An Initial Coin Offering (ICO)
When a cryptocurrency company raises funds, wishes to create a new coin, service or app, it is called an initial coin offering (ICO). It is the same concept as an initial public offering (IPO).
Investors buy into the offering and get the new token issued by the cryptocurrency company. They may use this token to avail the company’s product or service, or it may just represent a stake in the project or company.
How does the Initial Coin Offering work
When a cryptocurrency startup requires to raise money through ICO, there are the steps it follows:
It starts with creating a whitepaper which provides an outline -
- What the project is about
- How much money is needed
- What type of money will be accepted
- The need the project will fulfil upon completion
- How long the campaign will run.
- The founders will keep how many virtual tokens.
During the ICO campaign, the supporters and enthusiasts of the project purchase some tokens using digital or fiat currency. These coins are known as tokens. It is similar to shares that a company sells to investors during an IPO.
When the money raised does not meet the minimum requirement, it gets returned to the backers. At this point, the ICO is deemed unsuccessful. If the raised funds meet the minimum funding requirements within the specified timeframe, the company could use them to pursue the project’s goals.
Even though ICOs aren’t regulated, The Securities and Exchange Commission (SEC) can intervene. In 2018 and 2019, Telegram raised $1.7 billion in an ICO. As a result of alleged illegal activity by the development team, the SEC obtained a temporary restraining order by filing an emergency action. In March 2020, Telegram had to pay a civil penalty of $18.5 million and return $1.2 billion to investors after a preliminary injunction by the U.S. District Court (Southern District of New York).
Investors who wish to purchase ICOs should first familiarise themselves with cryptocurrency. In most cases, investors need to buy tokens with pre-existing cryptocurrencies. So, an ICO investor will require a cryptocurrency wallet set up for a currency like bitcoin or ethereum. It will also have a wallet capable of holding whichever cryptocurrency or token they wish to buy.
The investor would be unsure about the suitability of ICOs to participate. There is no set method to stay updated regarding the latest ICOs. An interested investor could read about new projects online, which can be the best. ICOs create a substantial amount of hype. Investors have numerous places to gather online to discuss new opportunities. There are multiple places online in which. There are dedicated sites that allow investors to find out about new ICOs, aggregate ICOs and compare various offerings.
Initial Coin Offering (ICO) vs. Initial Public Offering (IPO)
There are several methods for traditional companies to raise the funds required for expansion and development. A company could begin on a small scale and expand as per the amount of profit it earns. The company remains accountable only to its owners only. But, it also means a lot of time goes into building up the funds.
On the other hand, companies can take support from outside investors in the early stage. It gives them a good inflow of needed funds. But that also typically comes with the trade-off of giving away a part of the ownership stake. Yet another way is to go public where the funds get collected by selling shares to individual investors through an IPO.
Much like crowdfunding events, ICOs also have to deal with supporters wanting to invest in a new project, while IPOs deal with investors only. However, ICOs also vary from crowdfunding as the funds raised in crowdfunding campaigns are essentially donations, whereas a likely return on their investments influences the backers of ICOs. Hence, ICOs are called “crowd sales” due to these reasons.
ICOs also retain at least two significant structural differences from IPOs. First, ICOs are largely unregulated. That means that government organisations such as the Securities and Exchange Commission (SEC) do not oversee them. Furthermore, due to a lack of regulation and decentralisation, ICOs are much freer in structure than IPOs.
ICOs are structured under different methods. A company places a predetermined limit or goal for funding. So, every token sells at a pre-set price. Also, the total token supply is fixed. In other cases, the number of ICO tokens is static while the funding goal is dynamic. Thus, the funds received to determine how the distribution to investors takes place. The more funds are received in the ICO, the higher the final token price.
Other companies could follow with a dynamic token supply. It is determined as per the amount of funding received. In these cases, the price of a token is static. However, there is no limit for the number of total tokens, except for some factors such as ICO length.
Advantages and Disadvantages of Initial Coin Offerings
An investor gets shares of stock in a company in exchange for investing in the IPO. In an ICO, the company raising funds provides the blockchain equivalent, i.e., cryptocurrency tokens. The investor pays in ethereum, bitcoin or any other such popular token. In return, they receive a comparable number of new tokens exchanged.
