Are ICOs the new future of start-ups?
The term Initial Coin Offering (ICO) is a common buzzword in investment circles these days. While these ICOs are distant cousins of IPOs (in the sense that both share the objective of helping firms raise capital from various sources), their likely timing and means of achieving funds are quite different.
An ICO is a form of funding commonly known as ‘token sales’ that is especially favourable for early-stage companies. ICOs, based on blockchain technology, are taken up by forward-looking entrepreneurs and risk-taking cryptocurrency investors to place their bets on potential breakthrough ideas. These upcoming business concepts are valued through artificially created currencies that, theoretically, can be quantified in terms of wealth in the future – when the idea starts making money. There is nothing more than a promise that the company in question has a sustainable future ahead – no feasibility studies are undertaken. Nevertheless, investors are jumping onto this bandwagon in great numbers, giving this trend increasing momentum.
Gnosis, the decentralized prediction market platform, raised over $12.5 million in a Dutch token offering in only 15 minutes. Investors rushed to obtain Gnosis tokens (worth 250,000 Ether), which in turn had the project valued at a whopping $300 million almost instantly. Money was put down, not for the final product per se, but for a prediction, which was enough to kick-start the plan.
This explains why, while the trend has only recently gained momentum, it has accumulated over $1.3 billion so far this year for technology start-ups. In fact, in some of the offerings, demand surpassed the number of tokens available.
The Mechanics
ICOs take place in an intangible network, where money is created, exchanged, and disposed of in the cloud. This is because an ICO is essentially a crowd-funding platform for cryptocurrency start-ups, with the most well-known cryptocurrency being the revolutionary Bitcoin. Cryptocurrencies are nothing more than a set number of entries in a database that exist on a peer-to-peer electronic cash system, which is decentralized. These transactional entries are created and stored in blockchain technology, with encryption techniques being used to restrict the creation of monetary units and transfers. As opposed to commodities or fiat money, cryptocurrencies do not have any intrinsic value themselves, do not exist in physical form, and their supply is not determined by a central bank. They are transactions that are initiated, accepted, confirmed, and shared by a network of peers in the ‘crypto-world.’
A start-up interested in an ICO may create its own cryptocurrency utilizing protocols such as Ethereum, Counterparty, or Openledger, and set up a value based on the amount of money a project is required to deliver to achieve the roadmap outlined in its whitepaper. This article is like a miniature blueprint that outlines the project (what it is about, what its objectives are, its completion milestones, the amount of funding required, the duration of the campaign, and the type of money acceptable), offering a prospectus to the market to generate interest. The trick is getting the public to like and believe in the idea, even though nothing yet exists in tangible form to prove its feasibility or future prospects. People worldwide are then able to purchase the newly created tokens in exchange for established cryptocurrencies, such as Ether (ETH) or Bitcoins (BTC).
Interested investors may open their accounts on digital currency exchange platforms and start trading BTC and ETH for a variety of tokens for new projects. ICOs normally last a week or so, during which the price of the token varies according to the structure set up by the issuers. For example, the price can remain static to achieve a specific goal or funding target for the project. However, issuers may want to match the static supply with dynamic pricing, where the price of tokens rises in tandem with the amount of funding received. A third model may have a static price set with a dynamic supply – for example, where the value of ETH 1 is set upon the creation of a token. This will continue until the start-up achieves its funding target.
ICOs can involve multiple rounds of fundraising, with the specific tokens or coins on offer increasing in value closer to the release date. This incentivizes investors to put their money in as early as possible to reap the maximum reward.
What is important to note here is that, unlike IPOs, these tokens do not give investors any ownership rights or asset claims. Instead, they act as bearer instruments, giving users rights related to the specific project itself, not to the company that is launching the project. While owning the tokens does not entitle their holders to vote on the direction of the project, these rights are embedded within the ICO itself, where participating investors give input throughout the project’s lifespan. Users may be paid for a correct prediction or for the content they contribute through a proposal. Investors take part in these activities in anticipation that the value of tokens belonging to successful projects will rise drastically, generating a higher return on their investments.
Why the Buzz?
There is no doubt that ICOs have become highly popular, not just with fintech start-ups, but with people from all walks of life. They seem ideal for anyone who wants to raise capital quickly for an idea. There are a variety of reasons for this. Mainly, it is the speed at which money can be raised for a project that exists solely as a vision – this in contrast to VC funding, where investors will conduct greater examination on the management dynamics, market size, potential risks etc. The fact that this is largely an unregulated field also make ICOs attractive in terms of there being few or no duties and costs for compliance. For example, ICOs provide their issuers with multiple rounds of fundraising, with few (if any) intermediaries. These token sales are also not subject to direct taxation, with investors being liable to pay only capital gains tax, depending upon the jurisdiction. What makes this process even more appealing is the ease with which cryptocurrency tokens can be created, used in transactions, and exchanged thanks to technological growth. Issuers may no longer need to mine with complex codes to use this form of financing.
But entrepreneurs are not the only winners. Investors also enjoy taking part in ICOs for various reasons. This includes the chance to make huge profits, which can be witnessed by the massive returns in 2016 from Monero and NEM start-ups. ICOs also offer higher liquidity, which is not readily available in VC funding where exit options may be minimal. Here, profits can be pulled out easily by converting cryptocurrencies into Bitcoins or Ether, and then into fiat money. Platforms such as Coinbase, Kraken, Poloniex, and Yunbi allow investors to sell their digital wealth and obtain quick returns on investments as prices fluctuate drastically throughout the day. In fact, some individuals even engage in cryptocurrency arbitrage and shorting.
In July 2017, Omise, a fintech start-up in Thailand, raised $25 million with its ICO. While the company had already raised $20 million from traditional VCs, it also raised capital through tokens for its product Omise Go – a decentralized payment platform that enables users to share funds without having to deal with maintaining a bank account and incurring service or cross-border fees. Omise Go’s initial services will go live from Q4 of 2017, where token holders can make money by being a part of the network.
What’s Ahead?
The ICO market has grown at an exponential rate over the past few months. The risk that this could be another bubble, like the dotcom crash in 2000, has created unease. Regulators in particular believe that such a highly open market is prone to extreme volatility. It is a dynamic area, where numerous tokens can be created and wiped out every day. Too much demand by investors (due to speculation) could lead to catastrophe. The rapid development of ICOs as a source of funding is exciting but the sustainability of ICOs and cryptocurrencies as a whole has yet to be proven.
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