What is an ICO?

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How companies have made millions in minutes with an initial coin offering

An Initial Coin Offering (ICO) is a decentralized way of raising capital. Companies that go through an ICO will issue coins or tokens in exchange for your money. The money is then used by the company to develop its business and offering. It is important for readers to understand that most do not represent a share of ownership in the offering company.

Introduction

There’s been a lot of news this year about companies raising hundreds of millions of dollars by having an Initial Coin Offering, called an ICO. If you’re not familiar with an ICO, it can sound bizarre, or even like a scam (and some are). Here are the basics of what you need to know.

Why do companies do ICO’s?

Let’s say you’re a startup in the blockchain or cryptocurrency space. You think you’ve got a great idea, but you’re going to need some capital to support you while you develop your idea. Maybe you need some hardware or need to hire some top tech talent or establish relationships with industry partners.

You could try and bootstrap, living off what you can sell right away, but most companies in this space don’t have a product to sell to consumers that they can use to raise money. You could go the traditional venture capital route, but there are a lot of gatekeepers in your way, and some VCs shy away from the cryptocurrency space.

Or you could take your idea straight to the people for funding, in the form of an ICO. If your idea strikes the right chord with cryptocurrency enthusiasts, you could raise all the money you’ll ever need in one fell swoop.

How does an ICO work?

In an ICO, a business offers some new token or form of cryptocurrency in exchange for base currency such as Ethereum or Bitcoin.

Usually, the company making the offering promises that the token will have some kind of usefulness in the future. For instance, Filecoin had an ICO that raised over $200 million for their distributed file hosting.

Users purchased Filecoins during the ICO with the belief that the Filecoin currency will rise in value when the final product comes online because users will have to pay for their files to be hosted using the Filecoin currency.

Bancor raised over $150 million for their distributed cryptocurrency exchange, where users will use the purchased Bancor Network Token (BNT) as a reserve currency on the exchange.

Is an ICO like an IPO in the stock market?

Not exactly. Stock in a company entitles the holder to a type of ownership in a company. This may include receiving dividends from the company’s profits.

The tokens purchased in an ICO usually do not include any idea of ownership in the offering company. If they did, they’d fall under an investment category called a “security”, and be regulated, in the United States, by the Security and Exchange Commission.

There’s a lot of regulation there, so companies considering an ICO must structure their token as a utility, meaning its used in the system they’re building.

We’re in uncharted waters here. Just today, the SEC Chairman, Jay Claton, released a statement about ICOs. In it, he says,

“Following the issuance of the 21(a) Report, certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance.

Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.

Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.”

It looks like the SEC is trying to draw the line, but not making the line so clear cut that companies can skirt around it. Also today, the SEC halted the “Munchee” ICO due to securities violations.

“Even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security.

Determining whether a transaction involves a security does not turn on labelling[sic] – such as characterizing an ICO as involving a ‘utility token’ – but instead requires an assessment of ‘the economic realities underlying a transaction,’” the SEC wrote in the order.

Should you invest in ICO’s?

You could, potentially, make a lot of money from an ICO. If you invest at the ICO price, the tokens issued to you may shoot up in value when they get listed on an exchange. BUT, they could also tank. Like any other investment, you’ll need to do your own research. Here are some things to think about before investing in an ICO:

  • Do they need a blockchain?

Too many companies are going ICO just as a way to raise money, but when you read about what they’re actually trying to accomplish, there doesn’t seem to be a good reason for putting anything onto a distributed blockchain. Blockchains are a complicated piece of technology that most developers have no experience with. If a company is tacking on the use of a blockchain so they can call their token a utility, watch out.

  • Is it open source?

This isn’t necessarily a deal breaker, but a closed-source cryptocurrency should raise a red flag. Cryptocurrencies will, by their nature, be the target of hackers, and the best way to defend against bugs is to make sure your code has gone through a lot of peer review, especially if you’re working in the area of cryptography, which is so easy to get wrong.

  • Is the money raised going to be time-locked?

A time-locked ICO means that the company issuing the token can only withdraw their funds over time, instead of all at once after the ICO is complete. A company that raises tens of millions of dollars can coast for a long, long time without actually producing a working product. That’s why startups in the venture capital world raise money in series – it keeps their feed to the fire to ensure they’re working on something people actually want.

  • Does it seem like a true utility token?

If the token being issued doesn’t seem to have much of a use in the system that will be built, it may fall into the “security” category, which means the company could get shut down.

So, should you invest? You’ll have to do your own research and make your own call, but we strongly recommend waiting until a token hits a major exchange before buying any. By the time the token has reached an exchange, the company will have been at least partially vetted by the cryptocurrency community and the exchange it’s going to be on. It’s not a sure sign of a winner, but it will hopefully at least weed out any blatant scams.

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