An introduction to Initial Coin Offerings (ICOs)

  • By Tom Cleveland

  • December 14, 2018
  • 2:34 am BST

The human lexicon expanded in 2017 to accept a new term – Initial Coin Offering or “ICO” for short. Crypto news feeds buzzed with excitement, as this clever twist on crowdfunding generated $6 billion in new funds for development in the crypto space. Nearly 40% of these monies were concentrated in ten entities, but the rush was on to bypass the venture capital establishment and security regulations. These activities are unregulated, and as such, the criminal element in our society has also rushed in to join the fray. Fraud is rampant in this space. Investors must be more wary than usual.

ICO sounds extremely close to the term IPO, or Initial Public Offering. One favorite quote, used often in this arena, is: “An IPO, or initial public offering, offers a chance to make big money quickly by getting in on the ground floor of the next new Google or Facebook. An ICO, or initial coin offering, offers a chance to make big money quickly by getting in on the next new money.“ The big difference is that with an IPO, an investor buys a stake in the enterprise, and the owners must dilute their ownership interest. With an ICO, no dilution is necessary. The tokens are sold to investors, who hope that the new company develops something around their token, which makes its value in the marketplace appreciate significantly, thereby providing the desired return.

How much money has been raised via ICOs? As for the first six months of 2018, estimates of $7 billion are being bandied about, even though the SEC and other regulatory bodies have ruled the majority of ICOs to be securities and subject to security registration and disclosure requirements under penalty of law. In a few very public cases, the SEC has stepped in, seized funds, assessed penalties, and filed court actions. Potential ICOs have moved offshore to more hospitable jurisdictions, although some countries like China and South Korea have instituted outright bans on the new funding mechanism, citing them “as disruptive to economic and financial stability”.

ICOs actually had their start back in July of 2013. Mastercoin takes the honor for the first capital raise from the sale of a token coin. Ethereum actually followed suit in 2014 with a $2.3 million raise, quite paltry when compared to today’s Filecoin, which acquired $257 million in January of 2018. Early fundraisings may have lit the spark, but, to put things in perspective, capital raises in 2017 were more than forty times those raised in 2016. The unregulated nature of these schemes and the anonymity of the virtual ecosphere have also invited fraudsters, eager to join the global party. If it is not a “pump-and-dump” con game, then the ruse has taken the form of an “exit strategy”, where the management team disappears in the dead of night with the money, never to be heard from again.

ICOs come in a variety of types, and an entire cottage industry has sprung up to help young entrepreneurs through the process. It is not as difficult as you might think, and well over 1,300 of these ventures have been launched. As for type, according to CoinMarketCap.com, “About half of the money raised in ICOs has gone to the 10 largest ventures. Most tokens are made to be used as a means of exchange inside an application. They get a virtual credit or token, which can mean different things in different ICOs. Filecoin, a data storage network, raised $257 million, while Tezos, which has developed its own secure blockchain infrastructure, raised $232 million.”

To date, however, only an extreme few of these ICOs have actually produced any product worthy of note or achieved any material return for their host of investors. An incredibly high percentage of these startups have also failed in their first year. Per one report: “Fewer than half of all ICOs survive four months after the offering, while almost half of ICOs sold in 2017 failed by February 2018”. Other insiders have claimed that 90% of ICOs have failed, with a high percentage of these being attributed to blatant fraud, the reason why regulators have openly criticized the entire industry.

And yet, with these obvious issues, the funding mechanism continues to thrive and expand. Call it faith or blind luck, but the market value of several ICO tokens has skyrocketed, fulfilling the promise of quick riches for those willing to take the risk. For example, when NEO debuted as Antshares in 2015, its price was three cents per token. Over the past few years, the firm generated $4.5 million in earnings, thereby driving the market value up to a peak of $50 a coin, not bad from an ROI standpoint, if you like multiples of 1,600 and more. In July of 2016, the Stratis token kicked off at $0.007, but rose in late 2017 to $2.95, a paltry “400X” multiple by comparison.

