Picture Credit: Steve Buissinne (Pixabay)
Let us start by understanding what an ICO is.
The acronym from Initial Coin Offering bears intended resemblance with Initial Public Offering (IPO). In an IPO, a privately-held company is transformed into a public company by being listed on one or more stock exchanges and its shares sold to institutional and retail investors, as a form of raising new equity capital, monetising the investments of private shareholders, and enabling easy trading of existing holdings or future capital raising.
An ICO campaign, at its core, is somewhat similar to an IPO. The start-up usually ‘issues’ a brand new own cryptocurrency, a percentage of which is sold to early sponsors of the project, in the form of digital utility “tokens,” in exchange for fiat money or other cryptocurrencies such as Bitcoin or Ether (the native currency of the Ethereum platform). That is why ICOs are also sometimes called “token sales.” After the ICO, the bearer may use those utility tokens to redeem for some service provided by the start-up. Nevertheless, in practice, subscribers may have bought them in the hopes that their price appreciates in value and may be sold in the open cryptocurrency market for profit. Strictly speaking, this practice transforms those tokens into securities or some other instrument that would likely fail the Howey Test and call the attention of the regulatory authorities.
Even though controversial and not yet well regulated, ICOs are used as a crowdfunding model of capital for start-up companies to avoid the rigorous, demanding, and costly capital-raising IPO process required by venture capitalists, banks, and stock exchanges. That is what Mastercoin did in 2013, what is considered the very first ICO, even though that name was not yet used.
Notice that some purists insist that the term ICO should be only applied to the launching of those pre-mined ‘altcoins’ that are mostly code forks of Bitcoin, such as Peercoin, Blackcoin and Litecoin. They argue that these are mere ‘coins,’ in the sense that they hardly can do more than act as stores of value. In contrast, Ethereum’s innovative smart contracts feature, among other things, allows for anyone to issue a new ‘token,’ which can store complex, multi-faceted levels of value and, therefore, transcend being just a coin. Following that argument, the launch of an Ethereum-related token should more appropriately be called a Token Generation Event (TGE). Unfortunately, however, things are usually not so simple; the TGE initialism is more frequently used to refer to transmissible gastroenteritis, truly gay environment, or even to TGE Gas Engineering company. Therefore, if you presently find say some ‘TGE Advisor’ on LinkedIn, it most probably will be someone working in the gas industry rather than with cryptocurrencies. Consequently, in practice, the terms tokensale, TGE, and ICO are used quite synonymously, mainly because less and less ICOs are Bitcoin-based.
On the one hand, it can be said that ICOs democratise venture financing, previously restricted to professionals like venture capitalists, opening opportunities to retail investors who can now participate in exciting start-up projects. On the other hand, however, that same lack of regulation, in addition to some deficiency on public understanding of what these tokens are, may turn tokensales into relatively easy tools to defraud consumers. As a matter of fact, 46% of last year’s ICOs have failed already, not just because of malicious intent but also due to ill-conceived projects or technological issues such as lack of scalability or security. There are even stories of fundraisers forgetting everything about the project and spending the amassed money in luxury cars.
In an attempt to decrease reduce investors’ risk and re-establish trust in the crypto markets, Vitalik Buterin introduced last January the DAICO model, which combines some of the benefits of the Decentralized Autonomous Organization (DAOs) and the ICO model.
In essence, a DAICO contract serves two major roles. The first one is similar to the ICO and consists in governing the fundraising process: at the programmed sales opening date and time, the contract enters in “contribution mode,” allowing investors to send ETH to the contract address and instantaneously and automatically receive the issued tokens in their own sending Ethereum addresses in exchange for the ETH sent. When the tokensale period ends or the hard-cap is met, the contract automatically stops its ability to receive ETH, the sale is closed, and the raised funds are transferred to the project account. If the period ends without the soft cap being reached, the collected sums of money are automatically transferred back to the investors’ Ethereum addresses. On the one hand, all these automation features duly highlighted in the whitepaper could supposedly lower the risk perception on investors eyes and increase the intent of investing in the project.
On the other hand, DAICOs have a second role: controlling the utilisation of the raised funds. Differently from the usual ICO contract, which becomes inactive upon completion of the funding round, the DAICO contract keeps active by moving to a “tap mode” and governing the rate at which developers can withdraw from the token sale funds, or stop it altogether, according to a consensus among all the contributors, managed by a voting mechanism included in the smart contract. This collective voting mechanism is considered the key to ensuring that the funds raised are used properly and that investors’ interests are protected. If it is true that this feature was intended to increase even more the credibility of the project, by adding protection against frauds, it may also give too much power to contributors and submit the project to the risk of be put in the “kill mode” on a mass panic caused by some “fake news,” leaving some project managers still unsure whether to adopt it. Critics of the DAICO model argue that people got scammed because they are plainly too lazy to research appropriately; hence it might be naïve to think that somehow the same crowd of newbies will be keen to participate actively in the life of those start-ups into which they invested money.
About the same time as the DAICO introduction, another model was proposed by Trenton Gaddis as an evolution of the SPAC (Special Purpose Acquisition Company) concept. SPACs are publicly-traded buyout companies that raise collective investment funds through an IPO and put the raised funds into an escrow where it is held, earning a nearly zero interest rate, until the SPAC managers identify a merger or acquisition opportunity to pursue with the invested funds. The management team of the SPAC then has a specified period of time, usually 24 months, to identify a private company acquisition target and complete its acquisition. If such a deal is made, the management of the SPAC profits 20% of the common stock acquired for nominal consideration through founder shares, and other shareholders receive an equity interest in the new company. If no acquisition is completed within the specified period, the SPAC is dissolved, and the money held in trust is returned to the investors.
In this SPAC 2.0 model, the company first raises 10% of the intended capital for human capital by means of an ICO, in which investors receive real, valuable, exchangeable tokens for their money, ensuring them against not only the failure of the project but also inexecutable plans. The company must then complete the residual 90% in accretive deals, on a monthly, quarterly, or semi-annual and project-by-project basis to earn a 20% interest in tokens. At the same time, the investors are free to use their unheld capital for other opportunities until their funds are genuinely needed, instead of having the high opportunity cost regarding tying up their money for up to three years. This entire process is likewise governed by smart contracts, which offers transparency and a deterministic and impartial operation that will execute the coded terms on the precise time and on the exact instructed way.
This is all still very new, and certainly other models will appear to reduce risk and protect investors, ultimately helping to make the whole crypto-market more respectable and accepted.