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What Is an Initial Coin Offering (ICO)?

What Is an Initial Coin Offering (ICO)?

Initial Coin Offering (ICO) is an alternative fundraising mechanism in which blockchain startup issue their own crypto tokensand sell them in exchange for Bitcoin (BTC) or Ethereum (ETH). In some cases, fiat currency is also accepted. And users, in their turn, can either spend digital tokens on the platform or sell them later on exchanges at x3-x100 the price. Tokens are basically like vouchers that you can exchange for goods or services on a certain platform. Often people get confused between Initial Coin Offering (ICO) and Initial Public Offering (IPO).

Essentially ICO is similar to an IPO in which investors purchase shares of a company. One main difference between an IPO and an ICO is that token holders do not own any equity in the company that they’ve contributed to, therefore the company has no real obligation to the contributor to deliver on their promises.

Some key characteristics of an ICO include:

  • Participation in a project, Decentralized Autonomous Organization (DAO) or an economy.
  • Coin ICOsgenerally sells participation in an economy, while token ICOssell a right of ownership or royalties to a project or DAO.
  • Owning tokens do not always give the investor a right to vote on the direction of a project or DAO, with the rights of the investor embedded within the structure of the ICO, though generally, the investor will have input throughout a project lifespan.
  • The majority of ICOs involve the creation of a defined number of coinsor tokensprior to sale.
  • ICO prices are usually established by the creators of the economy, project or DAO.

  • ICOs may have multiple rounds of fundraising, with coinsor tokenson offer, increasing in value until the release date, with early investors likely to have greater rewards embedded within their tokens as an incentive.

  • ICOs conclude once the coins or tokensare tradable in the open market.

If we were to compare the key features of ICOs and IPOs, some of the similarities and differences would be as follows:

  • An IPO gives you ownership of the company based on the number of shares acquired, whilst an ICO may only give you rights of a particular project, not the company launching the project.

  • Decision making in IPO companies are centralized with the CEO and the board involved in the day to day running of the business, whilst with ICO companies/projects, decision making is decentralized, giving the investor a material decision making position.

  • Financial data is released as per the rules of the exchange on which the IPO took place, whilst for ICOs, these will either be public by way of the blockchain or as outlined within the white paper and agreement with the investors.

  • Companies launched by way of an IPO must pay taxes, with investors having to pay capital gains tax, whilst for ICOs, the company may not be subject to direct tax, only the investor being required to pay capital gains tax.

  • An IPO is a onetime sale with multiple intermediaries involved in the process of determining the conditions, pricing, etc., whilst ICOs can have multiple rounds of fundraising, with few if any intermediaries, the white paper, a blueprint.

  • And finally, stock exchanges and companies listed by IPO are heavily regulated, whilst the exchanges on which ICOs are launched are quite the opposite.

It’s important to note that, unlike an IPO, investing in an ICO won’t result in you having an ownership stake of the company you’re giving money to. You’re gambling that the currently worthless currency you pay for now will increase in worth later and make you money.

How Does an ICO Work?

Startup kick starts the ICO process by establishing the blockchain and set up of protocols and rules, at which point an ICO data is announced. Typically, ICO tokens are created on the Ethereum blockchain, following the ERC-20 token standard, and are thus called ERC-20 tokens. Along with Ethereum, there are other platforms that support the creation and issuance of digital tokens (e.g., Stellar, NEM, NEO, and Waves). In contrast, some companies that already have a fully functioning blockchain often choose to issue their digital assets on their own platform.

Taking the ERC-20 tokens as an example, a company may use Ethereum smart contracts to create and issue their own digital token. The ERC-20 protocol defines a set of rules that the company has to follow in order to issue a token on the Ethereum blockchain, and the smart contracts ensure that these rules are followed in a trustless way.

Once the startup founders have their tokens created, they need to convince investors to support their project by participating in their ICO. This is often achieved with the development of a whitepaper describing the company goals and how the new ecosystem is supposed to work. Founders may also pair that whitepaper with a website that provides more information about the people involved in the ICO and why they believe their cryptocurrency project is likely to succeed.

Why Do Companies Perform ICOs? 

An ICO can be a very effective method of raising venture capital and project funding. For startups, it allows them to get spendable currency based on an idea, which may or may not has been tested in the market. It is unlikely that many of these small, non-established companies would be able to get funding any other way.

For companies raising capital through ICOs, the advantages include:

  • The project, DAO or economy is not necessarily subject to direct taxation, which in contrast to companies’ fundraising through IPOs.
  • Sales of coins or tokens are direct, including multiple rounds, with few if any intermediaries required in the process, investors basing investment decisions on the content of white papers prepared by the fundraising entity.

While ICOs are to mainly raise capital for a startup, they are also used to kick-start the sale of a service to be taken to market or the use of a new cryptocurrency.

On most occasions, the investor becomes the consumer of the service being offered by the company raising funds through an ICO, which allows investors to buy coins at a discount, though valuation will ultimately be dictated by supply and demand once released to the market.

Risks of the ICO Space 

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In reviewing ICOs, there is no guarantee or sure-fire way of distinguishing the good from the bad, investors needing to avoid scammers who are using ICOs to dupe investors out of funds.

To make sure you don’t get scammed when you invest in an ICO, follow these steps;

1) Make sure that project developers can clearly define what their goals are. Successful ICOs typically have straightforward, understandable whitepapers with clear and concise goals.

2) Know your developers. Investors should expect 100% transparency from a company launching an ICO. This means that you should know who is involved in the project, what their business plans are, where they are located, what the timeline for the project is, and so on.

3) Look for legal terms and conditions set for the ICO. Because outside regulators generally do not oversee this space, it is up to you as an investor to ensure that any ICO you buy into is legitimate.

4) Make sure that ICO funds are being stored in an escrow wallet. This is a wallet which requires multiple keys in order to be accessed. This is useful protection against scams, particularly when a neutral third party is a holder of one of the keys.

There’s plenty of interest at present from an investor perspective, attributed to sizeable returns that investors have enjoyed to date, demand driving prices, with large prices gains incentivising investors to lock in profits, which can lead to mass sell-offs that could ultimately wipe out investor money, not to mention the company.

Regulation of ICOs

The biggest point of concern for ICO investors these days is the state of regulation in their countries. One of the most important reasons as to why governments around the world impose restrictions on ICOs is because of the several adverse effects of coin offerings that are observed.

There are many grounds on which governments around the world are looking into the regulation of ICOs, for instance, South Korea and China have both imposed restrictions based on the fact that investors can be defrauded by scammers using the coin offerings. ‘Pump and dump schemes’ are on a high-rise in the market with fluctuating prices. According to Financial regulators and governments, ICOs can also be a driving factor for money laundering on a worldwide level.

Nevertheless, some countries are far more welcoming than others, hence, the current progressions seem to be moving towards the proper regulation and acceptance of ICOs. With the cryptocurrency carving out its own space in the economic ecosystem, ICOs are here to stay.

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