Moving forward amid risks and expectations: ICO becomes a new model for blockchain capitalization

Initial Coin Offerings (ICOs) have become the new hot thing in the blockchain community. The idea behind an ICO is that a company promises to create a product or service based on the blockchain.

To raise funds for project development, companies issue digital tokens and sell them publicly, usually all at once.

Token buyers can then use those tokens to run services at a later date, hold them, or sell them for a profit.

An increasing number of blockchain startups are organizing token sales as a way to raise funds, similar to traditional securities firms’ IPOs. According to data from research firm Smith+Crown, ICOs reached $260 million in 2016 and have already raised more than $560 million so far in 2017.

ICOs are considered a crowdfunding alternative and are changing the way startups do business. It is essentially a way for startups to raise funds outside of the traditional system.

Although ICO tokens work the same way as company shares, they are not the same thing. Yes, for securities sales, they need to be registered with the Securities and Exchange Commission. However, tokens do not need to be registered, and are more like a license for people to obtain a particular application of the blockchain.

Breaking records

Mastercoin became one of the first projects to use this type of capitalization when it conducted a token sale in 2013. Despite warnings that Mastercoin might be an elaborate scam, investors took the risk and contributed $500,000 to the project.

In 2014, Ethereum followed this trend and raised $18 million in ICO token sales, although the project lost millions of dollars after the Bitcoin price crashed. But since then, the scale of ICO projects has continued to break records little by little, until a decentralized venture capital company set a record of $150 million in ICOs in 2016. This project was the infamous The DAO, which lost $50 million shortly after the ICO ended and then failed completely.

Since ICOs are not regulated by the SEC, regulators can do nothing after these incidents. Startups that issue tokens become self-regulatory entities, independent of third-party agencies, but ICO investors cannot be guaranteed that the roadmap promised by the founders will be respected. This ambiguous legal status makes ICOs a particularly risky investment.

No legal provisions

The U.S. Securities and Exchange Commission (SEC) is currently reviewing this capitalization method, but until a decision is made, investors cannot enjoy any protections on their investments.

Aaron Ting, vice president of the Malaysian Investors' Association, said:

“It’s an investment option for those who have a high-risk, high-reward appetite.”

Etherscan founder and CEO Matthew Tan explained:

“While the white paper states that by purchasing ICO tokens, investors will own a portion of the startup’s assets and liabilities as well as profits, if the project ultimately fails and the team runs away with the money, there is little you can do about it because there is currently no legal regulation or oversight in this space.”

Risk Appetite

By examining the progress of startups that have previously conducted ICOs, we can say that not many projects have been completed so far. It will undoubtedly take more time to grow into a successful global business, but successful projects will bring more confidence to investors in this space.

To make matters more difficult, it is not always easy to distinguish between good projects and scams. For this reason, industry experts insist that investors should conduct due diligence and gain a deep understanding of the project founders, feasibility of the project, and its potential for large-scale use before investing.

Hello Gold founder and CEO Robin Lee called for:

“It’s like the early days of the Internet. At that time, you couldn’t know whether Google, Amazon, and Apple would be the big winners. The potential of blockchain technology is huge, but it’s hard to know who will ultimately create the big success. It’s still early days.”

In addition, projects raising funds through ICOs face numerous risks. Pump-and-dump, a micro-stock scam that involves artificially inflating stock prices through false and misleading positive statements in order to sell cheaply purchased shares at a higher price, is not uncommon in the cryptocurrency trading market, which is unregulated.

At the same time, these projects may also be subject to cyber attacks that cause token prices to fall and then profit from it, especially hackers who use margin trading to expand their own interests at the expense of others.

New Model

Despite the risks associated with ICOs, they are uniquely suited to raising large sums of money while cutting out third parties. Instead of sharing revenue with traditional venture capital firms, startups can now reward their early adopters and the first people to believe in their project.

Bloomberg View columnist Matt Levine explains:

“Companies and customers are necessary parts of the system; in the new model of blockchain capitalization, investors are just an interloper and are not indispensable.”

From this perspective, tokens are used by customers to receive services, rather than being sold to a small number of institutional investors who buy tokens to profit from the future growth of the company. The ICO phenomenon demonstrates the need for investment freedom outside of the accreditation system. The blockchain ecosystem can even automatically regulate bad behavior in this space.

Richard Kastelein, founder of Blockchain Partners, elaborated:

“While there have been a fair number of outright scams, pump and dumps, and blatant Ponzi schemes in the ICO space, much of this criminal activity is now being mitigated by crowdsourced due diligence efforts by the community itself, as well as external ICO information services such as Smith+Crown and ICO Rating.

Just as VCs are taking a hard look at this funding wasteland, so should we. It’s not just about making money, but about embracing a new blockchain capitalization model that may one day fund not only blockchain projects, but other startups and even networks as well.

For more information, please see the [Blockchain and ICO] special topic