Initial Coin Offering (or “ICO”) may be the hottest new term in finance. At this point anyone who uses the internet has heard about people getting rich from cryptocurrency or companies raising millions in an ICO. In this installment of our series on cryptocurrency, we will explain what an ICO is, why companies do ICOs, and the similarities and differences between various sources of funding and ICOs.
We have written this article assuming that you have read our first two cryptocurrency articles about blockchain and cryptocurrency. In this article, we will not explain concepts explained in those articles such as what cryptocurrency is or the difference between coins and tokens.
What is an ICO?
An ICO is an event during which a company offers its specific token to the public at a set price in order to raise capital for a certain project. While anyone can attempt an ICO, successful ICOs are generally offered by companies that integrate blockchain technology. Currently, most tokens being offered are intended to be used as a form of currency in the company’s application to buy a product or service. Therefore, if you are not using blockchain technology that can transfer tokens smoothly between individuals, the tokens are not particularly useful. The tokens are generally categorized as either utility tokens or security tokens. For more information on utility and security tokens see our article on Cryptocurrency. While the type of token may change investors’ motivation to invest, the actual ICO process is the same.
ICOs generally follow the same five steps:
1. Develop an attractive blockchain application idea
The most important part of an ICO is a product that people believe in. ICOs happen very early in the life of a company, with some ICOs occurring even before a prototype has been built. Raising money this early is possible because companies have ideas for blockchain applications that investors believe are truly revolutionary. Because of the increase in fraudulent ICOs investors are scrutinizing the proposed product more intensely, making it even more important that you have a product people can believe in.
Examples of ideas that have led to successful ICOs include:
Golem: An application that allows users to rent their unused computer processing power to other computers allowing them to complete tasks in a fraction of the time it would take one computer.
TenX: An application that serves as a cryptocurrency debit card.
Filecoin: An application that allows users to rent out unused storage on their computers.
2. Create a white paper
Once the developers have an idea they believe can be successful, they need to communicate that idea to the public. This is done through a white paper. While not every ICO has a white paper, successful ICOs without one are rare. The white paper should explain, in detail, the project and all the specific features that developers believe will make it unique and successful. The white paper is not meant solely as a marketing tool. Its purpose is to be informative and educational. Ideally, after reading the white paper, investors should thoroughly understand what the project is, how it will work, and what value it will provide.
Because there are no standards or requirements surrounding white papers they can come in many forms. Some companies mimic the form of an S-1, hoping that it will bring a sense of legitimacy to their offering. Many white papers are written and look similar to an academic research paper, and others look more like a professional marketing document. Regardless of their presentation, good white papers will all provide the same important information.
3. Generate attention and credibility
After drafting the white paper, it is important for the company to create publicity for their ICO. There are a few ways companies attract attention for their ICOs. One way is through social media. There are large communities of blockchain enthusiasts on sites such as Reddit, Twitter, and Bitcointalk. While social media is a great way for companies to generate buzz around their projects, because of the many ICO scams, social media alone does not guarantee credibility. Both buzz and credibility are necessary for an ICO to be successful.
The first step in generating credibility is to build a professional company website. Your website should include an introduction to the team members (often with a LinkedIn profile or other information about the team’s credentials), a brief explanation of the product, a link to the white paper, and other evidence that your ICO is legit (lately many ICO companies are being certified by Big4 accounting firms or other trusted firms that are verifying the company). It is also important to receive support from prominent members of the blockchain community. To do this you need to research who the experts are in the type of product you are offering. If you can get them to comment their support online about your product, that alone may be enough to get many who know less about the product to trust your ICO. There are also many websites that list ongoing and upcoming ICOs that will either comment about whether they believe the ICO is legit or only list ICOs they believe are credible. Getting on these websites can add another level of credibility to your ICO. A few examples of these websites are ListICO.com, bestcoins.com, and topICOlist.com.