It is relatively easy for a company to launch an ICO to create tokens. In a matter of seconds, online services can generate cryptocurrency tokens. When weighing the differences between shares and tokens, investors must keep this in mind. The latter does not have any legal guarantee or intrinsic value. ICO managers generate tokens as per the terms of the ICO. Once they receive them, according to the plan, they distribute them by transferring them to individual investors.
The early investor in an ICO is motivated to purchase tokens hoping the plan will work after launch. Once that happens, its value will rise more than the ICO price, resulting in overall gains. The primary benefit of an ICO is the potential for very high returns. Indeed, ICOs have made many investors into millionaires.
When ICOs come into the limelight in the blockchain and cryptocurrency, they have also brought risks, challenges, and unexpected opportunities. Many investors invest in ICOs with the expectations of solid and quick returns on their investments. As the most successful ICOs over the past several years have indeed resulted in tremendous returns. It has been the source of the optimism people have developed in ICOs. However, this enthusiasm can also lead people astray.
As ICOs are still largely unregulated, scamsters and fraudsters keep looking for ways to dupe poorly informed and overzealous investors. When that happens, such investors may never recover the money they had invested lost due to incompetence or fraud as financial authorities, like the SEC, don’t regulate them.
In 2017, the meteoric growth of ICOs attracted backlash from both governmental and non-governmental entities. The People’s Bank of China called ICOs counterproductive to financial and economic stability and officially banned them. It also forbade the usage of tokens as currency. Also, it has prohibited banks from offering services related to ICOs. Prices of both ethereum and bitcoin have tumbled as a result. Many have regarded these events as a sign of more regulations to come on cryptocurrency. This ban has also penalised completed offerings.
In early 2018, Google, Facebook, and Twitter banned ICO advertisements.
When investing in ICOs, there is no guarantee that an investor won’t be on the losing end of a scam. To avoid losing money in ICO scams, investors should:
Be sure that project developers can clearly explain their goals. Successful ICOs typically publish an understandable and straightforward whitepaper with concise and clear goals.
Know the developers. Investors must expect 100% transparency from a company that is launching an ICO.
Read the legal terms and conditions thoroughly set for the ICO. It is up to an investor to make sure the ICO is legitimate as external regulators usually don’t look into it.
Make sure that ICO funds are in an escrow wallet. It is a type of wallet accessed with multiple keys. Especially when a neutral third party holds one of the keys, it becomes helpful in protecting against scams.
Securities and Exchange Commission Introduces the HoweyCoin
As regulations on ICO continued to be relatively obscure and vague, activity started to decrease dramatically in 2019.
To show the dangers of ICOs to small investors, The U.S. Securities and Exchange Commission introduced a fake coin called the HoweyCoin. Named after the Howey Test, the HoweyCoin refers to a test to find out if an investment is a security or not. The Howey Test determines that a transaction is an investment contract when a person invests their money in a joint enterprise and expects profits solely from the efforts of the third party or the promoter.
The SEC has applied to charge Kik, a messaging service, with unlawful sale of a security for raising $100 million in an unregistered ICO. The SEC took action against Telegram. It was another messaging app that had conducted its ICO.
According to the SEC, an ICO is not different from an IPO if the underlying token does not operate separately from an already existing business and raises money for that business.
Example of an Initial Coin Offering
As the ICO space got more prominent, its most significant projects also raised more considerable sums of money. While evaluating ICOs, one can analyse the return on investment and the funds raised in the ICO.
Sometimes ICOs with exceptional returns on investment are not the projects that raised the most considerable amount of money and vice versa. In 2017, Ethereum’s ICO raised $18 million over 42 days and was an early pioneer. It has established its significance for the ICO space due to its innovations related to decentralised apps, i.e., dApps. When ether debuted, its price was at around $0.67. As of Sept. 20, 2021, it trades at $ 3,304.82.
A company named Neo (formerly known as Antshares) started a two-phase ICO in 2015 & 2016. In its first phase that ended in Oct. 2015, and the second, which continued until Sept. 2016, it earned about $4.5 million in total. It has given extraordinary ROI to many early investors even though it isn’t one of the largest ICOs that raised the highest amount of money. At the time of the ICO, its price was around $0.03, while it traded at roughly $187.40 at its peak.
ICOs have more recently generated significantly more significant amounts in terms of total funds raised. Dragon Coin was able to raise about $320 million in its month-long ICO ending in March 2018. Later, the company behind the EOS platform broke Dragon Coin’s record when it collected a whopping $4 billion in its year-long ICO.
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