The rise of blockchain and the token economy in the past decade has created a mechanism to raise funds through an Initial Coin Offering (ICO). ICOs have been growing in popularity, and there now seems to be an infinite number of cryptocurrencies on the market.
In 2017 alone, there were 435 successful ICOs, each raising an average of US$12.7 million. The total amount raised in 2017 was US$5.6 billion, with the 10 largest projects accounting for 25 per cent of this total. Furthermore, tokens purchased in ICOs returned an average of 12.8 times the initial investment in dollar terms.
Compared to an Initial Public Offering (IPO) or crowd fundraising, ICOs have generated significantly larger amounts in terms of total funds raised within the shortest time frame possible.
During a one-month ICO ending in March 2018, Dragon Coin, a coin token for the entertainment industry, managed to raise about $320 million. Then, the company behind the EOS platform shattered Dragon Coin’s record by raising a whopping US$4 billion during a year long ICO.
What is an ICO exactly? How does it compare to other fundraising mechanisms such as Initial Public Offerings (IPOs) and crowd funding?
ICO vs IPO vs crowd funding
A company looking to raise money can tokenise its business model and create a new coin as a way to entice investors.
Interested investors can buy into the offering and receive a new cryptocurrency token issued by the company. The token may have some utility in using products or services offered by the company, or it may represent a stake in the company or project.
If the project becomes a success and rises in value, the tokens will also rise in value. In this way, early adopters, supporters and fans get to benefit from a huge return on their investment.
On the other hand, an IPO is the process of issuing shares to the public to generate more funds to expand. The shares or stocks can be traded on a public stock market. If the company rise in value overtime, stock holders will also enjoy benefits from the return on investment.
An IPO is different from an ICO in many important ways. First off, prior to an IPO, a company is considered private. A private company usually starts with a relatively small number of shareholders, which can include early investors like the founders, family, and friends, along with professional investors such as venture capitalists or angel investors.
When the company reaches a stage in its growth process where it believes it is mature enough for the rigour of a country’s IPO regulations, it will begin to advertise its interest in going public. Usually, only companies that have a US$1 billion valuation and acquire a unicorn status have a good chance to get their IPO approved.
The way an IPO is structured means that only individuals with access to these “unicorns” can participate in being part of their early shareholders.
Then, once the company goes public, the biggest return on investment will be channeled to the private investors and the founders of the company, and not the early users and adopters who have supported the company’s maturation along the way.
Consider popular startups such as AirBnB and Grab. If they had raised funds through an ICO model, the first hosts and guests of AirBnb, the first drivers and passengers of Grab buying their coins since their early days would have had the chance to reap benefits from these companies’ exponential growth.
While wealthier investors who bought more coins would generate even higher return, an ICO model means increasing the pie share for everyone, from the poor to the wealthy, creating “a rising tide that lifts all boat” scenario, thus a win-win for everyone.
Another benefit of an ICO is that any company can launch an ICO to raise funds without being restricted to the company’s size, fundamental values, and stage of maturation.
Any interested investor who thinks that the business or project’s concept is worthy of investment can support this project, even if it is a long-tail token project, or as simple as launching a small mom-and-pop shop in a developing country.
This allows for a better access to resources for everyone globally, regardless of which gender, educational, social, economic or political standing they come from.
Of course, small businesses, projects, and individuals can also raise funds through other means, such as crowdfunding like Indiegogo, Kickstarter, or patronage platforms like Patreon.
Micro-financing schemes also work to allow investors to lend money to individuals in developing countries and get returns from interest rates. However, all these ways do not compare to the potential of the return on investment (ROI) that investors might benefit from an ICO.
There is also better liquidity for the investors during an ICO process. While this is dependent on the terms and condition of each ICO, most of the time, investors will be able to sell their coins at any time.
In the case of an IPO, early investors are usually unable to sell their shares until the company goes public as there are no liquidity or a market to sell their shares. Hence this means only big backers who can afford to wait for multi-year ROI can invest.
As blockchain-based companies and their tokens are built on a publicly accessible ledger, the valuation, verification and accounting for the company will get to be decided through a decentralised, peer-to-peer consensus, rather than relying on centralised institutions, such as the government or the Securities and Exchange Commission (SEC).
The disadvantages of ICO
ICOs have been likened to multi-level marketing (MLM) schemes, a scheme where the growth of the company is dependent on distributors recruiting members down the line.
Distributors also earn through direct sales of products to their downline. Hence, the company’s revenue is dependent on whether they can continue getting new members onboard.
Similarly, new ICO projects usually do not have accountable fundamentals backing them. As such, the increase in the token value is dependent on whether initial investors manage to convince new investors to keep buying new coins, raising its prices. The last investors at the end of the chain would therefore be left holding the bag should anything happen to the company.
The lack of solid fundamentals and concrete financials of ICO companies also means that the price of their tokens hinges solely on the speculation of the market regarding the future value of these companies.
As a result, prices of cryptocurrency have become notoriously volatile, with major unavoidable crashes resulting in investors losing their precious life savings.
Because they are largely unregulated, ICOs are teeming with ponzi schemes, fraud and scam artists looking to prey on poorly informed investors. And since they are not regulated by financial authorities, funds that are lost due to fraud or incompetence may never be recovered.
Even a seemingly legitimate company like Telegram that raised US$1.7 billion in an ICO in 2018 and 2019, allegedly conducted illegal activities on behalf of their development team.
