A great scam or a good investment: What is an ICO?

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What is an ICO?

An ICO is an Initial Coin Offering, which essentially means “raising money on the blockchain.”
It’s become quite the status symbol to prepare for an ICO, with Paris Hilton, Floyd Mayweather, The Game (i.e., everyone and their dog) getting in on the act.

The ICO process is simple. All you need to do is copy some code to create an Ethereum Smart Contract (more on this below) and wait for the uncensorable pseudo-anonymous cryptocurrency to roll in.

A cute website, a “whitepaper” pdf, and an experienced team of marketers are handy too.

The term ICO sounds very similar to IPO—intentionally so. As ICOs do not depend on established stock exchanges or complicated regulatory filings, they are far cheaper than an IPO, where a company can expect to pay around US$10 million for the paperwork alone.

Most people can’t easily participate in an IPO in the United States for example, but by conducting an ICO fundraiser on the blockchain, people from all over the world can take part, and buy in at the same price, rather than queueing behind influential individuals and investment banks.

The Ethereum Blockchain

Most ICOs take place on the Ethereum blockchain, which functions similar to Bitcoin in principle. The cryptocurrency used by Ethereum is called Ether. Unlike Bitcoin, however, Ethereum allows for more complicated transaction types—so-called Smart Contracts.

A simple Smart Contract could work like this:

  1. You send one Ether to the address of the Smart Contract
  2. The money is forwarded to the owners of the Smart Contract
  3. The Smart Contract creates a token and sends it back to you

At the end of the process, investors receive a token in return for real money.

The investors can now trade this token between each other in the hopes of making a profit, similar to a stock certificate. But unlike stock, the token usually does not formally represent ownership over the company or entitle its holders to a share of the profits.

The ICO Token Economy

Instead of anything tangible, ICO fundraisers promise token holders the use of a future app or platform—the token acts as an entry ticket or in-app payment platform.

It’s hard to imagine a landscape in which every app requires its own tokens for use. We are used to free apps, and the process of acquiring specific digital currencies ahead of using an application seems rather cumbersome.

Maybe one day it will become more easy to obtain tokens automatically while using applications, but the process of using tokens for payments will always be more expensive than paying with cryptocurrency directly.

The history of ICOs

The first ICO was the development of the Ethereum blockchain itself. In 2014 a team of developers raised over US$18 million in Bitcoin in what they called a Crowdsale. When Ethereum launched in 2015, investors could redeem their tokens, trade them and use them on the Ethereum blockchain.

When the Crowdsale started, an Ether cost ~US$0.3. Today an Ether trades at around US$300—it’s returns like this that fuel the unheard of evaluations of ICOs and the dreams and desires of new investors.

Notable ICOs

The amount of money that some of the biggest ICOs have raised is dizzying. Brave raised US$35 million worth of Ether in less than 30 seconds to build a decentralized advertisement platform around their browser. Tezos raised US$230 million in two weeks to build a competitor to Ethereum, while a platform called Bancor raised US$150 million for something nobody seems to be able quite to describe.

The biggest ICO of them all, Filecoin, just completed a US$257 million ICO for what appears to be a better version of BitTorrent. For comparison, SpaceX only needed US$20 million in their initial round of funding to build reusable rockets and send them into space, and back.

Apart from defying common sense, few to none ICOs would be able to raise any money from traditional venture capitalists, who rarely give out such sums—especially to questionable projects. Though this doesn’t automatically mean they’ll all fail, there surely is little room for profit even in the unlikely event of success because most ICOs promise projects that are nothing but code. And, unlike services like Google or Amazon or products like Apple, ICOs can trivially be copied and forked into a free version after development.

Are ICOs legal?
What’s the worst that could happen with an ICO?

Are ICOs legal?

Many countries, including the United States, have very tight securities laws. Whether an investment product constitutes an illegal security or not is a complicated question, but it does not depend on the technology behind the security. It doesn’t matter that the security law was passed well before the Ethereum blockchain—and blockchains in general—existed.

Beware of ICO scams

It’s almost impossible for the average small investor to conduct due diligence on ICO projects. Many make outlandish claims about their technology and promise unreasonable returns or show a misunderstanding or ignorance about how blockchains work. It is inevitable that many ICOs will turn out to be deliberate scams, or at least become an exit scams once they are found out to have insufficient technical development.

Such exit scams can include dumping tokens on the market until they are worthless (after propping up their value through marketing), or claiming funds got hacked. Others again might simply spend their funds on a lavish lifestyle before abandoning the project due to a loss of funds, while blaming the engineers for an inferior product.

Likely the first token sale that used the term ‘ICO,’ Paycoin launched their blockchain after heavy marketing and big claims in 2014. The platform collapsed in 2015, and its founder Josh Garza was charged with securities fraud shortly after and is facing up to 20 years in prison.

Think before investing in an ICO

Investors will not face jail time but could lose their money in ICOs. Securities law largely concerns the issuer, though those helping with the creation, marketing, and trading of illegal securities may be criminally liable. Of course, as an investor, you will still be concerned about the legality of the token—the developers won’t be able to build their decentralized app from jail!

Much harder to assess is whether the project makes sense or not from a technology and business perspective (in my opinion, they almost all do not make any sense whatsoever).

As an investor, you will have to assess for yourself whether you believe the technology is feasible, whether there is a use and market for it, and if the token sale will likely founders in jail before the project completion.

Keep a cool head, never let yourself taken away by emotions, and don’t invest more you can afford to lose!


Also published on Medium.

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