An Initial Coin Offering (ICO) is a fundraising mechanism. In this mechanism, new projects sell their underlying crypto tokens in exchange for bitcoin and ether. It’s similar to an Initial Public Offering (IPO). However in IPO, investors purchase shares of a company.
What is ICO?
Although ICOs are a new notion, they have quickly become the top topic of discussions within the blockchain community. While many view ICO projects as unregulated securities that allow founders to raise an unjustified amount of capital, others argue that it is similar to an innovation in the traditional venture-funding model. The U.S. Securities and Exchange Commission (SEC) has recently reached a decision regarding the status of tokens issued in the infamous DAO ICO, which has forced many projects and investors to re-examine the funding models of many ICOs. The reliability is secured by the Howey test. If it passes the test, it must be treated as a security. Then, it is subject to certain restrictions imposed by the SEC.
Due to technologies like the ERC20 Token Standard, which abstracts a lot of the development process necessary to create a new cryptographic asset, ICOs are easy to structure. This is how most ICOs work: They have investors send funds (usually bitcoin or ether) to a smart contract that stores the funds and distributes an equivalent value in the new token at a later point in time.
Of course, there are few restrictions on who can participate in an ICO (assuming that the token is not, in fact, a security). Because you’re taking money from a global pool of investors, astronomical sums are raised in ICOs. However, there is a fundamental issue with ICOs; most of them raise money pre-product. This is why the investment is extremely speculative and risky. It is argued that, in order to incentivize protocol development, this fundraising style is particularly useful (even necessary).
We would like to give some historical content for how the trend started before we get into a discussion over the merits of ICOs.
History of ICOs
In 2013, several projects used a crowdsale model for funding their development work. For example, Ripple pre-mined 1 billion XRP tokens and sold them to investors in exchange for fiat currencies or bitcoin. Ethereum raised nearly $18 million in early 2014 — the largest ICO ever completed at that time.
The DAO, promising to create a decentralized organization that would fund other blockchain projects, was the first attempt at fundraising for a new token on Ethereum. However, it was the governance decisions would be made by the token holders themselves. This was unique. Due to technical imperfection, an unknown attacker was able to drain millions from the DAO which raised over $150 million. In order to take back the stolen funds, the Ethereum Foundation decided the best course of action was to move forward with a hard fork.
Although funding a token safely on the Ethereum platform was a failed attempt, it was realized by the blockchain developers that using Ethereum to launch a token was still much easier than pursuing seed rounds through the usual venture capital model. It was especially easy to create cryptographic tokens on the Ethereum blockchain for developers via the ERC20 standard.
Aragon, Status and BAT
It was also argued that crowdfunding projects might be Ethereum’s “killer application” due to the sheer size and frequency of ICOs. It was the first time that pre-product startups were able to raise this much money and in a short period of time. For example, Aragon raised around $25 million in just 15 minutes, Basic Attention Token raised $35 million in only 30 seconds, and Status.im raised $270 million in a few hours. As there are nearly no regulations and it is easy to use, ICOs have been started to be monitored by many in the community as well as various regulatory bodies around the world.
Legal Compliance of ICOs
There is no telling if they are legal or not. It can be said that ICOs have come up in an extremely gray area legally due to the fact that arguments can be made both for and against as they are new and unregulated financial assets. However, because of the SEC’s recent decision, the gray area is cleared up. Sometimes, as the token is simply a utility token -meaning it gives the owner access to a specific protocol or network- it may not be classified as a financial security. And some other times, if the token is an equity token -meaning that it’s only purpose is to appreciate in value, it looks a lot more like a security.
Although purchasing tokens leads the way to access the underlying platform at some future point in time, it’s hard to omit the idea that most token purchases are for speculative investment purposes. This is easy to figure out due to the valuation figures for many projects that have yet to release a commercial product.
Although the SEC decision may have provided some clarity to the status of utility vs security tokens, it will take some time to test the boundaries of legalities. Until further regulatory limits are imposed, it is for sure that people will continue to take advantage of this new notion.