Initial Coin Offerings (ICOs): what they’re really all about

"What is an ICO anyway?” I hear more and more people asking this question these days.  To anyone looking in from the outside, it’s a strange world of big money, moon-rocket emojis and mythical unicorns.

To find the real answer we must go back a little in time, but not too far.  This is still quite a new way for fledgling businesses to raise funding.

A brief history of ICOs

The year is 2013; Google still requires you to type in a command before it can help you; cars are still driven by people and powered by fuel, and Bitcoin is priced at just USD 10.

A group of Bitcoin enthusiasts gather at the San Jose Bitcoin conference to hear more about a wild idea circulated by a Mr. J.R. Willett in a paper he dubbed “The Second Bitcoin White Paper”.

In this paper he put forward the idea that:

“The existing Bitcoin network could be used as a protocol layer, upon which new currency layers with new rules could be built, and people could provide initial funds to hire developers to build software which implements the new protocol layer, and … will richly reward early adopters of the new protocol.”

The conference gave rise to the world’s first ICO

What he was suggesting was a crowd-sale to fund strong technical teams who wanted to make commercially viable platforms based on blockchain, where Bitcoin owners would exchange Bitcoin for access to these platforms.

That San Jose conference was where Willett started his fundraising, and thereby invented the ICO. He spread the word about his idea and raised money to help build it, without passing on any equity to the contributors, who instead received a new cryptocurrency, ‘Mastercoin’.

Willett raised USD 500k worth of Bitcoin and then the price of Bitcoin multiplied ten-fold and suddenly he was holding the equivalent of USD 5 million!   

As other people saw what had happened with Willett’s ICO, interest was inevitably piqued in many quarters.

Willett himself noted,

“Literally, within a few months, other projects were doing the same thing — the most famous of which was Ethereum.”

 

Funding without ICOs

If ICOs didn’t exist, how might a project like J R Willett’s get funded?  There are several options, but all of them have drawbacks.

Bank loans

Going to a bank for a loan might seem the obvious route, but if you do, you will quickly learn that the banks aren’t in the business of lending risk capital to unknown entrepreneurs.  “Come back to us when you can prove you have been successful over a three-year period and we will discuss what we can do.”

Venture Capital

 Venture Capital (VC) firms will take the same risk-averse approach as the banks.  “Come back to us when you have gathered seed capital from family, friends and your own assets and maybe have a minimum viable protocol.  When you have de-risked our investment we will give you the money you need and maybe more, but we will take a stake in your business and our clawback provisions mean you may have to pay some of it back if you fall short of our stipulated performance targets.”

Government start-up grants

These are non-repayable and don’t involve handing over equity, so they seem like an excellent option.  But, they are hugely competitive, only available for certain business types, and have stringent conditions attached.  “You want to do what? Sorry, we don’t cover that sort of business, and in any case, you are not proposing to take on new real estate or new staff, so you don’t fit the criteria for this application.”

Kick Starter / Crowd Funding

“Brilliant, we love your idea and we have lots of people who may contribute small amounts of money. We don’t think we can reach your funding requirements, but we can help!”

So, you see, there was literally nothing in the world like Willett was dreaming of.  At the time it was unique to Bitcoin, until of course Ethereum came along and eventually created a new platform and a new cryptocurrency specifically designed to help anybody create an ICO and try their hand at fundraising for their own technical project

How does an ICO work?

An ICO starts with a team that has a great idea and a willingness to work together. To raise money through an ICO they will design and communicate a plan and a vision to potential investors.

This includes explaining why they are qualified and capable of delivering their project if they raise sufficient money; what the project is and why it is viable; how much money they need, and what they will do with that money to deliver the project.

They are looking for people to exchange fiat currency (that is money declared by a government to be legal tender) or other cryptocurrencies for “tokens” that they issue and that are linked to their project.

Once the fundraising has been successfully completed, those tokens will either be exchanged for another token or coin that is immediately tradable in a market or exchange where the general belief is the value will rise, or the new token itself will become listed on an exchange or market.

Many of these new tokens are exchanged for two established cryptocurrencies; Ethereum and Bitcoin, and the demand for these cryptocurrencies created by the growth of ICOs has supported their meteoric rise in value, particularly in the last two years.

At this point, it’s worth noting that despite the name ‘cryptocurrency’, these tokens are not true currencies, but financial instruments that rise and fall in value depending on the success of the project to which they are associated, or due to the level of engagement in the market for that token once it has been successfully launched.

ICOs from 2017 onwards

Although it’s only 5 years since Willett demonstrated the potential of ICOs, we are already entering a new phase in which they are becoming an established way of raising funds for certain types of projects.

  • In 2017, 210 separate ICOs raised almost USD 3.9 billion, an average of USD 18.5 million each.

  • In 2018 year to date, there have been 429 ICOs completed raising a total of nearly USD 14.9 Billion in total, an average of USD 34.75 million each.

How does this compare to VC?

In Silicon Valley alone, in 2017 there were 8,076 closed VC deals, raising around USD 85 billion.

VC investment globally reached a record-breaking USD 155 Billion in 2017.  Although the number and value of ICOs is growing they still represent only 2.5% of the funds raised worldwide through VC deals.

So, why are ICOs attracting so much press and hype?

The answer is that ICOs are growing rapidly; the number of ICOs and the amount of funds raised is increasing dramatically.

  • The record ICO in 2018, “EOS”, raised just over USD 5 billion after a year of marketing to investors.

  • The total funds raised in the first half of 2018, were almost 4 times the total raised in the whole of 2017.

  • ICOs are beginning to channel traditional fundraising approaches for seed capital, which has become increasingly difficult to secure.

The good the bad and the ugly

The rise of successful ICOs has allowed more brilliant technology companies to become viable and produce new products and solutions that have real commercial value.

Unlike IPOs, where brokers often stipulate that investors meet some degree of qualification to take part, ICOs democratise participation in finance, enabling ordinary people with an interest in an area, or a technology to become involved in helping develop a project.

It has also allowed some to raise far more money than they require and still not manage to turn their plans into viable, profitable businesses.

It has likewise, regrettably facilitated some (not very many) significant scams where the money has disappeared mid-project.

There is a need for harmonised regulation

Governments and regulators are still deciding how to regulate ICOs and cryptocurrencies in general and states hold different positions and are at different stages in the development of their rules.

The most progressive ICOs now often bring their offer voluntarily to the local regulator, seeking answers as to what they can or cannot do.

We have seen ICOs implement Know Your Client and Anti-Money Laundering measures, taking responsibility for ensuring they know where their money comes from, despite the fact they do not give any shareholding, or say in their new business to any investor in tokens.

Whilst this is laudable, it is not the answer to the development of consistent, transparent standards for this important new form of fundraising.  We have long passed the time when self-regulation was seen as an acceptable way of assuring the rights and protection of investors.

External regulation is required to ensure that no ICO can set up and exit a scam easily.  It should protect the process and enable ICOs to take place fairly and openly for the benefit of the community.

With good, supportive regulation, ICOs can continue to do good, and we’ll finally get rid of Moon Rocket Emoji’s, Lambo memes and all-round outrageous expectations as to what an ICO is and what it can deliver.