ICOs or Initial Coin Offerings are used by cryptocurrency startups as a way of getting around the heavily regulated capital-raising process demanded by banks and investors. ICOs offer a percentage of the cryptocurrency for sale to early investors in exchange for fiat - or crypto - currency, but most commonly for Bitcoin. Because it is unregulated, it’s very popular in today’s crypto industry. According to Coinschedule, more than US $2bn was raised in March 2018 alone, and nearly US $5bn in the first financial quarter. Basically, they function like Initial Public Offerings (IPOs) or crowdfunding.
Sometimes this is successful. Ethereum realized a significant profit for early investors, raising around US $18m in Bitcoins (40 cents per Ether token) in 2014, and when it went live the following year the value soared as high as $14 per Ether, giving Ethereum a market capitalization of over US $1b.
While that sounds exciting, these ICO projects fail all the traditional investor metrics for valuation and security. They rely almost exclusively on bandying around the magical word “blockchain” to market their product, despite blockchain often having no applicable role in the project beyond raising funds and issuing tokens. This just gives the public a distorted understanding of what blockchain does. The products themselves would, in most cases, function more efficiently and effectively on a mainframe or centralized database.
In most ICO projects, the crypto tokens are arbitrarily assigned a purpose within the ICO ecosystem to justify it as having some kind of ‘utility’ and to artificially inflate demand for the token to boost its value and drive demand. The token can then function as a ‘voucher’ for the ICO product and services. Users are encouraged to purchase these in the hope that they will increase in value if the market hype inflates it enough. In reality, this is a kind of Ponzi scheme. Who really buys one, ten, or a hundred thousand dollars of ‘vouchers’ for any product without considerable brand recognition already behind it? This is a common ICO tactic.
Normally tokens without any utility value wouldn’t be a problem, assuming the issued tokens from the ICO counted for something like a real share of equity in the project, and by extension an investor’s claim to the project’s future performance-based earnings. But that doesn’t happen in most cases for several reasons. One of these is the ICO’s fear of regulators. Most ICOs are trying to camouflage their operation as something else other than securities by pretending they aren’t investments. This is to elude the so-called ‘Howey test’ - the generally accepted means of testing whether something is a security or not.
ICOs do this by including clauses in their contributor agreements precluding any obligations on their part to complete the project, compensate for failures, or pay out any equity in business ventures related to the project. The user effectively agrees that their investment is a donation, opening them up to a litany of risks in terms of project accountability, returns, or just a good old-fashioned scam. What is the point in investing in something like that?
Research by the Satis Group, an ICO advisory team, found that:
81% of ICOs are outed as scams.
6% fail before launch
5% go dead before launch
2.8% of those examined were dwindling on exchanges (near dead)
3.8% had been successful,
1.6% looked promising
The U.S. Securities and Exchange Commission (SEC) doesn’t agree that waiving all rights to investor protections makes ICOs any less of a security and have recently issued subpoenas to many ICO projects and related businesses. SEC Chairman Jay Clayton has declared that every ICO he has examined is a security and none had registered with the SEC. Inevitably this could open many ICO projects, even successful ones, to retrospective legal penalties.
There are, however, alternative and less vulnerable means of capital acquisition, such as Reg D 506(c) and Reg A+ M-IPO filings under the Jumpstart Our Business Startups (JOBs) Act (2012) for capital raises of up to US $50m that are completely SEC registered. One project taking this route is DNotes, which is well on its way to becoming the first cryptocurrency ever to achieve SEC registration. While these processes are much more complex and time consuming to undertake, they are orders of magnitude more rigorous and robust, provide the customer with far greater security from fraud, and offer a product with actual, fundamental equity value in the project.
Over time, it’s perfectly plausible that ICOs will revolutionize startup investment, but at this early stage, like all prototypes, they remain largely untested and potentially do far more harm than good. Trust is imperative in the business of investing and providing financial services. Without some kind of internal consensus over best practices, or external authority enforcing good behavior from developers (whether through incompetence or bad intent) things could very easily go horribly wrong for the best-intentioned investor. Until such time as those securities are in place, it’s probably best just to avoid ICOs altogether.