In March 2020, the U.S. District Court for the Southern District of New York issued a preliminary injunction, and Telegram had to return US$1.2 billion to investors and pay a civil penalty of US$18.5 million.
The decentralised valuation, verification and accounting model of ICO companies proves to be a double-edged sword. Even though it democratises the way companies are built and structured, a misinformed democracy is never a good thing.
Due to the huge knowledge and information gap in the crypto space, most investors have very little idea on what schemes they are getting into. Without the verification of expert financial institutions such as the government and the banks, it is easy for the average individual investor to fall prey into a scam.
Some ways to mitigate the downsides of ICO
Developed on the Polkadot network, Unit aims to be a user-friendly and accessible platform that makes tokenisation easy for everyone from all backgrounds.
Healy first got into the crypto space because his Wikileaks bank accounts were frozen by the US government. WikiLeaks, at the time, had just been banned from major payment platforms including Paypal for posting confidential military information. WikiLeaks then turned to Bitcoin donations because it could not raise and store funds in any other manner.
Michael suggested a few mechanisms that can be introduced to improve the token economy model and remove its possible downsides.
1. Creating a mechanism to back tokens with fundamental values
Introducing a sort of treasury system to create asset-backed tokens can work to stabilise prices, and insure investors against pump and dump scheme.
For example, on his Unit platform, token creators will need to prove solid fundamental values and the potential of their project before they can tokenise it. The project’s value is dependent on tangible, quantitative results like profit and loss, as well as abstract denominators like community support and faith, and the merits of the idea.
This value will be reflected and stored in a community treasury system, backed by both fiat money and cryptocurrency in a separate bank account. Every investor can easily assess a project or company’s value by seeing how much percentage of value is locked in the treasury. As the company grows in value, and the token prices increase, their treasury reserves will increase as well.
This feature will provide the tools for each participant of the new economy to differentiate signal from noise when deciding which tokens will be worthy of investment. It will signal the credibility of the project right away.
Investors need not worry about worst case scenarios such as scams and failure of the project as the currency locked in the treasury will be paid to the investors to protect them from such scenarios.
Investors will be the only ones who have access to the treasury. They are also allowed to exchange their tokens from their blockchain bank account with the fiat money in the treasury at any time, for example if they figure that the companies they invest in are not performing as well as they expect.
2. Creating a mechanism to account for a company or a project
According to Thy-Diep (“Yip”) Ta, co-founder of Unit Venture, and advocate in the crypto industry, the transparency of a company can be built into the blockchain ledger.
Right now, there is no way to track how exactly funding for ICO companies is used. We can check every transaction on the public ledger without banking intermediaries, but we do not have a way to see where our investment is going.
“If we build a publicly accessible accounting system to the ledger, everybody can verify exactly where and how their funds are used for. They will also be able to check the profit and loss of a company or a project,” said Yip.
Verification has to come from centralised institutions, like the banks, accounting firms, and so on. The blockchain technology will allow for peer to peer, crowd verification easily. This approach will also prevent fraud as all information will be written permanently and unalterably on the public ledger.
On the Unit platform, investors will be able to screen and filter tokens based on their transparent operations, accounting, and treasury value.
3. Training and education for all
In order to prepare for a new generation operating on token economics, Healy and Yip advocate for free, accessible education for everybody globally.
Crypto veterans and supporters should inform the public on the technicalities and mechanics of the blockchain technology, and help them understand its possibilities to create an equitable financing mechanism for everyone.
Meanwhile, a proper investor education will benefit and refine investors’ judgement when evaluating a company or a project to make investment decisions.
Only with the spread of awareness, mass adoption can be made possible. In order to do so, the Unit team has launched free online courses, conferences, forums, educational events, and community support groups spread across 200 cities all over the world.
4. Structuring the ICO in a way that minimises the downsides
ICOs can be structured in a variety of ways that might minimise the risk of pump-and-dump scheme and volatility of prices, most notably, creating a static pool of ICO.
In some cases, a company sets a specific goal or limit for its funding, which means that each token sold in the ICO has a pre-set price and that the total token supply is static.
A company might also get creative in their ICO condition to maximise the benefit and minimise the risk for investors.
An ICO might limit the number of tokens an individual can purchase to avoid creating “whales” that can pump and dump tokens at will and influence prices. Other ideas include locking in liquidity for certain period of time until stable price floor for tokens has been formed, introducing staking and burning of tokens to encourage investors’ holding them while benefiting from some revenue generation.
The different types of ICOs are illustrated below.
With every new system or model that creates a paradigm shift, there will definitely be imperfection and major disadvantages. The token economy model needs a lot of refining and modification for it to work well and efficiently.
“We are getting there, through trials and errors, slowly but surely,” Michael concluded optimistically. “The token economy is only at its infancy stage, but I am 100% convinced that we as a society want to move in this direction.”
Michael envisioned a future world where there is an abundance of different tokens supporting projects and businesses. Everybody will be empowered to become an investor, their portfolio of tokens will reflect their personality, their priorities, the values they believe in and the causes they support.
In the utopian view of the future token economy, there is a possibility to create a fairer, more accessible financing for everyone – encouraging more people to explore and experiment on innovative frontiers, create arts, and build a thriving, new economy sustained by purpose and passion.
Featured Image Credit : BLMP Network