Initial Coin Offerings (ICOs) are all the rage these days and though I’ve written already about how altcoins differ from Bitcoins, ICOs are a separate topic that need their own treatment. In this article, I seek to show how raising money through ICOs are very different than raising Venture Capital and how Cryptocurrencies are very different than companies.

What is an ICO?

ICO stands for Initial Coin Offering, meant to look similar to IPO (initial public offering) and give the buyer access to a token which is usually liquid right away (that is, the tokens may be bought or sold immediately). Instead of a share of a company as in an IPO, the buyer gets a token (or part of a token) instead.

History of ICOs

ICOs may seem like something brand new, but they’ve actually been around in one form or another for the past 4 years. The first one that had traction was a project called MasterCoin (now rebranded as Omni) which raised 5000+ BTC in what was called then, a crowd sale. The sale occurred back in the summer of 2013 and even back then, this was around half a million dollars.

The mechanics back then were a bit different in that users had to send Bitcoin to an “exodus” address which held all the funds. The basic idea, however, was the same. You could trade Bitcoins for some other coin that had yet to be developed. A single Bitcoin in the presale bought you 100 MasterCoins (MSC). The coins were not available to trade directly until early 2014.

Two additional crowd-funded presales happened in 2014 that had a lot of press. Ethereum and Factom. Both took funds in Bitcoin and distributed tokens later on. Since then, Ethereum has made ICOs significantly easier and many projects have taken advantage.

The Lure of ICOs

It’s easy enough to understand why you’d want to use ICOs to raise funds as this tweet shows. You have a large base of investors without creating and refining a pitch, negotiating a term sheet, networking with lots of people or even defining a minimally viable product, let alone making one. You really only need two things: marketing and some technical aptitude.

From a non-accredited investor standpoint, ICOs are attractive because they give you access to seed-stage companies that you would never have otherwise. Or so it seems…

How does a Token differ from a Share?

The big difference between an ICO and an IPO is what the user receives. In an IPO, the user receives a share of ownership in the company. They usually have rights to the profit in the form of dividends, rights to company direction in the form of shareholder voting, etc. In an ICO, the user receives a token that allows use of the token’s features. For example, buying ether lets you execute smart contracts on Ethereum. Buying Factoids allows you to record a hash on Factom’s chain, etc. Think of an ICO as a pre-sale like that of Kickstarter. You are reserving a right to the coin’s products once it’s available. (To be fair, the coin’s product could potentially include voting and profits, but most don’t do so)

In a sense IPOs and ICOs are similar in that demand for the product will drive up price, but in another sense they’re very different. A right to use a product is far different than an ownership of the company producing the product. It’s true that both are essentially bets on the future utility of the product, but they have very different risk profiles.

Risks and Rewards of Equity

When you have equity in the company, you have all the upside of the company. If the company makes profits, you potentially have a right to the dividends. If the company goes bankrupt, you have some claims on the assets the company owns, though, admittedly, public shareholders are pretty low on the totem pole. There are also limits to what the funds raised by an equity sale can be used for. For example, the CEO can’t just buy yachts with the money raised as that’s embezzlement.

Furthermore, you have some power as a shareholder to elect a new board of directors or to vote on any acquisition attempts of the company. As a shareholder, you have, at least nominal power to direct the company.

Risks and Rewards of Tokens

The money raised from the token sale has essentially no conditions. As you are buying a right to use a product in the future, you have no say in the way the money is used. If this sounds scary, it should. The people who take the money raised through a token sale can essentially do with it what they please, though to be fair, most set up some sort of foundation or contract to direct their activities.

Furthermore, your only power as a token holder is to buy or sell the token. You don’t get to decide the board of directors, you don’t get to vote for new features, you don’t get to decide who’s involved. It’s possible to add these things, but there’s no real way to enforce this other than to trust the people running the coin.

Liquidity Preference

Coins typically have no liquidity preference. That means that if the coin foundation decides to shut down, the people that bought the coin don’t get any money back. They are stuck with the coin with no recourse.

Contrast this with a typical seed stage fund where VC’s get at least a 1x Liquidity Preference, meaning they’ll at least get back their money before anyone else has claim to it. Some even have 1.5x or 2x liquidity preference, meaning they’ll get 1.5x or 2x their initial investment before anyone else gets a penny. Clearly, 2x terms are a bit predatory, but 1x is very fair. In a token, getting nothing is the norm.

A Coin is not a Business

The biggest difference is that a token is not a business, at least in the traditional sense. There really aren’t employees, though in practice, the foundation set up to distribute funds pays developers, etc to make and market the product. There aren’t really customers that can generate revenue. There are, however continuing costs. If there’s a foundation managing the funds, they must be paid. The developers of the coin must be paid. There are often marketing arms of these coins that must be paid. It’s not cheap to run a coin and all these costs have to come from somewhere.

Thus, the revenue raised at the ICO must essentially last through the token team’s entire life, which is why so many coins set aside a large number of coins for future funding. But this presents a problem, the supply then is controlled by the token team, which essentially means that the token holders can get diluted at any time. Supply increasing means demand decreases, meaning that value can be taken from token holders at any time. To be fair, though, there are ways to lock up additional supply in a pre-determined way, but that in itself introduces risk in not having flexibility to raise funds at opportune times.

Contrast that to a private company where issuance of new shares requires shareholder approval.

Open Source Software

Another risk to an ICO is the fact that the software is open-source. It’s possible, of course, to do an ICO on a coin that’s got a closed binary, but that’s not likely to be used by anyone that values security. A closed binary may steal your tokens or even infect your computer.

The fact that the software is open-source means that it can be copied at any time and all features with it. Whatever utility the coin may have may very well be available in another coin for essentially the marginal cost of creating a new coin. Or, if it’s useful enough, made compatible with payments in another token.

The implicit promise is that the developers of the coin will stay on to produce value for that coin and not produce another coin. Yet this is not a promise to be counted on. First of all, there are very few financial consequences to starting a new token with the same properties. Second, depending on how much an ICO has raised, there’s a motive to copy. Such risks are not merely theoretical. Stellar, for example, is essentially a Ripple 2.0.

Contrast this with a company that owns the code and can sue if copied. Even in an open-source context, there are licenses that prevent other companies for using the code for profit. They also have vesting for developers where developers get paid out only if the company succeeds. The incentives are very, very different and contribute to the risk in ICO investment.

Early Liquidity

Perhaps the biggest difference with ICOs is that they provide very early liquidity. IPOs generally happen when companies are at a fairly mature stage. There are reporting requirements, accounting standards and all sorts of things that need to happen in a company before they can go public, which puts public companies on somewhat even footing. With ICOs, however, no such requirements exist.

That means that ICOs have a tendency to trade on very little information. This combined with liquidity means that the volatility on these tokens tend to be very high. Depending on what you want, that may be a good or a bad thing, but what’s clear is that the volatility makes ICOs a much riskier investment.

Conclusion

This is not to say ICOs are bad or anything. Depending on your risk appetite, ICOs may be a perfectly fine investment. However, these coins are typically far less vetted than a typical A stage or even seed stage VC investments. Further, there are far fewer protections for the token holder than there are for the shareholder.

It’s not a coincidence that there are many coins that have less-than-stellar reputations in this space. Be careful and verify everything.

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