Everything You Need to Know About ICOs — The New Way to Finance a Venture
Wherever money is involved, there is innovation. That is no different for blockchain technology. The popular transaction-tracking technology, which we have written on before here, is now being applied in a way to raise funds for a venture. Part crowdfunding, part investment, Initial Coin Offerings (ICOs) have managed to present themselves as a new force in venture funding.
On our personalised financial news platform, CityFALCON, you can track ICOs here.
Startups need investment capital to fund their project until it becomes self-sustaining. Traditionally this money was offered by venture capitalists (VCs), and more recently by crowdfunding platforms. The VCs of course demanded an interest in the company to take the risk, and they could force founders out if the need arose. Their shares were also not easily traded. On the opposite end of the spectrum, crowdfunding allowed people to raise money with no financial return or commitment — these were often used for projects that enthusiasts simply wanted to attempt. Startups also use crowdfunding (with an equity component) as an investment platform, giving up equity in exchange for cash.
ICOs are similar to crowdfunding, as they can act as investment vehicles but, until late July 2017, with none of the regulation. The difference for ICOs is they are based on a new cryptocurrency, which is usually paired with a major cryptocurrencies like Bitcoin for exchange into fiat currencies. Crowdfunding requires central service providers and government-backed money, while ICOs are offered on decentralized platforms and distributed ledgers, which anyone can view.
Supporters fund the venture by purchasing the new tokens, which can represent anything from real equity to access to the new application. In fact, one of the greatest advantages of ICOs is the development from the beginning of an ecosystem that has its own, secure payment system. One such example is the ICO of Kik, set to release “Kin” tokens, which can be transacted for various services through the Kik service.
Anyone who can develop their own blockchain system can create their own cryptocurrency and sell tokens in exchange for national currencies to fund their project. It is certainly gives entrepreneurs innovative ways to fund themselves.
Conventional Practices of the Launch
The details of the project are generally published in a white paper, which is used as the technical foundation of the new currency. The white paper may include the terms of the ICO, such as the return of capital to participants if the project fails or misses targets and how exactly the tokens could be used in the ecosystem. This is the traditional prospectus with a technical twist.
Some common traits of ICOs include “early bird specials” and escrow accounts. The specials are meant to entice investors early by promising a discount on the service (or appreciation of the value of the tokens). These are how some ICOs can raise millions in minutes.
The escrow accounts are meant to build and retain customer confidence. Contributions can be stored here while details are finalised. The account (wallet) and the list of contributors is made public, and a few of the signatures on the wallet will not be involved in the project (otherwise the fund’s release is dependent on people working on the project — a clear conflict of interest).
Finally, the terms of refund are made available to the public. If there is no indication of how the business will proceed upon failure, then the ICO is risky. If there is indication, there should be an escrow account. If there is an escrow account and mention in the white paper (or elsewhere), the ICO is much less risky. Smart contracts can even be used to release the funds (see below).
Legality and Regulation of ICOs
As mentioned above, sometimes projects are only for enthusiasts, and in that regard, ICOs mirror crowdfunding for projects (i.e. non-equity campaigns). There may be no real expectation of return on the part of the funders — they may simply like the idea or want to be early adopters of a new technology (tokens used in ecosystems).
Other ICOs are meant to raise equity and promise investment returns. Until July 2017, there was no word on regulation from the concerned authorities. However, the SEC released an Investor Bulletin warning ICOs to heed the rules for raising funds with investment vehicles. The legal area is still solidly grey, and the extent to which ICOs will be regulated is yet unknown. The SEC left its options wide open. As a rule of thumb, any ICO that does not promise financial returns is probably safe, but if the ICO promotes itself as an equity-raising event, the SEC will probably require the same filings as traditional methods of raising funds.
Another concern with ICOs is jurisdiction. The SEC warns ventures outside US jurisdiction are not subject to US rules, and recovery of money in the event of fraud is minimal at best. The SEC of course works with various other national governments and vice versa, but be aware that if you are a UK national investing in a dodgy startup in a less regulated market, it may be impossible to recover fraudulently acquired funds. The stateless aspect of cryptocurrencies is a double-edged sword: entrepreneurs may not be subjected to regulatory filings, but that means investors are not protected. Activists in oppressive countries are afforded the protection of anonymity, but so are criminals.
Whether other governments will follow the SEC’s lead is for the future to determine, but it seems rather likely. The reasoning behind the SEC’s decision is to protect investors, and that conclusion will be reached by other like-minded agencies.
If ICOs are the means to collect funds, then smart contracts are a way to distribute and verify participation. Smart contracts cover two different concepts: self-executing agreement in code and legal contracts. The two are conflated, and the term “smart contract” refers to both types.
Code can be run on the blockchain to automate transactions. This kind of smart contract lays out the rules of an agreement in computer code, listens for the triggers, and executes upon trigger. Conditions are predetermined and the contract is distributed to the entire blockchain, so everyone knows what should happen when and for whom.
