An IPO, or initial public offering, offers a chance to make big money quickly by getting in on the ground floor of the next new Google or Facebook. An ICO, or initial coin offering, offers a chance to make big money quickly by getting in on the next new money. It’s a formula that’s led to over $3 billion being raised so far this year for a range of startups issuing digital tokens, a faster pace than any other early-stage venture capital funding. The rise of ICOs has prompted the U.S. Securities and Exchange Commission to issue cautions to investors and startups. China has gone further, banning ICOs entirely.
1. What’s the goal of an ICO?
It’s a way to raise money for new ventures trying to follow in the footsteps of digital currency pioneers bitcoin and ether. Despite controversies arising from fraud, theft and volatile speculation, they and their imitators have shown that it’s possible to develop communities of users willing to try unconventional forms of money. An ICO lets startups bypass the venture-capital process by turning to something comparable to a Kickstarter campaign. Those putting up the money get access to technology companies that are usually the realm of only institutional or high-income investors. Plus, there may not be a need for an investor to wait years to cash in (as is true with most IPOs), so long as they can find a buyer for the coins they’ve bought.
2. How many ICOs have there been?
According to CoinSchedule.com, there were 46 in 2016 and 202 this year through Oct. 23. The pace slowed after the SEC warning in July. There are many more flavors of digital coins -- CoinMarketCap.com lists 1,189 -- but only a small group of startups have issued tokens that caught investors’ imaginations. About half of the money raised in ICOs has gone to the 10 largest ventures. Filecoin, a data storage network, raised $257 million, while Tezos, which has developed its own secure blockchain infrastructure, raised $232 million.
3. How do these digital currencies work?
Most are made to be used as a means of exchange inside an application. Take Brave Software, which is developing a web browser in which readers are paid if they choose to view ads. Transactions will take place on a blockchain, the digital ledger technology first developed for bitcoin and popularized for other uses by Ethereum. Since you can’t stuff quarters into a blockchain, Brave created a unit of exchange that it dubbed a Basic Attention Token, or BAT, which is a digital currency issued by the company.
4. What do ICO investors receive?
They get a virtual credit or token, which can mean different things in different ICOs. For instance, the buyers of BATs can wait and use them on the Brave browser when the system is up and running. That kind of token, with a specific use in an application likely to attract users, is known as a utility token. Holders of tokens can hang onto them not to use but in the hope of capital gains -- betting that increased demand will lead to the kind of price rise seen by bitcoin, which this year hit a high of more than $6,000. The proliferation of ICOs untethered from concrete uses, and confusion over which type of offer is a token and which is a security, prompted the SEC to issue its guidance. Only one in 10 tokens issued is in use with an application it was intended for, according to Token Report.
5. How did Brave’s ICO go?
It put 1 billion BAT up for sale in May. They were all sold in less than a minute, raising $35 million for the company.
6. Was that as extraordinary as it sounds?
Yes and no. Silicon Valley is full of companies that raise large sums while in their infancy. But usually the buyers are experienced venture capitalists. The ICO market is far more wide open, and the success of companies like Brave attracted investors of all sorts. Gnosis, a prediction market application based on the Ethereum blockchain, raised $12.5 million in 12 minutes on April 24, resulting in a market value of almost $300 million despite having generated no revenue and having little more than a white paper describing what it intends to do. Its tokens, which would allow users to bet on things such as election outcomes, soared 200 percent over the summer.
7. What did the SEC say?
8. How serious is the risk?
There’s certainly plenty of weirdness for potential investors to wade through. The long list of projects offering new currencies include ones endorsed by Paris Hilton and Floyd Mayweather, plus one to "help measure demand for synthetic rhino horn aphrodisiac pills."
9. What did the SEC do?
It said it will treat some ICOs as IPOs -- as security offerings, in other words, with all the registration requirements that entails, unless “a valid exemption applies.” The SEC didn’t lay out exactly what will trigger that designation. The issue, the agency said, is that some ICO promoters may be leading investors "to expect a return on their investment or to participate in a share of the returns” from the project -- which would make the ICO a security offering. To avoid running afoul of the law, ICO issuers can try to establish a clear link between the rights attached to a token and its usage and performance on the blockchain platform. Companies can also impose a lock-up period during which the tokens can’t be exchanged, or ban conversion entirely. The SEC was also said to be monitoring some pending ICOs, including one for a token called ParagonCoin that cannabis firms or nonprofits could use to pay rent at co-working spaces.
10. Why did China ban ICOs?
ICOs have been deemed a threat to China’s financial market stability as authorities struggle to tame financing channels that sprawl beyond the traditional banking system. Widely seen as a way to sidestep venture capital funds, investment banks and capital controls, they have also increasingly captured the attention of central banks that see digital currencies as a threat to their reign. Following China’s example, South Korea has also banned ICOs.
The Reference Shelf
- The SEC’s investor bulletin on ICOs.
- A QuickTake explainer on bitcoin and blockchain.
- Bloomberg News articles on the popularity of ICOs, on the SEC’s clampdown and on the wide variety of proposed digital currencies.
- An SEC investigative report.