Demystifying ICOs
The investing world is abuzz! It’s been a while since the dotcom bubble and investors are finally excited about a rather strange change.
Traditionally, startups and early stage companies have gone the venture capital (VC) route when raising money. VC firms or investors identify startups which are performing well and looking for high growth and pump money into the company in exchange for equity or an ownership stake. It is a guessing game, with the investors hoping for the success of the startup to make good returns on their investment.
If you delve a little deeper, you can identify a few clear stages in the investing game.
First comes the initial seed funding or the seed round. This is usually very early stage and the investment is often made with the trust of the team and vision, since the company might not have a valuation or a growth projection to show off. Seed funds are what give life to startups, apart from the founders putting in their own money. Seed rounds are dominated by friends and family, angel funding and more recently, crowdfunding. Crowdfunding has taken off with Kickstarter and Indiegogo dominating the headlines. It has seen large success in disaster relief collections, in financing movements or causes, and even for freelancers to grow.
After an initial seed round, it’s time for the venture capital investments. This is the stage when a startup pitches its vision, team and mission to lure investors to pump in a significant amount of money. VC investments come at a time when the startup has reached a stage where growth is highly dependent on the amount of working capital they have and the quality of the team they hire. VCs always look for good ‘exit’ options, which allows them to walk away from the company with a handsome return in exchange for the equity stake they owned when providing the initial funding. VCs are not only a source of funds, but can also provide valuable insights and inputs for the startup with the ‘next big idea’. A startup may choose to bring in several VCs for their expertise and some have even turned down large investments to go with a VC who might bring more experience to the table.
VC investments can take place over several rounds, at different stages of the company’s growth. These are usually Series A, B, C, etc. VC investments may end when a company goes public or opens up a part of the equity to the public and get listed in a stock exchange. This is the usual exit strategy and investors are pretty happy when they get good returns on a successful IPO.
The entire process is laborious enough to warrant the creation of multiple TV shows and movies showcasing the intensity and drama of raising funds. That is, until blockchain changed everything.

Wait. Blockchain!? How did blockchain save investing?

Introducing initial coin offerings or ICOs. When Bitcoin started changing the landscape of peer to peer payments, it also opened the space of unregulated investing. Historically, there are not a lot of options for a company to raise funds. Governments have regulations on who can invest and even defines a minimum net worth to become an investor.
This creates issues for a world that is largely moving to a space of deregulation and decentralisation, instead relying on the quality of code and the projected success as bases for currency and payments.
Take Ethereum for example. It came out because a few folks in the community were not happy with the scope of Bitcoin. Bitcoin did not support scripting and was too slow to scale, which were deal breakers for application development. Ethereum became popular because of a crowdfunded token sale after initial development of the product. Some of the most enthusiastic in the community were already dreaming of building applications using blockchain and Ethereum turned out to be the perfect platform for that.

Enter the alt-coins

The Bitcoin and cryptocurrency space is subject ridicule once in a while when an alternate-coin pops up. Popular ones include Litecoin, Dogecoin and a homebred LakshmiCoin. While all these sound ridiculous, these set the foundation for ICOs globally. Each alt-coin is a fork of Bitcoin or a token issued on Ethereum which improves on some aspect, be it speed, privacy, proof of work, or scalability.
ICOs follow a few traditional rules of crowdfunding. ICOs are open to everyone, regardless of their financial health. Some ICOs choose to raise from only certain groups, but most allow the general public to participate.
If someone is interested in raising funds, ICOs are now a viable option. Lets say, a company decides to raise funds by offering the ‘EventCoin’. Traditionally, to raise funds, the company would have to approach multiple investors in the hope that its vision and mission resonates with their financial expectations. With ICOs, the community and stakeholders can participate in fundraising.
An ICO begins with a white paper. A public manifesto containing the company’s plan for using the funds, the returns expected and setting the limit of funds to be raised. The document will also include other information such as the share of the owners, the currencies accepted for funding and where ‘EventCoin’ can be used.
Continuing with the example of EventCoin, let’s imagine this currency can be spent at events to purchase: a ticket for a conference; food, merchandise and swag; subscriptions and super secret future events.
Now, because EventCoin can be spent within the company’s events, it becomes a token. An EventCoin would be accepted at cryptocurrency exchanges and merchants and would trade at a price which is pegged against bitcoins or ether.
When the company wishes to raise funds of 1 lakh Rupees in an ICO, then the total value of EventCoin issued is equal to Rs. 1,00,000. Each EventCoin is valued at a price calculated on the number of coins issued. If 10,000 EventCoins are issued and the fundraising is 1,00,000, each EventCoin is worth Rs. 10.
To take a real world example, the Ethereum project was the first successful ICO project, which raised around $18 million in Bitcoins or $0.40 per ether. This would mean that a total of 45 million ether were available for sale. If a person wanted to invest $40, he would get 100 ether.

