This serves as a crowdfunding phase – users receive tokens that they can use (either immediately or in the future), and the project receives money to fund development.
The practice was popularised in 2014 when it was used to fund the development of Ethereum. Since then, it has been adopted by hundreds of ventures, with varying degrees of success. While the name sounds similar to an Initial Public Offering (IPO), the two are fundamentally very different methods of acquiring funding.
IPOs usually apply to established businesses that sell partial ownership shares in their company as a way to raise funds. In contrast, ICOs are used as a fundraising mechanism that allows companies to raise funds for their project in very early stages. When ICO investors purchase tokens, they are not buying any ownership in the company.
Also see: The History of Ethereum
ICOs can be a viable alternative to traditional funding for tech startups. Often, new entrants often need to secure capital without an already functional product. In the blockchain space, established firms rarely invest in projects on the merits of a white paper. What’s more, a lack of cryptocurrency regulation can stop investors from considering blockchain startups.
The practice isn’t just used by new startups, established enterprises sometimes choose to launch a reverse ICO, which is functionally very similar to a regular ICO. In this case, a business already has a product or service and issues a token to decentralise its ecosystem. Alternatively, they might host an ICO to include a broader range of investors and raise capital for a new blockchain-based product.
ICOs vs. IEOs (Initial Exchange Offerings)
Initial Coin Offerings and Initial Exchange Offerings are similar in many ways. The key difference is that an IEO is not hosted solely by the project’s team, but alongside a cryptocurrency exchange.
The exchange partners with the team to allow its users to buy tokens directly on its platform. This can be beneficial to all parties involved. When a reputable exchange supports an IEO, users can expect the project to have been rigorously audited. The team behind the IEO benefits from increased exposure, and the exchange stands to gain from the project’s success.
ICOs vs. STOs (Security Token Offerings)
Security Token Offerings were once branded the “new ICOs.” From a technological standpoint, they’re identical – tokens are created and distributed in the same manner. On the legal side, however, they’re completely different.
Due to some legal ambiguity, there is no consensus on how regulators should qualify ICOs (discussed in more detail below). As a result, the industry has yet to see any meaningful regulation.
Some companies decide to take the STO route as a way to offer equity in the form of tokens. Also, this could help them steer clear of any uncertainty. The issuer registers their offering as a securities offering with the relevant government body, which subjects them to the same treatment as traditional securities.
How does an ICO work?
An ICO can take many forms. Sometimes, the team hosting it will have a functional blockchain that they’ll continue to develop in the coming months and years. In this case, users can buy tokens that are sent to their addresses on the chain.
Alternatively, the blockchain might not have launched, in which case the tokens will be issued on an established one (such as Ethereum). Once the new chain is live, holders can swap their tokens for fresh ones issued on top of it.
The most common practice, however, is to issue tokens on a smart-contract-capable chain. Again, this is done predominantly on Ethereum – many applications use the ERC-20 token standard. Though not all originate from ICOs, it’s estimated that there are over 200,000 different Ethereum tokens today.
The Basics of Bitcoins and Blockchains: An Introduction to Cryptocurrencies and the Technology That Powers Them
Besides Ethereum, there are other other chains that can be used – Waves, NEO, NEM, or Stellar are some popular examples. Given how flexible these protocols are, many organizations make no plans to migrate away but instead opt to build on existing foundations. This approach allows them to tap into the network effects of an established ecosystem and gives developers access to tools that have already been tried and tested.
An ICO is announced ahead of time and specifies rules for how it will be run. It might outline a timeframe it will operate for, implement a hard cap for the number of tokens to be sold, or combine both. There might also be a whitelist that participants must sign up to beforehand.
Users then send funds to a specified address – generally, Bitcoin and Ethereum are accepted due to their popularity. Buyers either provide a new address to receive tokens, or tokens are automatically sent to the address that the payment was made from.
Who can launch an ICO?
The technology to create and distribute tokens is widely accessible. But in practice, there are many legal considerations to take into account before holding an ICO.
