An Initial Coin Offering (ICO) is as of today, an unregulated way of crowdfunding, or raising funds in small amounts, for a cryptocurrency venture, a blockchain project or startup. A percentage of a new cryptocurrency (referred to as token) is sold, in exchange for another cryptocurrency or tender fiat money.
It is becoming a popular method of raising capital without the rigorous, tedious and costly process of regulations, banks and venture capitalists. In essence, it differs from an Initial Public Offering (IPO) in that, while an IPO sells shares of the startup company to early investors who hope to profit from its success, the main objective of an ICO to early supporters or enthusiasts is to benefit directly from the success of the project, by utilizing this token in the application once the project is completed (much like crowdfunding investors), or indirectly by the appreciation in value of their tokens (much like IPO investors). This is resulting in an unusual but growing mix of states and objectives of early investors, who are also backers and supporters, and this is the reason that ICOs are referred to as “crowdsales”. Another more crucial difference between an IPO and an ICO is that while in the former, investors are sold shares in the ownership of the company, in the latter, investors are sold a byproduct of the project which can appreciate in value if the business is successful.
In the last few of years, ICOs have started to generate noise and genuine interest in the technology, startup and venture capital investment communities. However the idea has a longer history – the first issue was done by Mastercoin in 2013, shortly followed by Ethereum, that raised more than $18 million dollars in Bitcoins or about $0.40 per Ether. Others quickly followed and the market ballooned to about 50 offerings a month as of November 2017, totaling $2.3 billion dollars in 2017, more than ten times the amount issued in 2016. In 2017, there were 435 ICOs, raising on average $12.7 million, and Ethereum was the leading blockchain platform for ICOs with more than 50% of market share. As of November 2017, 446 transactions, or 40% of ICOs were based on the EU, which have raised $1.76 billion, or 46% of total issuance sales, followed by the US with 244 campaigns.
The recent surge in ICOs of cryptocurrencies, as an alternative low-cost method of seed funding early stage projects, has caught governments and regulators’ attention alike. In particular, regulators around the world are muddled and not aligned with the application of jurisdictional enforcement. This is due primarily to their lack of understanding of the underlying asset generated and the ultimate endeavors of these new entrepreneurs. In the US, the Securities and Exchange Commission has put out guidelines for preliminary consideration before embarking on these transactions and is debating how, when, and who should they enforce. Furthermore, the Commodity Futures Trading Commission has signaled that it might classify tokens as commodities.
Some ICOs have started to use a “Simple Agreement for Future Token” (SAFT) as an adaptation of a private placement contract, designed a few years ago for venture seed funding. Investors buying these contracts can convert their initial investment amounts in tokens at stipulated discounts in an eventual future series A round funding event. However securities legal experts are currently debating the merits and effectiveness in bypassing tough definition hurdles used by the SEC in determining whether an asset is construed as a security, thereby subjecting its issuer to rigorous filings and registrations.
At the center of the issue is whether a token is a byproduct, or an end product (e.g. cryptocurrency for general transactional use) of these startups. In addition, there is the question of whether a token constitutes a security and/or a commodity in the case of a pre-sale of future tokens, by which the investor would ultimately profit by taking on “enterprise risk”, as well as in the case of the sale of tokens of an already operating project which can already be traded in an exchange. The SEC seems to be leaning to treating tokens as securities in the former case, while treating on a case by case basis the latter. Meanwhile the CFTC is more inclined to treat tokens as commodities under the latter case. Investors must be cognizant and informed of the changes in regulations, as they could impact the legality, and ultimately, the returns of their investments.
Whether a token is a security depends on the facts and circumstances underlying the ICO, and in particular the function the token performs. A “utility token”, which is issued for the purchase of goods and services from the platform, may not be considered a security. If a token is a security, then the sponsor can register the ICO as a private placement offering (Regulation D), thereby avoiding public solicitation and to a maximum of 35 accredited investors (i.e. high net worth individuals). Alternatively, it can exempt the ICO from registration (under Regulation A+). Regardless of the form of private placement requirement, the sponsor needs to consider the transferability of the tokens, as it may limit the ability to be traded on the secondary market.
An ICO could be issued under the SEC crowdfunding regulation by a US person, but it places limits and restrictions on the amounts issued the size per individual investment and the resale of tokens. In addition, the tokens issued under this regulation are offered on funding portals and broker-dealers that are registered under the Exchange Act, so this alternative is viable for non US sponsors.
Another important consideration has to do with a virtual currency, since its ICO sponsor could be subject to Bank Secrecy Act (BSA) regulation as a “money transmitter”. Therefore, the accompanying requirement to verify customer identities creates a significant burden in an industry where the purchase of tokens typically involves anonymous or pseudonymous transactions. Notwithstanding the above, given the BSA definition of a money transmitter, an ICO sponsor of a decentralized token or cryptocurrencies (e.g. Bitcoin) generally would not be subject to these regulations, while the activities of transferring, redeeming and accepting virtual currency of a sponsor of a centralized platform might become subject to them.
A final crucial element to keep in mind when building an Ethereum-based application has to do with licensing. This is due to the open source nature of the software employed (i.e. core, applications and middleware), which most unexperienced developers may assume is free and open for commercial use. However, although the Ethereum Foundation philosophy is that its software is released under the most liberal of licenses, or “permissive” (i.e. open for commercial exploitation), many of them are “restrictive” (i.e. they limit a licensee’s ability to relicense modifications or developments on commercial terms). Thus, until a final license is decided upon, the current shifts in philosophy (owing to conflicting rifts among its various stakeholders), Ethereum-based application developers will bear this risk, which in the worst case scenario may jeopardize their modification’s proprietary value and render the whole project commercially unviable.