What’s the point?

Well, if you had purchased ether at $0.311 when the ICO was announced, you’d have returns of roughly 97781%, considering the current trading price of ether is about $305.
This all sounds too exciting, but what do you do with the tokens?
This is where ICOs have a superior advantage over IPOs.
You had to have a genuine interest in the company to invest a large sum in it, but what if you could invest a small amount and get a few tokens which can be used for products and services offered by the company?
Here’s how it would work. You purchase Rs. 5000 of EventCoin, at a rate of Rs. 10 per coin. By purchasing 500 tokens for Rs. 5000, you now own tokens that can be used to purchase tickets, merchandise and all the swag you want, but if you hold on to the tokens because you believe that the price will rise, you may enjoy extra returns.
Since the tokens are pegged to an existing cryptocurrency, it is easy to trade in EventCoin. The company’s white paper defines how the investors are rewarded when the value of EventCoin goes up or down. As more and more people start purchasing EventCoin, the value goes up as its acceptance increases. People can choose to trade in their bitcoins and ether for EventCoin and enjoy the benefits of the growth along with the company.
ICOs are also a great way to build a community around an upcoming product or service. Once the sale is successful, you have a community of token holders, who all benefit from the increase in growth of the company and have the value of the token increase.

Here is where it gets a little murky

Since cryptocurrencies are in a regulatory sandbox in most countries, there is no surety that you’ll get returns on your investment.
Unlike traditional investing, which allows you to own a stake in the company you’re investing in, you don’t own a part of the company when you buy tokens in an ICO, so you don’t participate in any decision making or influence the direction the company moves.
The company bases the entire sale based on a white paper, which is not binding. If a company violates the white paper, there is no resolution or redressal.
ICOs can be tweaked to include equity as an offering, and these are termed as registered securities offerings.
The tokens more or less represent code or a script and can be exchanged for other tokens. This makes the company susceptible to significant financial damage if the community is unhappy with its direction.
ICOs, being largely unregulated, are very easy to use as a scam. Since there is no party to regulate and allow an ICO, it is pretty easy for fraudsters to dupe people.
Token sales or ICOs can only be completed if the minimum funding goal is met. If the sale falls short, the entire funding is cut off and the whole ICO process has to be redone, with a fresh sale of tokens.

Case study: Kik Messenger

On a positive note, ICOs are great for a few services where the tokens can be used in exchange for a product or service. Take the example of Kik Messenger, which recently executed a token sale for ‘kin’, a currency within Kik Messenger.
Kik realised that the majority of its users are teenagers and millennials who want to get on the cryptocurrency bandwagon. At the same time, there is a huge demand for good P2P payment systems, integrated well into a chat application. With Apple Pay launching, Kik decided it needed a digital economy within the messenger. Kin is would be fully integrated into Kik messenger and related apps. Users can use this new digital currency by holding in a digital wallet to send tokens to other users and pay for additional services like ad-free experiences, food delivery, and premium stickers. It passes through an exchange only when converting to cash or a different cryptocurrency.
Of course the best way to get a large number of people using Kin is to have a lot of people buy into the idea. The initial white paper was released in early September 2017 with a hard cap of raising $75 million with the contributors owning 5% if the hard cap is reached. There would be 10 trillion Kin generated, making the initial value of 1 Kin = $0.0000075. But it doesn’t end with using Kin to enhance your emoji or sticker experience. Kik users earn Kin for watching ads or providing value to other users. You can spend KIN to receive advice on a fashion app, join a clan on a video game or pay an entry fee for a premium group.
Although Kik did not meet their minimum funding goal, it is remarkable as one of the first large social media companies to have a token sale and sets a precedent for other companies looking to raise funds in nontraditional ways.

Further reading

Last modified 3yr ago