For every success story, however, there are multiples more of failure, victims of fraud and deceit, and incompetent executives with unrealistic business plans. The odds may be better than your local lottery ticket, but casualty rates are extremely high. Some programmers have chosen the ICO route because they can raise money for projects that venture capital would never consider funding. What happens if the programmers never build anything? Investors lose with no recourse. Fred Wilson, a partner at Union Square Ventures, opined on his blog: “Right now, with all of the enthusiasm for crypto assets out there, I am very concerned that nobody is being careful about anything.”

What happened in the market to permit ICOs to exist?

It is a sad fact to recount, but after the Internet “bubble “ burst in the early 2000’s, followed by “9/11” and the Great Recession”, venture capitalists and lower echelon funding firms all but vacated the space. What capital they did raise was generally allocated to the care and feeding of what companies were left in their respective portfolios. New ventures went wanting, which led to the crowdfunding craze, where investors were promised some future service or product down the road.

Once Bitcoin became established and futurists viewed blockchain technology as the next wave of innovation that would sweep the planet, every enterprising programmer in the blockchain space had visions of unbridled future success, if only the proper funding vehicle were available. As is often said, necessity is the Mother of invention. The idea of selling tokens for future services, as had been done in a way with crowdfunding, became the market’s answer for what was to become the ICO industry.

Tokens may not be shares in the company, but they are designed to be the mode of exchange for a service or application, yet to be developed. In some cases, the tokens will share in the distribution of a future revenue stream for a specific project, thereby acting like a pseudo share, but without any basic ownership rights. There are also asset-backed varieties, but the exact relationship may require a bit of faith on behalf of the investor. Diversity may command this space, but it is also said that 80% of all ICOs choose the Ethereum platform as their base. The Ethereum version of blockchain is thought to be more flexible than the rival Bitcoin model.

How has the capital funding industry taken to these events? Per one analyst: “ICOs are turning my own profession of venture capital on its head. For the first time ever, capital raised through ICOs eclipsed VC money in Q1 2017, according to CoinDesk’s state of Blockchain report, and this gap will only continue to increase.” From another front, Emma Channing, general counsel at The Argon Group, quipped: “The froth and the attention around ICOs is masking the fact that it’s actually a very hard way to raise money. I don’t think Silicon Valley has ever seen anything quite like ICOs.”

How does one go about investing in an ICO?”

If you are still game to invest in the ICO space, there are several steps in the process, the first of which is to build awareness as to how ICOs work and to learn much more about any targets that you do select. How do you find these targets? You can learn about new projects by observing the conversations on Reddit, or, better still, you might want to checkout the website at “ICO Watchlist”, which also allows you to read up on new and old programs, while comparing one offering with another. The more time invested on the front end is time well spent, and it may prevent your being caught up in a scam down the line.

Once you have determined your first target, whether pre or post offering status, you will have already visited the ICOs official web page, read its whitepaper, terms sheet data, and how to register or participate in the venture. The ICO will require that you have funds typically in either a Bitcoin or Ether wallet, held by the exchange of your choice. You will need to share this address and have the necessary funds available in your wallet. Once the settlement takes place, the new tokens of the ICO will be returned to your wallet. At some point, if everything moves according to plan, then you may be able to sell your tokens or exchange them with the ICO firm for USD or whatever other fiat currency you select, depending on their terms. If it is a fraud or the company does not make it, you could lose your entire investment.

Fraud Risk is pervasive in the ICO space – What are some examples?

Crooks are always smart enough to go where the big money is, and today, investors trying to cash in on the ICO wave hold the big money in the virtual world. All manner of tricks have been used to lure in unsuspecting victims, including claims of outrageous returns, large bonus commissions for bringing in more investors, and high-profile celebrity endorsements. If you plug “Top ICO Scams” into your search engine, you will be amazed at the number and current nature of the responses. Despite warning after warning, the investing public is still in the dark regarding ICO Fraud Risk.