Blockchain-based technology has a bright future ahead, and markets are still awash of cash needed to be deployed into higher returns than current yields. Furthermore, the open-sourced nature of the coding, developing and collaboration in the technology has made these projects cheaply accessible to new entrepreneurs. However seed funding these projects can be hard especially without any large venture capital backing the project.
A token issuance can be beneficial in terms of legal costs and crowdfunding efforts as it is sold to less accredited but more enthusiast investors, similar in spirit to a donation. But adding a new token is not a negligible investment in terms of developer hours, and even if a startup can do it, for a token investor, it’s still the big trading pairs that effectively dominate in volume for now, such as Bitcoin to Bitcoin Cash.
For tokens built around solving a specific problem, trading volume is likely to stay light until their products are ready to go into operation. In addition, there’s the problem of whether or not the underlying protocols can actually handle demand.
In any case, an important point is that not all tokens are minable, as the blockchain protocol may only be run by insiders or the original developer owners of the project. Most cryptocurrencies are minable by the very nature of being blockchain-based, thereby rewarded to those individuals that maintain the system (e.g. Bitcoin, Ethereum) and hold what is called a Proof-Of-Work coin. Large scale miners will benefit from economies of scale, and generally an increase in mining difficulty and a reduction in block rewards will increase the prices of minable tokens.
Pre-mined tokens are those that have been already mined ahead of time by insiders before being traded on the open market, and constitute a percentage of the blockchain total supply. A lot of people consider a large pre-mine to be unethical as it means that the creators mined an amount of coins and are profiting by selling them to the public, in order to fund the project.
The non-mineable cryptocurrencies are simply the ones awarded to the individuals maintaining the system. Most of them will have the circulating supply in wallets. However these tokens, which are also referred to as Proof-of-Stake (PoS) coins, will generate (or “mint”) new coins just by sitting in a wallet (a bit like interest). So the more you have, the more you earn. But unless the project is very successful, the price of non-mineable tokens might decrease once the rewards given out to holders have been depleted, as it would be unprofitable and irrelevant to hold such coins.
Under current tax legislation, the proceeds of an ICO are considered taxable income, as the IRS treats tokens as a property. However, a new US Cryptocurrency legislation currently under approval by Congress would make the nature of the proceeds of an ICO affect the taxable income as it would exclude from it cryptocurrency proceeds (up to $600), whereas cash proceeds would not qualify for the exclusion. Also, purchases made with digital currencies could become subject to taxable income. Furthermore, tokens could be considered interest in partnerships or associations, with its various tax implications.
As with any nascent industry, the long term profitability and ultimate sustainability of new entrants to the market as the industry develops, depends on the fundamentals of the project, and how innovative its business model becomes.
In the case of ICOs, the disruptive nature of the blockchain protocol of smart contracts for example, with its incentives and advantages can certainly have a transformational impact in any industry across the economy, from transactional purposes (e.g. Bitcoin, Litecoin), to smart contracts (e.g. Ethereum, Ripple) in commercial aviation, insurance underwriting, instant messaging, financial derivative clearing and settlement, to name just a few.
But that doesn’t mean the return on these investments is guaranteed, as not only has the technology not been thoroughly tested, but in some large projects there are serious scalability issues. Another big risk is the general lack of investors’ knowledge of the team of developers, insiders and original owners of these projects, which in most cases are in different physical locations. Some fundamental factors to consider before investing for the long term in a specific token are:
Similarly, ICO sponsors should bear in mind other secondary market considerations, especially if they forecast high demand from short term speculators rather than long term investors and supporters. They include:
Another important consideration for ICO success is how clogged the platform is at the time of launch. This has become apparent with some ICOs whose launch dates are being delayed because of other DApps (decentralized applications) running off the Ethereum platform, which are consuming large amounts of data and node processing time. While there are many scalability solutions being proposed, a reliable scalable blockchain protocol or solution has not been consolidated in the developer community. And some seed investors are calling for simpler, smaller, less ambitious projects that can adapt well to the current scale of the public crypto blockchain platforms available today. As such, leading developers are calling for “off-the-chain” protocol solutions, leaving only validation and storage as on-the-chain tasks, relieving the blockchain of needed capacity. Ultimately, the winning solution will not only combine the right off-the-chain tasks, but will strike the right game theory balance of incentives for on and off the chain nodes, to avoid cheating and/or overpowering one another (TrueBit is a shot in the right direction).
Finally, ICO sponsors should be aware that while retail investors may want to get in on the ICO market, financial service providers haven’t been in a rush to provide a secondary market. However, the industry is catching up to the dominant coins, as new cryptocurrency hedge funds begin allocating capital. There are also discussions around providing leverage and margin capabilities in some of the largest exchanges (for market making, shorting and daily speculative trading) as part of the overall custody ecosystem. However, most of the best tools are only available to traders in larger cryptocurrencies such as Bitcoin and Ether, as trading volume is one of the main data points cryptocurrency exchanges, which facilitate trading solely between coins, look at before adding a new asset.
Source: www.icostats.com as of 11/30/2017
Source: www.icostats.com as of 11/30/2017
 A list of active, upcoming and recent ICOs can be viewed at www.icoalert.com
 According to venture capital firm Atomico