Overall, the cryptocurrency space is lacking in regulatory guidelines, and some crucial questions are yet to be answered. Some countries prohibit launching ICOs outright, but even the most crypto-friendly jurisdictions have yet to deliver solid legislation. It’s therefore necessary that you understand your own country’s laws before considering an ICO.
Also see: What is Blockchain?
What are the regulations surrounding ICOs?
It’s difficult to give a one-size-fits-all answer because there are so many variables to consider. Regulations vary from one authority to another, and each project likely has its own nuances that may affect how government entities view it.
It should be noted that the absence of regulation in some places is not a free pass to crowdfund a project via an ICO. So it’s important to seek professional legal advice before choosing this form of crowdfunding.
On a number of occasions, regulators have sanctioned teams that raised funds in what they later deemed to be securities offerings. If authorities find a token to be a security, the issuer must comply with rigorous measures that apply to traditional assets in this class. On this front, the US’s Securities and Exchange Commission (SEC) has provided some good insights.
In general, the development of regulation is slow in the blockchain space, particularly as the tech outpaces the slow-turning wheels of the legal system. Still, numerous government entities have been discussing the implementation of a more transparent framework for blockchain technology and cryptocurrencies.
Though many blockchain enthusiasts are wary of possible government overreach (which might hamper development), most of them recognise the need for investor protection. Unlike traditional financial classes, the ability for anyone around the globe to participate presents some significant challenges.
What are the risks involved with ICOs?
The prospect of a new token granting huge returns is an appealing one. But not all coins are created equal. As with any cryptocurrency investment, there are no guarantees that you’ll have a positive return on investment (ROI).
It’s difficult to determine whether a project is viable, as there are many factors to that you must bear in mind. Prospective investors should perform due diligence and conduct extensive research into tokens they’re considering. This process should include a thorough fundamental analysis. Below is a list of some questions to ask, but it is by no means exhaustive:
- Is the concept viable? What problem does it solve?
- How is the supply allocated?
- Does the project need a blockchain/token, or can it be done without one?
- Is the team reputable? Do they have the skills to bring to run the project?
The most important rule is never to invest more than you can afford to lose. Bear in mind that cryptocurrency markets are incredibly volatile, and there’s a major risk that your holdings can lose value very quickly.
How to Identify a Scam ICO
An exit scam ICOs are quite popular so the ability to identify them can save you much money.
According to Ernst & Young, almost 10% of all funds raised by ICO’s end up in the scammers' wallets.
However, there are ways to identify fraudulent ICO. Look for these common signals:
- Anonymous team. Many scams do not publicise their team, so no one can verify who is related to the project. It is a major red flag.
- An offer seems to too good to be true. If the project offers you ludicrous returns or impossible products, that’s a major red flag.
- No roadmap. A serious startup always plans ahead and is open about its further steps. If the future of the project is concealed, it’s probably non-existent.
- Bitcointalk.org thread. A legit way to launch an ICO is by announcing it on BitcoinTalk.org. It is the largest forum for Bitcoin and cryptocurrencies, and legitimate projects will gladly participate in the discussions and answer all the questions.
- Code. Credible projects will commit their code to Github where everyone can review it. No code, no project.
- Is the token or blockchain necessary? Many projects can function well without a distributed ledger. Many projects try to take advantage of ICO’s just to collect extra money. So ask yourself, does it really need its own coin?
- PR and media activity. Trustworthy projects hire qualified marketing specialists who manage to create an active, engaged community. Also, it is always a good sign if the project gets positive mentions in quality publications.
Remember not all ICOs are scams, and they also provide a legit way to raise funds for legit and cool projects.
Also see: What is Bitcoin?
Initial Coin Offerings have been tremendously effective as a means for projects in their early stages to acquire funding. Following the success of Ethereum’s Initial Coin Offering in 2014, many organisations were able to acquire capital to develop new protocols and ecosystems.
Buyers should, however, be conscious of what they’re investing in. There are no guaranteed returns and such investments are highly risky.
Also there’s little by way of protection if the project fails to deliver a viable product.
If you are new to the Cryptocurrency world and would like to open an account we recommend Cex.io.
See an explanation on the video below about ICO's; shared on Youtube by CNBC.