Updated: Jan 14
What is an ICO?
An Initial Coin Offering (ICO) is a method of raising funds through the use of cryptocurrencies. Its use is most popular in projects that have not yet fully developed their blockchain platform, product, or service. The payment is usually made with Bitcoin or Ethereum, but in some cases, fiat currency is also accepted.
Investors participate in Initial Coin Offerings with the hope and expectation that the company will be successful, driving demand and causing the underlying tokens to increase in value. In other words, they hope to get a good return on investment (ROI) as early supporters of that particular cryptocurrency project.
How does an ICO work?
An ICO is often compared to an IPO (Initial Public Offering). However, this comparison is quite deceptive. IPOs usually apply to established businesses that sell partial ownership shares in their company as a way to raise funds. In contrast, ICOs are mainly used as a fundraising mechanism that allows companies to raise funds for their project in very early stages, and investors who purchase their tokens are not buying any ownership in the company.
Typically, ICO tokens are created on the Ethereum blockchain, following the ERC-20 token standard, and are thus called ERC-20 tokens. Along with Ethereum, there are other platforms that support the creation and issuance of digital tokens (e.g., Stellar, NEM, NEO, and Waves). In contrast, some companies that already have a fully functioning blockchain often choose to issue their digital assets on their own platform.
Taking the ERC-20 tokens as an example, a company may use Ethereum smart contracts to create and issue their own digital token. The ERC-20 protocol defines a set of rules that the company has to follow in order to issue a token on the Ethereum blockchain, and the smart contracts ensure that these rules are followed in a trustless way.
Once the startup founders have their tokens created, they need to convince investors to support their project by participating in their ICO. This is often achieved with the development of a whitepaper describing the company goals and how the new ecosystem is supposed to work. Founders may also pair that whitepaper with a website that provides more information about the people involved in the ICO and why they believe their cryptocurrency project is likely to succeed.
Why do companies perform ICOs?
An ICO can be a very effective method of raising venture capital and project funding. For startups, it allows them to get spendable currency based on an idea, which may or may not have been tested in the market. It is unlikely that many of these small, non-established companies would be able to get funding any other way. Traditional financial institutions would be unlikely to loan the startup money on the basis of a whitepaper alone, especially in the crypto space where lack of regulation has caused reluctance on the part of these institutions.
While new companies and startups represent the bulk of ICOs, things are changing. Some established companies are now recognizing the value of ICOs and the power of decentralization offered by cryptocurrencies. Some of these companies are performing ICOs to launch new projects on a blockchain-based system as a way to raise capital or to decentralize their business. This practice is called a “reverse ICO.”
Can anyone hold an ICO?
The short answer is yes. With the right guidance, almost anyone can develop a token and write a whitepaper that describes its eventual application. But the company or individuals who do so need to create a viable blockchain-based venture. This requires knowledge, skill, and experience that not everyone possesses. They also need to research the complex web of regulatory issues that vary from one jurisdiction to the next and may soon change in response to ICOs’ growing popularity.
To hold a successful ICO, the venture should be sound and backed by solid evidence of how the project or idea will work, why it’s valuable, what it does, who needs it, and how it can be developed. Selling the idea and convincing investors to buy is another critical step towards positive results.
The growing number of ICO crowdfunding events attracted the attention of regulators all over the world, and regulation is a hot topic in the cryptocurrency community. Within the US, the SEC (US Securities and Exchange Commission) and the CFTC (Commodity Futures Trading Commission) are two regulatory institutions that are continually discussing the regulatory framework for ICOs and cryptocurrencies.
Regulation of the ICO sector is still in the early stages, and there is no uniformity across different countries. On the one hand, too much regulation is likely to hamper the growth and development of the emerging sector of cryptocurrencies and blockchain technology. On the other hand, some argue that regulation will likely bring greater legitimacy to the space, easing the fears of traditional financial institutions who have so far been reluctant to explore it.
Somewhere in the middle, a balanced approach is lauded by many who believe the crypto ecosystem is not supposed to be a “wild west” financial space but should be free enough to work outside the confines of the traditional financial system.
While some jurisdictions - such as China and South Korea - have declared all ICOs illegal, the US SEC issued a detailed bulletin on ICOs, warning potential investors to perform due diligence before engaging in new investments. The SEC also said that some ICOs might qualify as securities, and if so, are subject to federal securities regulations.
Why does it matter?
ICOs use cryptocurrency as their primary funding instrument and, as such, offer a new avenue for innovative businesses and individuals who want to do things differently. More and more attention is drawn to cryptocurrency as new blockchain startups raise increasingly larger amounts of capital. Nonetheless, the ICO route may present both favorable and unfavorable outcomes. While ICO scams and huge public failures have a detrimental impact on cryptocurrency’s reputation, successful ventures give cryptocurrency more authenticity in the eyes of the public.
ICO tokens that see widespread adoption and reliability may relieve some of the uncertainty that institutions and consumers have about entering the crypto space. While this new method of investment is still working out its kinks, it is considered by many as a viable alternative to traditional fundraising routes and may become a compelling approach for companies going forward.