Bitcoin continues to play a key role in the digital finance game. As it continues to evolve, the concept of blockchain and coins grows alongside, resulting in the realization of cryptocurrency as a fundraising opportunity and becoming the trendsetter for ICOs.
ICOs are like a goldmine in the early stages of capital-driven investments that are commonly full of significant entry barriers. Startups raised more money through ICOs than other traditional fundraising methods.
What are ICOs?
ICO or initial coin offering is a capital or fundraising activity in a blockchain-based environment. It’s similar to an initial public offering (IPO), a traditional method of raising funds and issuing stocks. The difference is that ICO is based on cryptocurrency.
Coins and tokens are the two most common types of cryptocurrencies. Simply put, coins are like fiat money or store value that act as currency, while tokens are like coupons or vouchers that can raise money for startups.
Startups usually opt for ICOs, especially if they’re having difficulty obtaining appropriate financing for their projects through traditional financial institutions. In ICOs, tokens crowdfund their projects.
When it comes to investing, ICOs are called crowdsale. In ICOs, investors get tokens that may offer them some benefits. They expect their investment in the project to become successful, increasing the token's value.
These tokens get issued by organizations known as issuers through ICOs. They're typically categorized into four:
- Community tokens that give memberships in a certain community, like file sharing ability or connections to other community token holders or users;
- Currency tokens that represent cryptocurrencies and have exchanges or value references;
- Utility tokens that entitle holders to the right to use the goods or services provided by the firm; and
- Securities tokens promise holders future cash flows from the firm.
In general, these tokens, especially the latter two, are contingent on the success of the fundraising and the startup, making them similar to equity tokens. However, selling these tokens through ICOs is far different from equity sales.
Sale Process of Tokens through ICOs
In ICOs, startups raise capital using blockchain technology where they can sell tokens to investors directly. The first step is publicizing the ICOs on cryptocurrency websites. These sites will then direct investors to a whitepaper.
A whitepaper outlines all key information about ICOs. There’s no standard length, size or form, or legal requirement for it, so firms tend to decide what they want to include. Despite this, its length and text complexity are correlated with ICO success. Hence, a whitepaper is a very important source of information for ICO investors.
The whitepaper also specifies what rights come with a particular ICO token. Each token generally gives investors different rights, and every token confers multiple types of rights. Here are most of the common types of token rights:
- Payment rights, where the only payment for a service or platform is the token.
- Access rights, where the token is needed to use the platform.
- Profit or fee rights, where token holders get a percentage of profits or revenues.
- Contribution rights, where tokens holders can be responsible for managing the network that doesn’t involve generating blocks for a blockchain.
- Block creation rights, where tokens will secure the project’s blockchain.
- Governance rights, where token holders can affect project specs, direction, rules, and more.
For the next step, investors give cryptocurrencies to firms in exchange for tokens, which can get completed in a few minutes to over a year. Investors can sometimes trade the tokens on the secondary market even before it's finished.
Types of ICOs
ICOs can either be private or public. First, private ICOs are only open to a limited number of investors, which are generally accredited. They could be high-net-worth individuals or financial institutions. In private ICOs, companies can set a minimum investment amount.
Second, public ICOs are more like a democratized form of investing. It targets the general public, which means anyone can become an investor. However, private ICOs are becoming more sensible than public offerings due to regulatory concerns.
Steps in Issuing ICOs
ICO is a long process requiring in-depth knowledge of technology, finance, and the law. But, to sum it up, the main concept is to leverage the decentralized systems of blockchain technology in capital-raising activities while aligning various stakeholders’ interests.
Step 1. Identifying Investment Targets
Every ICO starts with a startup or a company’s intention to raise capital. They should identify the targets for its fundraising and prepare relevant materials about the project for potential investors.
Step 2. Creating Tokens
Tokens are fungible, tradeable, and representations of an asset in the blockchain. However, tokens don’t provide an equity stake in a company but rather deliver their holders some stake in a service or product generated by the company.
They shouldn’t be confused with cryptocurrencies since they’re modifications of existing cryptocurrencies. They’re created using existing blockchain platforms that run existing cryptocurrencies, like Ethereum, with slight changes to the code.
3. Promotion Campaign
To attract and achieve the widest potential investor reach, companies sometimes run a promotion campaign online. However, many large online platforms ban the advertising of ICOs.
4. Initial Offering
After creating the tokens, they will be offered to the investors. These offers must be structured in several rounds. ICOs can be structured in different ways:
- Static supply and static price, which means each token sold in the ICO has a preset price set by the company, and the total token supply is fixed;
- Static supply and dynamic price, which means the total funds received in the ICO will determine the overall price per token; and
- Dynamic supply and static price, which means that the funds received will determine the supply.
Then, the company can use the proceeds from the ICO to launch a project. Investors, on the other hand, will either expect to use the acquired tokens to benefit from this project or wait for the appreciation of the tokens’ value.
ICOs vs. IPOs & VCs
The best part of ICOs is that there are little to no restrictions on how these tokens get traded because these markets are usually not regulated. On the other hand, the SEC heavily regulates IPOs and venture capital (VC).