4. Create the token
The actual mechanics of how to create a token are beyond the scope of this article, but we will cover a few important points. Companies need to determine the number of tokens that will be created and circulated. This is an important decision because the number of tokens will eventually determine the demand and market price of the token. If too few tokens are created they may be too expensive for people to purchase and use in the application, but if there are too many there may be tokens that are not sold or remain unused. Companies also need to decide on an initial price for the token sale. This price should be low enough that people are willing to buy and can expect a return, but the price also needs to be high enough that companies raise the capital needed. While tokens may seem similar to stock for public companies, there are very important differences. Stocks represent shares of ownership and the right to future profits of the company. Tokens give the holder the right to access the company’s product in the future and rarely, if ever, represent ownership in the company. This topic is discussed in more detail in our article on cryptocurrency.
5. Begin the ICO
Lastly, you need to actually hold the offering. When deciding the date and time of your ICO it is important to give the community enough time to learn about and get excited for your ICO. But you also don’t want to wait so long that the hype around your ICO begins to die down. During the ICO period, customers will purchase tokens on your website with cryptocurrency such as Bitcoin or Ethereum. Customers can either hold the tokens until they can use them to access your product or they can “cash out” by selling the tokens on a secondary exchange.
Why do an ICO?
Now that we have discussed how to do an ICO, you are probably wondering if an ICO is right for your company. First, ask yourself: does my company offer a product or service that relies on blockchain technology? If the answer is no, then an ICO is probably not right for you. If the answer is yes, then there are a few factors to consider. (Please note that the following analysis assumes you have a working prototype and business plan that would interest traditional funding such as venture capital, angel investors, or private equity. Without these options it would be difficult to receive substantial traditional funding and impossible to pursue an IPO.)
The first factor you should consider is the amount of capital you need to raise. ICOs are primarily suitable for young companies looking to raise smaller amounts of capital. In 2017 the median of ICO proceeds was $10 million, one-twelfth of the 2017 median for IPO proceeds (about $120 million). During 2017, the largest ICO raised $258 million while the largest IPO raised $3.4 billion. Although an ICO can be much easier, the regulated process of an IPO may be worth enduring if you need to raise amounts in the hundreds of millions. During 2017 only six percent of ICOs raised over $100 million. On the other end of the spectrum, if you are only looking to raise a few hundred-thousand dollars it may be wise to pursue crowdfunding.
So, if you are looking to raise a few million dollars rather than hundreds of millions or hundreds of thousands, a more appropriate question may be: should I pursue traditional funding such as venture capital (VC) or should I pursue an ICO?
To answer this question, we need to consider a few factors. We will refer to venture capital firms as our placeholder for all traditional funding, but in most instances any traditional source of funding could be substituted. The first factor to consider when deciding between traditional funding and an ICO is whether you are willing to give up partial ownership. Almost every form of traditional funding will require a certain portion of company ownership (shares) in exchange for capital. The value of your company and the amount of capital you are receiving will determine the ownership percentage you will need to surrender. On the other hand, you will not be required to give up any ownership during an ICO. While giving up ownership seems like a bitter pill to swallow traditional funding offers benefits that you would not receive if you pursued an ICO.
Two of the most important advantages to VC funding that you may not receive through an ICO is expertise and a network. Most VC firms will only invest in companies they think they can add value to. If you receive VC funding you will most likely receive formal guidance that can improve your product, help you successfully bring your product to market, and keep you from common pitfalls, as well as general business management advice. VC firms will also put you in touch with significant players to help bring your product to the next level or give you the credibility and publicity you need. Considering this, you need to ask yourself: could your company benefit from the guidance and network of a VC firm or do you have the expertise needed within your management team to pursue an ICO? Is the benefit you may receive from a VC firm enough to justify giving up a portion of your equity in the company?
