Understanding Initial Coin Offerings (ICOs)
Have you ever contributed to the crowdfunding of a new venture that inspired you? Then you might be wondering if an Initial Coin Offering (ICO) is an investment opportunity for you. What is an ICO? How risky is it? How are ICOs regulated, if at all? We tell you what you need to know about this new type of investment.
What is an ICO?
Put very simply, an ICO is a means of raising capital used by start-up and early-stage enterprises, or entrepreneurs. Instead of offering shares, as in an Initial Public Offering (IPO), the company offers digital tokens created using blockchain technology. Generally, the investor must pay for the digital tokens using another cryptocurrency – Bitcoin and Ethereum are the most popular. Occasionally fiat currency (“normal money”) is accepted.
What is a digital token?
A digital or crypto token is a digitally scarce unit of value created and determined by computer code (the blockchain). There are three types of digital tokens, although only two are commonly used in ICOs. Currency tokens, like Bitcoin, can be used as payment for transactions with a vendor willing to accept them. You can buy luxury goods and other tangible items with currency tokens. In an ICO, the start-up will offer utility tokens or asset tokens (also called investment or security tokens). The benefits offered by utility tokens vary and usually include access to particular services provided by the company. Asset or investment tokens give the owner the right to participate in the issuer’s future returns and, in some cases – but rarely, voting or other participation rights.
As a very rough comparison, you can think of a utility token in terms of crowdfunding: you receive a sample of the company’s product or service or a discount on a future purchase in exchange for your investment. An asset token is more like buying shares, as you are entitled to participate in future returns, i.e., receive dividends.
Why do companies issue ICOs?
There are certain benefits to raising capital via an ICO for new businesses. An ICO is an alternative to venture capital or private equity investment. In these types of investment, the investor usually receives an equity stake and a role in the governance of the company (typically a seat on the board). Not all entrepreneurs want to relinquish full control to a venture capitalist in this way. Other options open to early-stage companies are private placements, IPOs, or crowdfunding. Of these, only crowdfunding is wholly democratic and unrestricted. To secure a private placement, the entrepreneur needs access to selected investors, usually institutions or wealthy individuals. Not all start-ups enjoy such access. Both private placements and IPOs are heavily regulated and the requirements may be too onerous for a young enterprise seeking seed capital. Crowdfunding can be an extension of family and friend networks, and some crowdfunding campaigns have achieved phenomenal success, such as the Allbirds footwear brand and MVMT Watches. But it is unpredictable and, along with the successes, there are some catastrophic failures. An ICO appeals as a more sophisticated form of fundraising than crowdfunding but a less restrictive option than private equity, private placement, or an IPO.
What is the process of issuing an ICO?
Although an ICO may be simpler than an IPO or other means of raising capital, it is not an easy option. There is still a rigorous process to follow. Digital tokens must be created with a specific set of rights attached to them, and they must be priced. The timeline must be established and the target audience determined. A “white paper” (equivalent to a prospectus in an IPO) and business plan for the venture must be developed and issued. And a marketing plan must be designed, which will focus heavily – probably exclusively – on social media tools and the digital environment. The entrepreneur normally establishes an advisory board and hires experts who will conduct the ICO campaign.
Once these steps are in place, a small proportion of tokens are pre-sold at a discount, usually to raise the money to fund the ICO itself and to test the market. Quite often, pre-sale investors can purchase their tokens with fiat currency rather than cryptocurrency, which simplifies the process for all parties.
Lastly, the ICO happens, when cryptocurrencies are sent by investors to a public digital wallet address in exchange for the tokens. There is often a cap on the number of tokens sold. Tokens are sent to the wallets of the investors at an exchange rate determined by the timing or size of the contribution. Many ICOs last about a month, but the duration will depend on token demand. After the ICO is concluded, investors often want to exchange their tokens for fiat currencies or cryptocurrencies. Therefore, new cryptocurrencies aim to list on a token exchange to ensure the tokens can be traded after the ICO. This is the only way to access liquidity and attract new investors as the token becomes a new currency. Unfortunately, many ICOs wind up delisting. Not all ICOs succeed.
Advantages of an ICO
For the issuer, i.e., the entrepreneur or start-up company, ICOs have advantages over conventional fundraising methods. An ICO bypasses financial intermediaries such as banks and stock exchanges, which makes the offer process faster and less costly. The technology needed to release an ICO is relatively straightforward and readily available. These lower barriers to entry democratise capital markets and facilitate market entry, in much the same way crowdfunding does. But the amount of money that can be raised is far higher than with crowdfunding or other fintech models, and can be higher even than with traditional IPOs.
Disadvantages of an ICO
The features of an ICO that make it attractive to the entrepreneur are also what make it risky for the investor. ICOs are not regulated in many jurisdictions, including South Africa at time of writing (though a regulatory working group has been established to consider regulatory approaches). Because of the lack of regulation, the white papers issued in advance of an ICO vary considerably in their content and quality. The only standardisation seems to be a technical description of the underlying technology and a description of its potential use and benefits. Even more comprehensive white papers do not contain the detail that is found in an IPO prospectus, and the information is not verified. This could allow fraudsters or scammers to go unchecked.
Legal protection for investors is weak, as ICOs operate outside of existing legal and regulatory frameworks. This means that, in the event of bankruptcy of the issuer, investors have no legal recourse. They also have no control over the company they have invested in, as they have no voting rights, unlike shareholders in an IPO.
Finally, all cryptocurrencies are highly volatile, and ICOs have perhaps the highest volatility of all digital assets. ICOs are not subject to the disclosures required of legacy businesses or other investment types (e.g., private placements or IPOs), and therefore ICO investors have very limited assurances. An ICO is not an investment for the faint-hearted. It is, in effect, a gamble.
For more information
We advise caution in purchasing any digital assets, including an ICO. Be aware of the risks and avoid investing money you can’t afford to lose. If you have questions about ICOs or any aspect of digital asset management, contact Simon on 086 099 5146 or email firstname.lastname@example.org
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The information on this website is provided to assist the reader with a general understanding of the law. While we believe the information to be factually accurate, and have taken care in our preparation of these pages, these articles cannot and do not take individual circumstances into account and are not a substitute for personal legal advice. If you have a legal matter that concerns you, please consult a qualified attorney. Simon Dippenaar & Associates takes no responsibility for any action you may take as a result of reading the information contained herein (or the consequences thereof), in the absence of professional legal advice.