In case you are curious about the form these attacks take and how gullible your fellow man can be, here are a few real-time examples of recent major capers:

  • Modern Tech and Pincoin: This Vietnamese concern raised over $660 million from 32,000 investors for its Pincoin. The founders promised 48% returns and paid 8% commissions for new investors, but they gave a new meaning to the term “Exit Strategy”. When the group began issuing a new iFan token as payment to investors, suspicion was aroused. The management team’s “exit strategy” ensued, as they disappeared in the night from their headquarters, leaving not a penny behind.
  • Plexcoin: This venture raised some $15 million by promising an extraordinary rate of return of about 25% per month to U.S. and Canadian investors. The SEC got wind of the scam and seized the cash, shut the business down, and fined the founders. A little less than $1 million is still tied up in the payment network in Plexcoin wallets.
  • Centratech: Would you invest in a startup because a favorite celebrity endorsed it? Floyd Meriweather spoke on behalf of these crooks, which tipped off the SEC. The scam has been shut down, but the money is still missing.
  • Onecoin: As impressive as the name sounds, this multi-level ICO Ponzi scheme defrauded thousands of citizens for millions of dollars across India and Europe. Even Chinese authorities have fined the group $30 million. The firm never has operated a distributed public ledger system, but still operates in the shadows, nonetheless.

Do you get the picture? None of these schemes are that original. Each takes an old idea, dresses it up with slick marketing materials, a sophisticated website, makes outrageous promises, and still manages to draw in victims for large sums of cash. These examples are but a few, but can you believe that investors fell for “Ponzicoin” or for the latest attempt at adult entertainment, “TITcoin”? When you have a moment, plug those names into your search engine, but be very wary when investing in any ICO by any name.

What steps can one follow to protect against ICO scams?

Curbing one’s greed and avoiding any deal that sounds too good to be true are always the best ways to protect against fraud. There are never any guarantees. Today’s modern conman is steeped in the art of persuasion, psychological manipulation, and using technology to gain an edge. Looks can always be deceiving, especially in the virtual world, but here are a few prudent steps to follow, care of the folks at Investopedia.

  • “Make sure that project developers can clearly define what their goals are. Successful ICOs typically have straightforward, understandable whitepapers with clear, concise goals.
  • Know your developers. Investors should expect 100% transparency from a company launching an ICO. This means that you should know who is involved in the project, what their business plans are, where they are located, what the timeline for the project is, and so on.
  • Look for legal terms and conditions set for the ICO. Because outside regulators generally do not oversee this space, it is up to you as an investor to ensure that any ICO you buy into is legitimate.
  • Make sure that ICO funds are being stored in an escrow wallet. This is a wallet, which requires multiple keys in order to be accessed. This is a useful protection against scams, particularly when a neutral third party is a holder of one of the keys.”

And do not forget about Regulatory Risk?

Regulators sat on the sidelines and observed the ICO phenomenon from afar, but one of their primary missions is to protect investors from fraud. With the prevalence of fraud in this space, regulators across the globe have come out of hibernation with both guns blazing, so to speak. Here are a few comments from the “leaders of the pack”:

  • SEC in the United States: “The SEC this summer warned startups that they could be violating securities laws with the token sales. In an investor bulletin, it warned of the potential for fraud, scams and hacking. It will treat some ICOs as IPOs — as security offerings, in other words, with all the registration requirements that entails, unless a valid exemption applies.”
  • The FCA of the UK: “The FCA has added its voice to other watchdogs around the world, issuing a formal consumer warning about the risks of Initial Coin Offerings, or ICOs. ICOs are very high-risk, speculative investments. Investors should be conscious of the risks involved and fully research the specific project.”
  • China bans ICOs: “Chinese officials deemed ICOs as a threat to financial market stability. The People’s Bank of China said it will strictly punish offerings in the future while penalizing legal violations in ones already completed. The regulator said that those who have already raised money must provide refunds.”

With the current ICO failure rate approaching 90% by most estimates, regulators cannot stand idly by and allow such carnage in their respective jurisdictions. Whenever one of these entities makes a statement, effects an arrest, or issues penalties to an ICO purveyor, market valuations across the board will suffer. If liquidity is an issue, which it most surely is with any ICO offering, then the suffering could resemble a death spiral. Be wary, alert, and skeptical at all times.

Concluding Remarks

ICOs are the latest rage in the investing world. Young blockchain entrepreneurs have found an exciting new funding mechanism for avoiding regulatory compliance and intermediaries, such as venture capitalists, banks, and stock exchanges. Are these propositions the latest in a long line of “get-rich-quick” or “lose-a-bundle” schemes that cyclically pass like wildfire through the investment community or do they “have legs”? Time will tell us all, but, if you wish to stray into these dangerous waters, be cautious and do twice the amount of due diligence that you would normally do on a speculative bet.