Another factor to consider is the importance of liquidity. Once you have completed an ICO your tokens will be bought and sold over the internet, enabling founders to sell tokens they hold. This will allow you and other founders to receive cash when you have a large amount of money tied up in the company. Receiving funding from a VC firm will not allow you the same liquidity. If you pursue the traditional funding route you will need to wait until the next round of funding for additional liquidity.
Effort is also an important factor. Even assuming you have a company VC firms are interested in, the traditional funding process can be much more burdensome than an ICO. In order to receive VC funding you will need to develop complex financial projections and pitch decks1 that speak to investors and may be more detailed than what is included in an ICO white paper. Once you have all your materials, you will need to meet with as many private institutional investors as possible. At these meetings investors will question you about every aspect of your company and product. When pursuing an ICO, on the other hand, ultimately all you need is a good white paper and the right amount of credibility and publicity. Rather than VC firms telling you what you are worth, you determine the price, the valuation, and the amount you want to raise, and if the public agrees you will get your funding.
You should also consider credibility when deciding between VC funding and an ICO. While ICOs are receiving increasing public attention, ICO scams and the lack of regulation have caused many people to view ICOs as unreliable and illegitimate. The opposite is true of VC funding. When companies receive VC funding, meaning that somewhere between about one and fifty people believe in the idea, the company is praised and almost instantly legitimatized. Therefore, traditional funding may be better for a product that relies heavily on credibility and public trust.
Unlike any other source of funding, ICOs come with a security risk. Keep in mind that there is always a chance that an ICO could be hacked. When you raise capital through traditional funding or IPOs you know with near 100 percent certainty that you will receive all the money you raise. ICOs do not come with that same certainty. Many ICOs have been hacked and some of the proceeds stolen. While security around ICOs is constantly improving, there is always a chance that you may lose a portion of the funding raised through an ICO.
There are many reasons to consider an ICO. ICOs provide young companies with a comparatively easy way to raise capital. They also provide many attractive benefits, such as the unregulated (and therefore easier) process and founders’ ability to maintain complete control. On the other hand, ICOs lack many of the benefits that other sources of funding provide. For example, ICOs do not come with the guidance and expertise of VC funding or the amount of capital that IPOs provide. While ICOs can be very beneficial, there are many sources of funding to consider, so it is important that you adequately research whether an ICO will be the most beneficial for your company.
ICOs vs. IPOs
As ICOs are becoming more popular, more people are trying to understand them. As with most new things, people often try to compare ICOs to more familiar concepts, like IPOs, venture capital and other traditional capital sources, and crowdfunding. The most popular comparison is between ICOs and IPOs. There are many similarities and differences between ICOs and IPOs, and while this article will not be able to address all of them, we will try to highlight the most important ones.
Capital raising – The most common reason people equate ICOs and IPOs is the capital-raising aspect. The primary purpose of both ICOs and IPOs is to raise capital. Additionally, both ICOs and IPOs are the first time companies receive capital from the general public. IPOs raise capital from the public in exchange for shares of ownership, and ICOs raise capital in exchange for company tokens. ICOs also generally offer a predetermined number of tokens, similar to IPOs offering a specific number of shares.
Value of the asset offered – ICOs and IPOs are also similar in the value of the asset they are offering (tokens for ICOs and shares of stock for IPOs). Both assets are offered at a predetermined offering price. However, immediately after conclusion of the offering the assets begin to fluctuate in value. Hoping the value of the asset will increase is often the main reason people invest in ICOs or IPOs.
Liquidity of the assets – Tokens and shares of stock are both generally highly liquid assets. Stock is registered and traded on specific stock exchanges such as the New York Stock Exchange. This allows investors to easily find others willing to buy or sell stock. While tokens are not registered on a traditional exchange, there are many websites that allow investors to buy and sell tokens and cryptocurrency.
Initial offering document – While there is no requirement that an ICO produce a document explaining their company and product, almost every ICO has a white paper of some sort. During IPOs, companies are required to publish a form S-1 outlining what they do and what they intend to use the proceeds from the offering for. Although the content may be different between S-1s and ICO white papers, the general purpose of these two documents is very similar. Both are meant to inform the public of why they should invest in the company and why the company needs to raise capital.