The self-execution aspect is especially useful for machines. In a future Internet of Things (IoT), machines will need a means to transact with each other autonomously. A smart refrigerator that tracks grocery usage might call its transaction code, in which a smart contract is embedded. That code stipulates if milk is at 10%, more milk should be ordered. The refrigerator sends FridgeCoin to an affiliated company that accepts FridgeCoin. (FridgeCoin are a hypothetical ICO’d cryptocurrency specifically for this manufacturer’s network). The owner adds FridgeCoin at the convenience store and doesn’t need to worry about having more than £50 at risk of loss due to fraud. Everything is done automatically, with a hard upper limit on possible loss (though hopefully other security features are built in).
Legally Binding Contracts
The smart refrigerator crosses into legally binding contract territory once an agreement is reached between two parties. That would occur when the refrigerator sends the FridgeCoin and the service accepts payment. The service should now deliver a product. This is a simple contract.
More complex, legal contracts may arise from coded scenarios. Their proponents often tout the low fees associated with cryptographic transactions, and there is the distributed ledger — everyone in the blockchain has a copy of the contract, so a single party cannot modify it without everyone knowing. This offers protection to both side.
Contract law is flexible in what constitutes a contract. As long as the elements of a contract are present, a legally bind contract exists. Enforcement outside a governing body’s jurisdiction may be difficult, but an agreement with such elements is a contract. The more optimistic supporters believe these will replace normal contracts in the long run. Whether they will is certainly up for debate.
Setbacks, Drawbacks, and Advantages
As with most new technologies, there are some problems with ICOs, alt-coins, and smart contracts. The most frightening is a technical glitch in the software. Since these transactions and contracts are automated, often never involving a human at all, there is the potential for flawed code to wreak havoc. Then there is the intentional exploitation of code by hackers. One high-profile case is the Veritaseum debacle, in which Veritaseum lost ~8 million USD to a hacker who compromised the wallet containing funds.
Furthermore, hard forks are a real concern for individuals. While the blockchain traces all transactions and all network participants maintain their own ledger, sometimes a divergence occurs or is deliberately created in order to enforce a specific history (generally to block mishaps). However, like all things technical, this could be exploited for a sophisticated attacker’s benefit.
The DAO was a stateless VC fund meant to invest in other projects on behalf of participants — however, an exploit allowed a third of the funds to be stolen. The community forked Ethereum (the base cryptocurrency for DAO), and recovered the funds. This raises an interesting, though, because on one fork the coins lie with one party, but in the other fork, the coins lie with another. The immutability feature of blockchain tech (no one can unilaterally change a contract) is broken.
Other drawbacks include fraudulent projects, the difficulty of recovering funds, and the statelessness of projects. Statelessness raises plenty of legal and jurisdictional questions, while fraud and recovery are difficult to combat and enforce.
There is some light, though. First, forks are a rare occurrence and cannot be implemented by any one party. Even if the core developers were to push a fork, if all the nodes running the software to keep the CC alive were to refuse, there is no consensus and hence no fork. The distributed agreement system of blockchain particularly reinforces this security feature.
Another major advantage is simply the volume of funds and money to be raised. The rapid appreciation of value of some coins or the ability to adopt early may be the only factors for some participants. And large sums of money can be raised rapidly. The Brave browser raised 35 million USD in thirty seconds. That is astounding. And that opportunity was available to the public at large, not just a select group of investors. Note, however, that the public would need to execute a transaction in the first 30 seconds to avoid being refused due to all the tokens being sold out.
Caveats and Tips
Some of the disadvantages listed above should clearly demonstrate the need to be cautious when dealing with ICOs, especially if you expect a financial return. But here are some caveats and tips broken down into simple bullets:
- Question the prospectus — if the company is using ICOs, ask why they cannot raise funds with a conventional method
- Know exactly what your tokens represent (equity, voting authority, etc.), and what exact actions smart contracts can perform on them (can a condition shift voting power away from you?)
- Understand the project and the ecosystem (if it exists) — don’t rush headlong into an ICO that promises stellar benefits in its ecosystem, especially if the ecosystem has yet to mature or even be developed (unsurprisingly, it is immensely difficult to convince others to accept a completely unbacked, newly minted currency in exchange for real products and services)
- Other common cautionary tips should be observed, such as not succumbing to high-pressure, time-restricted sales, avoiding “too good to be true” investments, and doing your due diligence
With the SEC announcement, it is very likely that ICOs will be regulated. And while this will cause fees to be associated with starting projects, it does protect investors from excessive fraud. Expect similar announcements from other nations’ regulatory agencies.
Whether smart contracts will replace traditional contracts is unlikely for the near future. Coders are usually not lawyers, and complex contracts, such as real estate transfer, probably won’t be encoded without at least a supplemental human component. Of course, simple contracts between individuals are rather likely to occur (like the teenager down the street who paints houses over summer break might enter an electronic legal smart contract rather than a paper-based one).
As for funding, ICOs are a great way to jumpstart a brand new ecosystem for an application that acts as an interface between the digital exchange of agreements and the real world. As evidenced by some recent ICOs, they are also a spectacular way to raise funds in a very short period of time with little need for the associated fees.
On our personalised financial news platform, CityFALCON, you can track ICOs here.