The role of Initial Coin Offerings in Financial Markets

What is an ICO?

In 2017 $2.1 billion has been collected by the new funding mechanism called Initial Coin Offering (ICO). This funding mechanism is being used by blockchain startups who sell their crypto tokens or coins to the public for the first time. They are gaining in popularity as they evade government regulations, are quick to execute and the coin issuing company does not lose parts of their company ownership. 

Funding collected from ICO's have been growing annually at an exponential rate
Funding collected through Initial Coin Offerings

So how do ICO’s actually work? Essentially, a company creates a new crypto coin with their preferred characteristics. In the next step the new coin can be purchased by an investor in exchange for a fiat currency or another existing crypto coin. If the coin has enough demand a crypto exchange can chose to include the coin in the secondary crypto coin market where it can be traded similarly to shares on the stock market.

According to the CoinDesk database in 2014 ICO’s have gathered $30 million, in 2017 it gathered $2.1 billion and the three biggest ICO’s of 2018 alone have gathered $2.32 billion in funding. Of the $2.32 billion, Telegram alone, the company known for their messaging app, gathered $1.7 billion. This shows the potential which cryptocurrencies have as a funding device.

ICO’s have many similar features to IPO’s and crowdfunding which needs to be compared to better understand the concept.

ICO vs IPO

Initial Coin Offerings have a similar structure to IPO’s as the investor buys a digital asset that is sold to the public for the first time. A token which is sold in an ICO can offer a similar experience to an IPO as it can offer properties such as the right to claim dividends. An ICO token however can also take on other properties such as a currency or be a utility token which gives you the right to a product or service.

It is important to note that even though ICO’s may look similar to IPO’s, ICO’s often do not follow financial regulations and thereby their promises are not legally binding. So be careful and informed when investing in ICO’s and read our ICO due diligence advice at the end of this blog.

Furthermore, ICO’s do not use any intermediaries in their process. These are not needed in an IPO either as has been demonstrated this year by Spotify. A direct listing process (DLP) has been used by Spotify which allowed them to directly sell their existing shares on the stock market instead of selling newly issued shares which are sold in an IPO. However, even though the success of ICO’s and the DLP of Spotify show it is possible to sell shares to a market without intermediaries it is important to know that the intermediary in IPO’s, known as Underwriters, perform important tasks. These tasks include among others the compliance to regulations and the pricing of shares, whereby they ensure the investors do not buy overvalued shares and the guarantee of all shares to be sold.

Finally, going through an IPO process is not possible for all companies. To be listed on an exchange investors need to know about the company and be interested in trading it. Additionally, the costs which are associated with an IPO average $4 million which is roughly 7% of the capital raised in an IPO (Thomson, D. 2017). Hence, an ICO is a lucrative alternative as it is a low cost process and does not have to give ownership rights away.

The steps which occur in an Initial Coin Offering
The process of Initial Coin Offerings

ICO vs Crowdfunding

Crowdfunding and Initial Coin Offerings hold many similarities in regards to the company and investor characteristics. Both funding mechanisms are mostly used by younger and smaller companies. Additionally, the investors tend to be more non-professional investors and only few institutional investors. With the exception being the Telegram ICO who claim to have gathered $850 million from only institutional Silicon Valley investors (Vigna, P. 2018).

A big advantage that crowdfunding and ICO’s have over other funding mechanisms such as venture capitalists is the potential for better matches with investors with similar interests and the low cost of collecting the funds.

Crowdfunding is also known for rewarding investors with early access to products. ICO’s work similar when issuing tokens that allows access to services. However, the majority of ICO investors are hoping for an appreciation in the token value. Thereby they can sell it for a profit on the secondary crypto market.

Investor Due Diligence Advice

This are our 5 points of advice which should be considered before investing in an Initial Coin Offering.

Don’t be an ignorant investor. Inform yourself!

  1. Be aware of the risks. Both business and market risks. E.g. the business model can fail and the value of currencies can drop.
  2. Know what the company does. Read the company white paper.
  3. Know what you receive. Is it a currency, a utility token or does it give you ownership and claim to dividends?
  4. Look at the team of the company. Do they look qualified to reach the company goals. Are they truthful in their goal or are they going to run off with the money?
  5. Will the company be profitable and will that positively influence your investment?

Future of ICO’s

The future of Initial Coin offerings is hard to predict. Currently the hype is growing and increasing amounts of money is collected through ICO’s. However, they are becoming more and more tackled by governments who require them to follow regulations. As prime examples both China and South Korea have banned the use of ICO’s. Hence, the interest of the tech startups who and the government interests conflict in regard to ICO’s.

Some startups are attempting to combine the best properties of ICO’s with the properties of an IPO. Some startups are working closely together with regulatory bodies to make it compliant to regulations as well as safer for the issuing companies and the investors.

In the end only time will tell what shape initial coin offerings will take in the future and whether it will stay a free rebellious decentralized market which is free of regulations or if hybrid ICO and IPO systems will be set in place.

 

If you have further questions on Initial Coin Offerings and Blockchain, feel free to send us an email on letsgo@toblockchain.nl. We also welcome you to look at our Blockchain Trainings

Sources and Interesting Literature on ICO’s, Crowdfunding and IPO’s

Adhami, S., Giudici, G., & Martinazzi, S. (2017). Why do businesses go crypto?

An empirical analysis of Initial Coin Offerings.

Agrawal, A., Catalini, C., & Goldfarb, A. (2014). Some simple economics of crowdfunding. 

Innovation Policy and the Economy14(1), 63-97.

CoinDesk LLC. (2017, November 26). CoinDesk ICO Tracker. Retrieved from

https://www.coindesk.com/ico-tracker/

Coindesk LLC. (2018, May 14). State of Blockchain Q1 2018. Retrieved from
https://www.coindesk.com/research/state-blockchain-q1-2018/?slide=66

Conley, J. P. (2017). Blockchain and the Economics of Crypto-tokens and Initial Coin

Offerings (No. 17-00008). Vanderbilt University Department of Economics.

Nica, O., Piotrowska, K., & Schenk-Hoppé, K. R. (2017). Cryptocurrencies: Economic benefits

and risks.

Thomson, D. (2017). Consider an IPO to fuel your company’s future? PwC Deals.

Vigna, P. (2018, May 02). Telegram Messaging App Scraps Plans for Public Coin Offering. Retrieved from
https://www.wsj.com/articles/telegram-messaging-app-scraps-plans-for-public-coin-offering-1525281933