with US$295m raised by venture capitalists representing blockchain start ups, VCs falling behind this year for the first time as the numbers of ICOs continue to increase.
Since the Mastercoin’s ICO, it was estimated that ICOs raised a lowly US$25m in 2014, falling to US$10m in 2015 following Bitcoin’s price collapse of 2014. In 2016, the trend reversed, with ICOs raising an estimated US$225m, supported by a rally in the price of Bitcoin, which drove interest into both blockchains and Fintech.
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While there have been plenty of success stories, in the 2nd quarter of last year, an Ethereum based project named The DAO entered an ICO to launch an investment fund without a fund manager, with the investors being involved in all of the investment decisions upon launch. The ICO raised almost US$150m, almost 70% of 2016’s total capital raised through ICOs. By mid-2016, hackers managed to get away with more than US$40m from the DAO, bringing the project to a grinding halt and the value of Ether down with it, Ether’s price falling from US$19 to under $12 in just a matter of days. In the interest of market capitalizations and protecting the investors, Ethereum created a new blockchain and ultimately reversed the theft, leaving the original Ethereum blockchain, now known as Ethereum Classic behind, a small minority continuing to support and assign value to the old blockchain.
Despite the inherent risks, which are not just down to hacking, but also fraudsters and scammers, 2017 looks to be another stellar year, with ICOs raising in excess of $150m by mid-May of this year, based on numbers from Smith + Crown.
Concepts are getting more and more innovative and the speed with which capital is raised is getting faster by the day and, without the regulatory oversight things could burst before the likes of the SEC catch up.
How Does ICO Work and How to use ICO
Start ups kick start the ICO process by establishing the blockchain and set up of protocols and rules, at which point an ICO data is announced.
For the creator, the next step is to begin mining for coins that will sold during the ICO, with social media sites, Reddit and a rising number of cryptocurrency related website used as a marketing medium to attract investors ahead of the ICO data, creators looking to draw in as much interest as possible to not only raise the required funding, but also push demand and prices post ICO.
In the background, the creators will make their final checks and adjustments to ensure its smooth sailing by the time of the ICO.
For the cryptocurrency creators, they will need to join an exchange, the exchange similar to that of a stock exchange during an IPO, with investors needing to have an account with the exchange to be able to buy the new cryptocurrency with other cryptocurrencies or fiat money.
Active and up and coming ICOs can be found through various sites, with the purchase of cryptocurrencies being made through the selected exchange, with investors also able to buy directly through the creators official website.
Exchanges that are widely recommended for the purchase of new coins include Bittrex, Kraken, Poloniex, Livecoin, SpaceBTC, Bitlish, though there are many others.
Documentation requirements vary depending upon the investor domicile, with the requirements outlined on the respective exchange’s site and creator website.
A step by step of an ICO can be summarized as follows:
Pre-Announcement: This is the marketing stage of a future project through sites frequented by cryptocurrency investors, with the creators of the project preparing a white paper, essentially an investor presentation outlining the details of the project.
Once the white paper has been circulated, the company will get a sense of whether there is investor interest in the project proposed, with the company then addressing concerns and addressing risks raised by would be investors to reach a final business model and a final version of the white paper.
Offering: This is the final version of the white paper, setting out the terms of a contract for the benefit of the investors, made on behalf of the company entering into the ICO.
The offer will outline the project details, the total amount of capital required, together with project timelines. It will also indicate the financial instrument to be sold during the ICO, normally tokens. The financial instrument will have a value assigned to it, together with the rights of the investor along with the expected period after which the company will commence returning earnings to investors, traditionally by way of dividends.
Once the offer has been signed, the ICO start date is announced and the marketing campaign moves into overdrive.
Marketing Campaign: This is a pivotal component of the ICO, with the marketing campaign key to the company being able to raise the necessary capital. Companies are generally nascent and unknown, bringing marketing agencies into the frame to make the necessary presentations, etc. The campaign will tend to last up to a month on average, target audience being institutional and some smaller investors. Participants of crowdfunding programs tend to be the main segment, investors generally more willing to back projects, with their involvement in the project considered a positive for both the investor and the company.
Once the marketing campaign comes to an end, the buying and selling of tokens commences, with the company having established an exchange for investors to acquire tokens.
The ICO: Companies generally release tokens on blockchain in two ways:
- Collect the specific capital, outlined within the offer, and then divide and distribute the tokens to the investors based on initial investment made.
- Alternatively, tokens are sold on cryptocurrency exchanges, which means that the tokens need to be released on a number of exchanges in advance for trading.
Once the sale has ended, the company commences on its obligations.
For the investor, it’s a case of exploring the various exchanges or social media sites that publish active and up and coming ICOs and then opening an account, acquiring the tokens, having completed the necessary due diligence on the company or project in question.
The New Way of Tech Companies to Raise Money
Start up companies are generally some form of an entrepreneurial venture, which will take the form of a new, rapidly expanding business targeting the needs of a marketplace by way of innovative products, processes and services.
While historically, start ups would have raised capital through venture capitalists, the advancement of fund raising through ICOs has been almost spectacular. While venture capitalists tie up investor money for lengthy periods of time that can extend to years, ICO money is far more liquid and with value easily assigned, traded within a very short period of time. The liquidity associated with ICOs is certainly a contributory factor to the increasing number of ICOs, with the lack of cumbersome documentation and unjustified demands and requirements of the VC also avoided.
Adding to the upside for start ups is the involvement of the investor in the decision making process, whether it is an actual business or a project, providing the investor a say, many of the initial investors in start ups being entrepreneurs and experts in their respective fields.
Blockchain technology and cryptocurrencies have certainly paved away for the more innovation, with the lack of regulatory oversight allowing start ups to push the boundaries created by those before them.
Successes from ICOs are well publicised, with some of the most well-known ICOs including, but certainly not limited to:
- Ethereum (ETHER-ETH): US$18.5m raised in capital. At ICO investors paid US$0.4 per Ether back in 2014. The value of an Ether hit a high of US$14 per Ether in 2016. Ether is certainly one of the more well-known early success stories. Year-to-date, Ether’s market cap has surged in excess of 500%.
- ICONOMI (ICN): US$9.1m in capital raised.
- Maidsafe Coin (MAID): US$7m raised in just 5-hours, which had been the record for the most amount of capital raised in the shortest period of time.
- Golem Project: The Company’s goal is to build a P2P global computer network, with blockchain data handling payments in GNT tokens. US$8.6m in capital raised in just a matter of hours.
To be honest, these ICOs pale into insignificance by today’s standards, Bancor Foundation raising a whopping US$153m of Ether through the sale of its tokens in just 3 hours in mid-June.
Post ICO, there are some great returns for investors that continue to grab the headlines, Ether not alone.
Ripple’s XRP springs to mind, up 10x to dwarf Bitcoin’s 150% year-to-date return.
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