When explaining what is an initial coin offering, I can’t put it better than Andreas Antonopoulos. In The Internet of Money Volume 2, he described them in as:
“…an opportunity to do something never done before: bridge the big gap between early-stage, organic financing and stock-market public offerings, which is a pretty big gap. In that gap, companies can now fundraise from a completely globalized audience with enormous velocity. That creates a very new environment for fundraising, with spectacular successes and spectacular failures.”
The rest of this article will go into more detail to explain the initial coin offering phenomenon. After reading, you will understand:
- How an initial coin offering (ICO) is similar and different to an initial public offering (IPO)
- How initial public offerings fail to help early-stage projects, and place legal limits on investors
- Some of the opportunities that an initial coin offering presents to help early-stage projects and willing investors to connect, along with the pitfalls to watch out for.
IPOs – The Predecessor
We will preface this explanation of the initial coin offering by looking at the term it was derived from – the “Initial Public Offering” (IPO). IPOs see a company offer shares in itself on a public stock market for the first time.
In 2012, Facebook conducted a $16 billion IPO on the NASDAQ. Once Facebook’s IPO was complete, any member of the public could buy a slice of ownership in Mark Zuckerberg’s brainchild. Before the IPO, investors could only gain a stake in Facebook by negotiating with the company or its existing investors directly. This is what the billionaire technology investor Peter Thiel did – investing $500,000 in 2004, roughly eight years before Facebook’s IPO.
Because of all the rules imposed by securities regulators, conducting an IPO is a very expensive business. For one thing, it necessitates filing a prospectus – a long, prescribed document that outlines the investment case in detail. Writing this prospectus requires a great deal of input from costly lawyers and investment bankers, plus significant attention from the company’s senior management. This cost and scrutiny makes conducting an IPO a landmark in a company’s development. By the time Facebook did its IPO, it was already a social media giant with hundreds of millions of active daily users.
Options For Early-Stage Companies
But what about earlier-stage projects, unable to bear the prohibitive cost of an IPO? If they can only justify raising, say, $1 million, then they cannot afford all those lawyers and bankers and still have enough leftover to make the undertaking worthwhile. Until recently, the only way they could raise money was through investment from venture capitalists, as in, someone like Peter Thiel. The general public were legally prohibited from investing in startups – it was deemed “too risky” by the powers that be.
Two recent innovations have altered the landscape. The first is equity crowdfunding, which is the subject of my first book. To encourage innovation, many countries decided to relax their laws for early-stage startup financing, enabling companies to raise small amounts of capital from the public (typically between $50,000 and $5 million), with a reduced disclosure regime. In equity crowdfunding, the fundraising project still needs to follow the rules, but the rules they have to play by less burdensome.
The second innovation is the subject of this article. The Initial Coin Offering (or ICO) represents a fundamentally different philosophy. Equity crowdfunding sees issuers adhere to a set of simplified rules from the securities regulators, whereas ICOs sidestep the issue of regulation altogether. Let’s see how.
What Is An Initial Coin Offering?
An initial coin offering asks investors to contribute crypto to fund a project. Because fiat money is not involved, an initial coin offering generally exists outside of the purview of regulators. All that’s happening is one type of crypto is being exchanged for a new token, offered by the initial coin offering project.
Some countries are moving towards reigning in initial coin offerings by demanding that issuers adhere to the same regulations of ordinary securities offerings. The problem with this approach is that crypto is inherently borderless. Projects will simply setup their initial coin offering wherever the regulations are lightest.
In many cases, what is on offer with an initial coin offering is not actually equity in the company. Instead, you may be getting a revenue share from the value the company creates, or a share of the underlying asset that the token represents. These types of securities are barely covered by the law.
Unregulated, very-early-stage investing is about as Wild West as it gets. It is extremely speculative, and if that bothers you, then the initial coin offering space may not be for you. If this is what you decide, then that is completely fine. Most people’s risk tolerance will be more than satisfied through dealing with more established cryptocurrencies like Bitcoin. An initial coin offering is an even higher-risk proposition Bitcoin. It is wise to build up some hands-on experience with crypto basics before dealing in your first initial coin offering.
What Investors Need To Know
The frenzy of interest in the initial coin offering space has led to some very dubious projects. Some people worry it is fuelling a bubble. Because there is nobody stopping anybody from starting an initial coin offering, those in charge of them can attach whatever price to them they want.
There will be failures – including tokens which honestly try but do not succeed, and the far less-forgivable deliberate scams designed to enrich the founders at the expense of the investing public.
But there are legitimate initial coin offerings as well. Ethereum was an initial coin offering, and investors there would be very happy with how it has performed since then. There is also the argument that if you are going to be playing in a high risk market, you should try to be in one where the potential rewards are as high as possible. This is the philosophy that venture capital have – they expect that most projects they invest in will fail, but they expect that their gains will more than offset their losses.
The earlier you invest in a project, the more speculative it is. Initial coin offerings are undeniably risky. But “risk” is not exclusively negative – risk carries the possibility of gain, not only the possibility of loss. Just as Peter Thiel found out by investing in Facebook.
The greatest gains are open to those who take the largest risks. Some initial coin offerings have returned 1,000x the initial investment.
Having said that, you shouldn’t take foolish risks. The cryptocurrency landscape has undeniably attracted more than its fair share of cowboys. At a minimum, there needs to be a white paper with a good idea behind it, and a website which is professionally put together. This white paper should have been subject to outside scrutiny. In another article, we’ll go into how to look at inital coin offering investments in more detail.
But for now, keep this in mind: Buyer beware!