Despite being riskier than IPOs due to their lack of regulations, ICOs are the most practical option for many smaller firms raising early-stage funding. Both IPOs and VCs are not lenient towards early-stage companies with little to no track records.
First, IPOs are very costly. They’re only considered after the firm is sufficiently large enough. Second, it’s very hard to ask VCs for startup investments. So, even if they invest, they tend to require a large share of and control, which might not be in the new companies’ interest.
Other Advantages of an ICO
Finances Decentralized Networks
ICOs act like installment loans, serving as a source of financing for startups. The only difference is that ICOs are done via cryptocurrencies without red tape in mainstream fundraising platforms.
Instead of imposing accrued costs to initial developers, ICOs provide finance for the improvements of new decentralized networks without providing them with more network control than any other cryptocurrency holders.
In addition, platform helpers, also called validators, can be reimbursed after launching a network. The balance between the incentives received by the platform’s creators, validators, and cryptocurrency holders depends on the token’s value trussed in the network’s value.
Democratizes Access to Investment Opportunities
Like the pre-sale of products through crowdfunding, ICOs permit startups to fundraise from potential users, resulting in utility tokens. Utility tokens are used as consumptive goods, in which an investor can access service as a means of loan collateral, payment, or even stake for gambling.
ICO gives an issuer an early signal about the consumers’ demands for a better-informed investment while building a platform. In other words, utility tokens merge the customer and the investment mechanism into one tool.
It can potentially redistribute network growth profits from financial mediators. This advantage is far better than typical companies with distinct cash flow approaches between equity-holders and customers.
Issuers make a plausible commitment for token scarcity and control. When the token contract is written before the ICO, how tokens get paid for services on the platform and the token vesting for insiders are inflexibly determined. That means they can’t be changed.
However, it’s an exception when instead of the actual tokens, the rights to future tokens are the ones sold in the ICO. The platform can prevail independently of the issuer if this happens after the platform and token contract are set.
Makes Rapid Liquidity
Lack of liquidity is a typical deterrent for startups, but ICOs allow it. Liquidity here refers to the capability to take advantage of an interim overvaluation. It happens when a cryptocurrency exchange lets you trade in a new token.
Within a few days of the ICO, this new token is already tradable for fiat currencies and cryptocurrencies. What’s more, not only do investors have high liquidity, the secondary market has real-time pricing too that is based on the project’s current value.
Nevertheless, it has two limitations. First, some ICOs provide or ask for lock-up periods. During this time, tokens can’t be sold by ICO participants. Second, liquidity is not always guaranteed.
Some tokens are exchange-traded, but many ICO tokens can’t. So, even though some tokens are recorded, there’s a big possibility that a holder may not find another party that can participate in their financial transaction.
More Returns for Everyone
ICOs are profitable not only to startups but also to investors and issuers. First off, ICOs generate buyer competition. Investors tend to value tokens without entrepreneurs being aware of the consumers’ willingness to pay in advance, allowing more funds to be raised than other traditional fundraising methods.
Reports in a study have shown that after ICO investors adjust for returns of the asset class and impute negative 100% returns to those that don’t list their tokens in 60 days, they earn 82% return on investment (ROI).
The study added that there’s a 179% average return within a 16 day-holding period, starting from the ICO price to the opening market price’s first day. Also, investors can realize 13.2 times the initial outlay in returns if they had only blindly invested the same amount in each visible ICO, including those that failed.
In 2018, the top 500’s average ROI of an ICO was 1,762%. The top 100 ICOs’ average ROI is 5,444%, while 53,552% for the top 8. These significant returns cannot be matched by traditional fundraising methods, which is why ICOs are popular with investors.
Issuers can generate market liquidity too by underpricing ICOs. As a result, it can increase the demand for tokens, whose value is determined by the number of users. In other words, tokens’ inherent value increases if their demand is high, which also brings in large funds.
Speeds Up Network Effects
Tokens make network effects faster, which is very common in the marketplaces where ICO issuers would aim to assemble. There’s a need to build network effects as soon as possible because it’s easier to emulate decentralized applications.
One of the essential aspects of an ICO relative to a typical network effect is the incentive to pre-join while taking advantage of token appreciation. So, an expected token appreciation encourages more investors to join a platform.
Then, when token holders are encouraged to help a platform to succeed through finding bugs, using tokens directly, or adding features, the platform would build a mechanism to free existing supply from a non-traded reserve inventory or even issuing tokens in the future.
If a token’s value originates from people employing it, there would be an equilibrium between letting investors buy tokens for startups and eventually sharing it with other potential users. There are also some ICOs that give airdrops or give tokens away for free.
ICOs’ unregulated status not only let startups raise large amounts but also avoid compliance costs. It also removES intermediaries and their associated costs because ICOs allow direct interaction between the startups and investors.
Additionally, using a token has cheaper transaction costs than other currencies, mainly when agents reside in different countries. As a result, it’s unnecessary to have a native token to accomplish a conventional currency service on some platforms.
ICOs are entirely unregulated. If you’re planning to invest in it, you need to exercise a high degree of caution. But it’s undoubtedly a reliable crowdfunding option. Initial users take an equal portion of the profit, eventually making a company successful.