Regulation – One of the most discussed differences between ICOs and IPOs is the involvement of government regulation. IPOs are highly regulated. From the moment companies begin considering an IPO they start preparing for the intensely regulated environment that accompanies registering with the Securities and Exchange Commission (“SEC”) and becoming a public company. The IPO process itself involves an extensive audit, preparing registration documents, and a series of exchanges between the company and the SEC to ensure that everything they are telling the public is factual. ICOs on the other hand currently have no regulations. There is no requirement that they be verified by any third party, there is no agency fact-checking what they tell the public, and there is no assurance that any of the proceeds will ever be used to develop a product. However, the SEC has begun to issue statements regarding cryptocurrency. While there is currently no regulation around ICOs, that may change as the SEC gives more consideration to cryptocurrency.
Amount of proceeds – ICOs tend to raise much less money than IPOs. As mentioned above, the median proceeds for an IPO was $100 million during 2017. Only six ICOs raised more than $100 million dollars in 2017. During 2017, the median proceeds for an ICO was about $10 million.
Process complication – ICOs are fairly simple when compared to IPOs. In theory, an ICO can be accomplished by a single individual with a computer. In reality, sophisticated ICOs involve multiple parties and substantial planning. Many companies will hire attorneys to ensure their ICO complies with all relevant laws and to avoid making statements that could be considered fraudulent from a legal perspective. While the SEC does not regulate ICOs, there are still laws regarding the sale of securities and other assets to the public. Companies pursuing an ICO may also hire a marketing firm to assist in helping them generate buzz and credibility. While ICOs may require multiple parties and planning, IPOs require many more parties and much more planning. Most companies headed toward an IPO will hire attorneys, investment banks, auditors, and financial reporting specialists in addition to coordinating with the SEC and potential investors. The IPO process involves creating financial statements, having the financial statements audited, drafting an S-1, getting the S-1 approved by the SEC, pitching to potential investors, and a multitude of other things. It is common for IPOs to take at least 4-6 months from the beginning to the end of the process, while a sophisticated ICO can be completed in a month or two.
Access – ICOs and IPOs also differ in public access. Although IPOs are technically “public” offerings, they are not open to any investor. During an IPO companies will go on a roadshow where they meet with institutional investors that have shown interest in investing in the company. These institutional investors are massive investment funds like mutual funds, pension funds, or banks, not individual investors. ICOs are genuine “public” offerings. Anyone with a computer and some cryptocurrency can log onto the ICO website and exchange cryptocurrency for the token being offered. However, as ICOs become more popular it is becoming increasingly difficult to “get in” on an ICO because they often sell out quickly or the website’s bandwidth is taken up by larger investors that are buying massive amounts of tokens at a single time. That being said, ICOs are still much more publicly available than IPOs.
Company lifecycle – Another differences between ICOs and IPOs is the stage in a company’s lifecycle when they undergo the offering. IPOs happen much later in a company lifecycle than ICOs. Before an IPO, companies will have gone through many smaller rounds of funding from private investors such as venture capital firms. IPO companies also will have been operating for many years before an IPO. This gives IPO investors a track record of the company’s performance. Alternatively, ICO companies are generally much younger than the typical IPO company. Some companies complete successful ICOs with only an idea before they have even produced a prototype. This is another reason that ICOs are so risky: the companies often have no track record beyond other projects or companies the founders have contributed to.
Company ownership – ICOs and IPOs have a very different effect on the ownership of the offering company. During an IPO, companies offer actual shares of ownership. This means that before an IPO there are a few people that own and have control over the company, but after an IPO that ownership is spread throughout the public which can lead to thousands of people having a piece of ownership. This is vastly different from an ICO. During an ICO there is no change in ownership. The company is offering only tokens which give the investor the right to something in the future but that have no ownership component.
