A Practical Guide to ICOs

Lately, while we have been working on some cryptocurrency projects, we were also at the Consumer Electronics Show (CES) where not only was there nothing blockchain related, we also engaged with many people who are still very confused and/or ambivalent about all the crypto hype.

This was the genesis of our post a few weeks back trying to pick apart the threads of Blockchain, Cryptocurrencies and ICOs. A chief source of confusion is that many people are conflating Blockchain and Initial Coin Offerings (ICOs). These are distinct threads. Blockchain is an important technology foundation, ICOs are ‘just’ a fundraising mechanism. No one uses the term Stock Market interchangeably with Javascript; Linux and IPOs are obviously very different things.

We thought it might be helpful to look a little more closely at Initial Coin Offerings (ICOs), to help clear things up a bit. In particular, we think it helps to expand a little on why ICOs are so popular right now.

ICOs, as noted, are just a brand new mechanism for raising money. They have become incredibly topical because the existence of Blockchain technologies has enabled the creation of this new mechanism. Ignore the Blockchain piece, and this is just a way to raise money for a company, or some other project.

In speaking to start-up management teams lately, the idea of an ICO has gathered immense appeal. An ICO is seen as the preferred method to raise money for many start-ups. There a few reasons for this:

First, it has become much harder to raise venture money. The big VCs have been generally slowing their pace of investment and tightening up terms. An ICO can be closed in a few months.

Second, it is ‘easy’ money. For a new company, raising a seed round of $1 million – $2 million can be time consuming and fraught with uncertainty. Moreover, there is far greater flexibility in the obligations of an ICO. Raising venture money requires the sale of equity. Typically, ICO participants do not get equity in the company raising money. Instead they are betting investing in the ‘intrinsic value’ of the token.

Third, as a result of the above, early stage start-ups can quickly raise money on incredibly ‘founder-friendly’ terms. Instead of pleasing investors, the company focuses on the token ‘community’, and it is generally easier to please these stakeholders.

This list should raise some flags. The common thread running through all of the above is the assumption that your ICO will be funded quickly. It is no longer clear how easy it is to raise an ICO, and there appears to have been a sharp drop in the number of ICOs since the beginning of the year.

A bigger issue is the question of what the investors buying tokens at the ICO get in exchange for their cash. Eventually (maybe already) ICO investors are going to demand more rights and impose more obligations on the companies holding the ICO.

The fact of the matter is that for a period last year, selling a cryptocoin was a very cheap source of capital for companies. That cannot persist, and is probably already changing. Easy ICOs are almost certainly an arbitrage opportunity, with buyers not fully understanding the value of their investment. The ‘Market’ tends to quickly close any arbitrage opportunities, and we believe this window will close.

Our advice to companies considering an ICO is to move quickly but also be certain that having a blockchain process is something your company really needs. Not all problems need to be solved with a digital token, and it may not make sense to use a token for your specific business goal. Admittedly, it has been a great way to raise money, but if you are starting from scratch today, by the time you bring your ICO to market, conditions may have shifted. Distorting your tech stack to accommodate an illiquid cryptocurrency may not be worth the ‘ease’ of raising money in this way.

UPDATE: Just before we published this, we learned that there will be no more ‘ICOs’. The lawyers are now telling clients that the SEC views the term ICO as far too similar to IPO, which could lead to investor confusion. The term that companies will use now is ‘Token Sale’.

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