How the ICO works in financing the cryptocurrencies?

During the last years, it has become quite common to talk about financing through Initial Coin Offering (ICO) in the blockchain ecosystem, although not all the investors know what they are. The ICO are very similar to what we know as IPO in the capital markets. The main difference is that the subject of financing is not a company itself, but a blockchain based project, usually a cryptocurrency. In this post, we will see what are they, as well as the risks and opportunities they represent and how they work.

ICO vs. IPO

As we mentioned earlier, the ICO is like the IPO of a new company looking for financing. However, what the ICO look for financing is not a company but a new cryptocurrency project. This way, the developers can afford the initial costs of the project, which are basically the design of the cryptocurrency and the implementation of the software. The owners of the project make the first issue and offer the new cryptocurrency in exchange for other currencies already existing, which may also be interchangeable by fiat money. Therefore, the ICO consists in offering to the potential investors new cryptocurrencies in exchange for money.

In a traditional IPO, the company sells one part of its shares to the public. This way, the company obtains financing in exchange for giving part of its ownership and control. In fact, every shareholder has voting right and decision right in the shareholders meetings. Therefore, the new shareholders are not mere speculators expecting for yield, but they have also decision power in the future of the company. All the details of this process must be defined in the prospectus of the IPO.

ICO

In the ICO, the prospectus is what we know as White Paper, and this document explains all the details for the process. It includes information about the target investors, how many token will be issued, what is the goal of the project, etc. Due to the lack of maturity of most of the blockchain projects, this transaction has become a good alternative of financing. This occurs also due to the difficulty of finding other financing sources such as banking or debt issues.

What does the ICO finance?

We can identify two kind of projects which the ICO will be able to finance: on one side, we may find the new cryptocurrencies. In these cases, we issue the first lot of tokens, and the rest of them are created through mining and staking processes. This is quite usual, and some big cryptos such as Ethereum have used ICO to finance their development.

The other main goal of the ICO is to finance blockchain projects. Although blockchain is the underlying technology for almost every cryptocurrency, its usefulness goes far beyond. There are other uses cases in which blockchain can make a very good sense. From financial services to the management of ownership rights or even the management of identities. Indeed, the DeFi industry is the best representation of it, and it aims to transform the way the finance sector works actually.

At the end we can define the ICO as a type of crowdfunding. The investors decide to put the money on the future of a project with the expectation of getting back with profits. This investment does not include any kind of right or decision power in the implementation of the project.

ICO structure

However, we have witnessed a lot of situations in which the ICO has become a huge failure. This happens because the ICO are not really regulated, and therefore the investors are totally unprotected. However, they are also a very good idea to finance innovative projects on the blockchain ecosystem.

Decision elements in any ICO

Now that we know what the ICO are and how they work, let’s take a look to their basic elements. These elements cannot guarantee by themselves the success of the investment. However, they can be helpful in the process of identifying the real projects from the frauds.

  • White paper – as it occurs in a traditional IPO, the prospectus is essential. It must contain all the characteristics of the issue, with the risks, the calendar, and the technical details. In fact, this should be the main document to support any investment decision we may take in an ICO.
  • Team of developers – as important as the white paper is the team of developers working in the project. If this team is composed of trusted and reliable professionals in the sector, the likelihood of a fraud is much lower.
  • Prototype of the project – when we are researching about a blockchain project to invest in it, it can be useful to see a prototype version of it. This way, we should be able to see how it would look like when finally goes live.
  • Website of the project – in the website of the project we may test some elements such as the transparency. The higher amount of information we have, the higher probability of being a serious project.
  • Smart Contract – last but not least, we must care about the technical inception of the project. If the Smart Contract is publicly available, we may test if it is really secure and, therefore, there is no risk of loosing our investment.

Apart from the mentioned elements, we must also consider other aspects. The advertising of the project, as well as the reputation in the financial industry, can also be useful indicators. In the last place, a good financial advisor may also avoid being victims of frauds.

Pros and cons

We already mentioned that the ICO represent an alternative financing source for blockchain projects. The excessive dependency on the baking system sometimes becomes an entry barrier for innovative projects. However, the appearance of the ICO removes this obstacle. Additionally, the ICO does not need any intermediaries at all, which makes the process much cheaper and more agile. In the last place, it allows the investment from retailer agents because it does not require huge amounts of money. Therefore, it is a universal and more accessible form of investment.

On the other side, there are several reasons why some investors are still reluctant of this kind of investments. First of all, they face a market risk. This implies that, if the project does not succeed, the cryptocurrency could devalue and, therefore, they may loose their investment. This risk is intrinsic to any investment. Additionally, there is also a technical risk. If the code of the project is not safe enough, someone could access the funding of the project for unfair purposes. This would mean the bankrupt for the project and the loss of the money for the investors.

Last but not least, there is also a regulatory risk. This kind of transactions are out of the scope of the current regulation, which means that they are out of the traditional financial system. Some countries such as China banned these transactions. This may imply not just a possible tax evasion, but also the use of ICO for criminal activities. In the same way, the ICO may be used to collect the money and then, cancel the project. In this case, the owners may keep the money and the investors would not be able to claim to anyone. This is why we should know very well the project we intend to invest in.

Hits and failures

During the last years some ICO have showed themselves as real failures in which the project was just a claim for collecting the money. In these cases, the investors usually loose all their stake. In fact, almost the 46% of the 902 ICO launched in 2017 did not succeed due to the failure of the project or because they were fake. This give us an idea about the success rate of this kind of investments.

Additionally, due to the 100% digital nature of these projects, all the ICO have a huge dependency on the code of their developers. If some hacker breaks the code, he/she could deviate the money to an external account, creating huge looses to the investors. This is what happened in “The DAO“, in which a hacker found a mistake in the code, an took more than $ 50 million from 11.000 different investors. The author of the theft is still missing.

DAO hack

However, we can also see a lot of success stories. In these cases, both the investors and the owners of the project took great profit from the ICO. We can calculate the yield of these ICO taking into account all the money collected and the revaluation of the cryptocurrency. The higher is the amount of money collected, the easier to fulfill the goals will be for the developers.

Future of the ICO

Due to all the previously mentioned, the ICO can be considered as a really interesting alternative way of financing for blockchain projects. However, the investors must be very careful before they make any decision without attending the basic elements of the project. The details of the ICO, as well as the team of developers and the characteristics of the tokens issue are essential. It is important to remind that there is not just a market risk, but also a high rate of fake and failure projects. Furthermore, the regulation still does not fully protect the investors in this kind of investment.

One of the main causes of the unfit regulation of the ICO is the lack of experience with these transactions. The risks are still a disincentive for investors, which becomes a break for its growth in the long term. However, we already know enough successful ICO to consider the importance of this financing source. Once the regulation covers these processes, the failure rate should decrease, while the number of ICO should grow. Anyway, the investors will remain as ultimate responsible of their decisions, so they should be careful enough before investing in ICO.

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