ICOs have been compared to IPOs all over the internet, for good reason. They are inherently linked through the use of the words “initial” and “offering”. More importantly, they are both ways for companies to raise capital and access public markets. ICOs and IPOs, however, do have significant differences. Most notably, there is a massive disparity between the amount of regulation surrounding the two and the amount of money that can be raised. ICOs and IPOs also differ in their effects on company ownership, their public availability, and the maturity of the company when they occur.
ICOs vs. Crowdfunding
While ICOs are often compared to IPOs, there is an argument to be made that ICOs are more similar to crowdfunding. Crowdfunding is a relatively new source of financing that enables young startup companies to collect small donations from the mass public. Individual donations typically range from $1 to $500 with the aggregate funding totaling between thousands of dollars and millions of dollars. Most crowdfunding platforms, like Kickstarter and Indiegogo, are rewards-based platforms where individuals contribute money towards the development of a product and receive a completed version once the project is finished. Those who donate to these types of platforms are not investors in the company—they are customers who pay for a product upfront.
ICOs and crowdfunding are similar in that they are both ways for anyone who is interested to provide capital to a company or project they believe in. Additionally, investors in ICOs and crowdfunding do not receive equity in exchange for their investments. Instead investors receive tokens in the case of ICOs and completed versions of products in the case of crowdfunding. ICOs and crowdfunding also typically happen very early in the life of a company. Often crowdfunding and ICOs will occur before companies have begun to produce or sell their products. Another similarity between ICOs and crowdfunding is formal regulation. There is little government regulation surrounding crowdfunding and almost no regulation surrounding ICOs.
However, ICOs and crowdfunding have very important differences. Unlike an ICO, after crowdfunding is completed the rights received by investors are not listed on an exchange or easily bought and sold. So, there is no speculative element possible through crowdfunding. The amount of capital raised is also a significant difference between ICOs and crowdfunding. During 2017, the median of ICO proceeds was $10 million dollars. Crowdfunding tends to raise much less money – some of the most successful crowdfunding campaigns in history only raised $10 million. While crowdfunding and ICO investors are similar in that they do not receive equity shares in exchange for their investments, they can differ greatly in what they do receive. Investors who participate in crowdfunding campaigns almost always receive the completed product in the future or nothing. ICO investors on the other hand, can receive anything from currency to use in the completed application’s environment to the right to certain company assets.
Figure 1. Funding Comparisons (1 – most favorable, 4 – least favorable)
Initial coin offerings are becoming more and more common. ICOs allow blockchain companies to access capital earlier than ever before and through a process that is much simpler than the traditional funding process. While ICOs can be a great alternative for companies seeking capital, comparing ICOs to any specific traditional source of funding can be misleading. ICOs do have certain similarities to IPOs, but they have very significant differences, specifically the amount of capital and the lack of regulations. ICOs also differ from crowdfunding and traditional funding sources like venture capital. Although drawing comparisons between something new and something we are used to can often help us understand the new thing better, in the case of ICOs and other sources of funding it may be detrimental to our understanding. There is not a perfect comparison for ICOs and trying to fit ICOs into our traditional thinking around capital raising may not be possible. Instead, we should view ICOs as a new source of alternative funding that is becoming more and more important in the world of finance but that is still widely misunderstood.
- Investopedia: Initial Coin Offering
- Blockgeeks: What is An Initial Coin Offering? Raising Millions in Seconds
- Investopedia: What is an ICO?
- Blockgeeks: ICO Basics, To Invest or Not?
- Hackernoon: ICOs for Dummies (like me)
- CoinClarity: ICO 101 – Initial Coin Offering Basics
- Masterthecrypto: Crypto ICO v. Stock IPO – What’s the Difference?
- Feedough: Initial Coin Offering (ICO) v. Initial Public Offering (IPO)
- Invictus: VC v. ICO