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Part 1: Initial Coin Offerings – Overview

Jun 26, 2017 AltcoinsICO 0

Digital currencies have had a spectacular year, reaching a combined market capitalization of over $115 Billion. Along with this, a new trend of fundraising has emerged – the initial coin offering. Like digital currencies in 2013-2014, initial coin offerings (ICOs) are becoming popular lately as more crypto start-ups are using it as an alternative to the traditional fundraising methods. According to Forbes, ICOs have raised over $380M funding as of May 2017, compared to $225M in 2016, $10M in 2015, and $25M in 2014 (historical figures are from the research firm Smith + Crown).

There are 3 traditional ways for a company to raise money:

  1. Selling shares or equity – company sells ownership in exchange for cash
  2. Raising Debt – the company borrows money and promises to pay it back along with interest
  3. Pre-selling goods and services – customers pre-order products and the company uses the funding to produce the goods

The main premise of an ICO is that the cryptocurrency venture can create a digital coin or a token which is subsequently offered for sale to the public in an initial offering. You can think of an ICO as a similar process to an initial public offering (IPO) with the main difference that instead of equity share in a company, ICO will grant the investor a new coin or a token. Depending on the structure of the ICO the investor receives the coins for their investment. Venture capital firms and in rare cases for public investors, they are granted equity for the investment in the coin along with voting rights and dividends. The more common use case for an ICO is the value they provide to the investor which gives you access to using a specific project or a service. The venture, in turn, uses this money to grow and expand their platform.

Before we go into what makes these coins so special, let’s examine how a typical ICO is structured in a nutshell:

  1. When a cryptocurrency venture wants to raise funds through an ICO, it publishes a white paper which includes a summary of their business plan and what the project is about. Furthermore, the below information is highlighted in the white paper:
    • How much money is needed to undertake the venture or the project?
    • The company raising funds generates a fixed supply of crypto coins
    • How many virtual tokens will be created by the company raising funds and what portion of this supply will be issued to the public or retained by the founders?
    • The type of fiat money or crypto currencies (i.e. Bitcoin, Ethereum, etc…) accepted
    • The timing of the ICO campaign – including the date when the tokens will be issued and how long the ICO will run for
  2. During the ICO, the project backers and investors buy the distributed crypto coins with fiat money (dollars, euros, etc…) or crypto currency (Bitcoin, Ethereum) for a stake in the ICO. These coins are referred to as “tokens” and are similar to shares of a company sold to investors in an Initial Public Offering (IPO) transaction. A distinguishing factor between these tokens and IPO shares is that the “tokens” do not entail ownership of the company and any voting rights (discussed in more details below)
  3. The ICO is deemed to be successful and complete if the funds raised to meet the minimum funding requirements. If the fundraising is short of the required funding, the money is returned back to the ICO investors and the ICO is canceled.

Now that you have a basic idea of an ICO and the fundraising process, let’s discuss why investors are so excited about this innovation.

The newly issued coins are not limited to being traded in the exchange for services within a given platform but can be also traded on the market around the world. Early investors are motivated to buy the crypto coins hoping that the platform will become successful and widely used after launch. This would lead to a higher value of crypto coins compared to the time of project launch. Given crypto coins differ from traditional equity or common shares, they are priced based on the market perception of value and increased adoption of the platform. This creates an interesting dynamic, where the investors or platform users are incentivized to bring new users to grow the platform, which should lead to higher adoption for the coins, and likely to a higher price.

The most successful ICO to date has been Ethereum, the smart contract platform. Ethereum raised $18 million at $0.40 per Ether (token) in 2014. The project went live in 2015, which has now soared to ~$35 billion market cap and $370 per Ether as of June 2017.

Below we examine the advantages and risks associated with ICOs that an investor should consider before investing.

Advantages of the ICOs:

One of the advantages is that ICOs create liquidity and growth equity without giving up equity in most cases. This means that the venture founders do not give up or dilute existing ownership in their start-up by raising funding. However, as an investor, this can turn into a risk because investors have no voting rights, as opposed to traditional equity ownership in a company.

ICO build a global community of pioneers, early adopters, and investors who are incentivized to spread the word about a given project or platform and thus expanding the network. The more people join the network the more the platforms benefit from a positive network externality.

Successful ICOs, with the added liquidity, have resulted in multiple times return on initial investment comparable to angel investors returns from investing into a successful start-up. Although coins are not securities, investors can exit at any time, they have a similar liquidity to gold, stocks, and foreign exchange trading on global markets.

Risks of the ICOs:

Despite the fact that ICOs have been gaining traction over the last few months, investors should be careful and perform their due diligence when investing in an ICO. The ICOs are often issues in an unregulated environment, meaning that Securities Exchange Commission (SEC) or other regulatory bodies do not have the oversight over the ICO process. The funds that are lost due to a fraudulent process may never be recovered.

The rapid rise of ICO especially in 2017 shows some typical characteristics of a bubble and draws comparisons to the 1999 – 2000 dot com bubble. Despite being unable to determine the actual value the ventures, the number of companies seeking an ICO as well as the total dollar amount invested into ICOs has increased. Therefore, ICOs have placed high valuations on some start-ups that do not match the economic value of the startup, which is a typical and similar pattern to the dot com bubble.

Fraud is part of the ICO market as there have been cases of inaccurate or false information. The lack of reliable information and disclosure is an issue given offerings are posted on online forums, where contributors are easily able to add positive or negative publicity on a given ICO. This leaves some investors confused or not confident to act on an investment decision.

Conclusion

The investor is not guaranteed to get their money back or even make a profit.

Despite the risks, the demand for ICOs and cryptocurrencies is increasing. ICOs exhibit high risk/high reward and while some have been extremely profitable, other have failed, leaving investors with useless tokens. In an ICO there is significant trust that the project will be completed; however, if the project is not completed there will be a loss of invested capital. Therefore, it’s recommended to thoroughly review all available information and aspects of the ICO before making an investment decision.

 

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Davit K

Davit is a corporate development professional at one of Canada's largest FinTech companies, responsible for strategic planning and execution of M&A transactions. He spends his free time traveling and writing about new developments in blockchain and crypto currency world.

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