Editor’s note: Moses Choi and Subash Mandanapu also contributed to this blog post.
Initial Coin Offerings (ICOs) posed a fundamental question to the startup and venture capital worlds in 2017. That’s because ICOs allow emerging companies and foundations backing projects to raise cash without traditional regulatory compliance or diluting ownership — a detail that has not gone unnoticed by U.S. Securities and Exchange Commission, resulting in formal admonishment and concerns about their long-term viability. The fact that ICOs are nascent, however, should not distract from a recent spike in offerings from issuing companies and demand from investors, which suggests that interest is growing.
So what exactly is an ICO?
An ICO is a crowdfunded sale of cryptocurrency tokens directly to investors where the proceeds are used to support the development of a blockchain-based project. Observers have estimated that up to $1.7 billion in ICOs have been issued since the beginning of 2016, according to the cryptocurrency news site CoinDesk. Startup companies are enthralled by the prospect of raising capital without giving up equity and without acquiring a debt liability. ICO investors receive tokens, which provide access to the product. They are also decoupled from the product’s market value, so their own value may increase as demand for the product increases — or it may fall to zero.
Bitcoin started with a clean slate in 2009. The public could participate on an equal footing and receive both fees and newly minted Bitcoins in exchange for ordering transactions chronologically (a process generally referring to as mining). Other early public blockchain projects followed a similar path by launching a functional network with no pre-mined coins.This changed in 2013 with Mastercoin, which was designed as a protocol layer built on top of Bitcoin, for creating new currency tokens. Inspired by crowdfunding, Mastercoin’s creator decided to support the development of the project by holding a fundraiser, during which supporters could send Bitcoin to a specific address in order to purchase Mastercoin tokens that would become useable when the new platform became functional. The project raised about $500,000 from 500 investors and is now known as the Omni Layer. This fundraiser is the earliest known Initial Coin Offering (ICO).
By 2014, the Ethereum Foundation was created as a Swiss non-profit to coordinate the contributions of software developers implementing the Ethereum protocol. Vitalik Buterin, an Ethereum co-founder, published a blog post, which launched the Ether token pre-sale. Over a 42-day period, Bitcoin could be sent to a particular address to be exchanged for Ether pre-loaded into user wallets. Documents outlined how the sale would be conducted, the anticipated Ether-supply growth rate, and how the proceeds would be used, including as compensation of the Foundation team members. The blog post emphasized: “Ether is a product, NOT a security or investment offering. Ether is simply a token useful for paying transaction fees or building or purchasing decentralized application services on the Ethereum platform.” In total, 11.9 million Ethers were distributed in exchange for $18 million worth of Bitcoin. The Ethereum network went live in the summer of 2015 and was the most notable ICO at that time.
How ICOs work
The process of an ICO involves the buyer sending existing crypto-currency (often Bitcoin or Ether) to a specified address during a time period determined by the token creator. The token creator also specifies an exchange rate, which may be a formula dependent on factors such as time and total contribution. At the end of the ICO period, the token creator delivers the newly created tokens to the buyer.
In the case of any ICO pre-sale, tokens are sold with the expectation that they can be exchanged for the services provided by the network. As was the case with the Ethereum ICO, there is no ability to exchange ownership if the coins themselves are implemented on a newly created blockchain. In that case, the buyer essentially receives an IOU which may only be redeemed or exchanged in future when the services launch. However, it has become more common for tokens to themselves be implemented on an existing blockchain layer.
The ICO sale itself — at least up until now — has usually been handled in an ad hoc manner, but one that follows a predictable sequence. Usually the project or company will create a website and issue one or more technical white papers describing the project. The company will also describe the total number of tokens and the schedule on which they will be created. Then, the company describes how the proceeds from the token sale are to be distributed to founders, developers, and other participants within the ecosystem they endeavor to create.
The organization holding the ICO decides what the time period will be, when it will take place, and how many tokens will be sold (The ICO usually ends when either limit is reached). Many ICOs (e.g., Civic) put a cap on the amount raised and/or the number of tokens created, while others (e.g., Tezos) allow the market to determine these parameters. They also decide on the exchange rate formula for the newly created token. When, for example, an ICO is conducted using Ethereum, the project developers create a smart contract and publish its address. That contract is designed to accept Ether within the specified limits and to issue tokens at the specified exchange rate. One side effect of operating on a blockchain is that large investors may offer to pay miners larger transaction fees in order to ensure that their transaction is included earlier in the blockchain – almost guaranteeing them a place in line. The ICO holder may sometimes be able to take steps to minimize this if they so choose. If the ICO is popular, it can cause temporary congestion on the blockchain as a large number of investors compete to be included in blocks. Note that another side effect of using a public blockchain, is that there is a visible record of all sales.
There is no universal ICO paradigm, as they do not usually represent equity and are not currently regulated, but there are some common patterns that can be observed. First, it is common for the organization that issues the ICO to discount the tokens as compared to their estimate of the price when the system is fully functional. Thus, the early buyers have some expectation that the price will rise if the project succeeds. While any tokens held by the project become assets on the books, they likely will not recognize any liability for the tokens that are sold.
In some of the networks that are created, the participants earn income through a combination of fees for services and sometimes newly minted tokens as they are mined. The project creators often cap the total number of tokens so that there will be a limited supply – some have argued that Bitcoin and similar capped currencies or tokens are therefore deflationary. As time progresses, the project has an expectation that the network service providers will earn less income from newly minted tokens and more from tokens paid as fees. If the ecosystem is seen as robust and growing, there is also an expectation that the value of the token will increase.
As ICOs become more popular, we begin to see some emerging standard practices. Services are springing up with the purpose of tracking upcoming and completed ICOs. Others are developing platforms for holding ICOs and for creating what is presumed to be the necessary legal framework. CoinList is an example of service which seeks to be an ICO platform. It is created by AngelList and the decentralized application startup, Protocol Labs. They worked with lawyers and VCs to create a legal framework that they term a Simple Agreement for Future Tokens (SAFT). Filecoin became the first ICO offering on the platform on Aug. 10, and it’s not a coincidence that the token was created by Protocol Labs for a storage ecosystem that uses its own InterPlanatary File System (IPFS) peer-to-peer decentralized protocol.
In many cases, the ingenuity behind the types of companies that choose to use ICOs to foster decentralized ecosystems in conjunction with blockchain-based services will be as interesting to watch as the success or failure of the ICOs themselves. In the near term, stakeholders should be asking some specific questions: What regulatory framework will emerge? What does it mean that companies unable to raise $10 million from VCs can raise $100 million from ICO investors? And how should investors evaluate ICOs? The SEC has already waded into the conversation with its July 25 ICO bulletin and its larger report on The DAO, establishing that it believes virtual coins or tokens” in an ICO “may be securities,” and in cases where that is true, “the offer and sale of these virtual coins or tokens in an ICO are subject to the federal securities laws.”
As it stands, startups are entering uncharted territory in many ways, and the choices they make now, along with those of regulators, will set the stage for what ICOs’ proponents hope will be a maturing and lucrative space in the near future. Orange Silicon Valley’s fintech and blockchain analysts will watching these developments attentively, so expect to see more about the above issues and more on this blog.