Recently we have seen an alarming trend of companies funding their projects via an Initial Coin Offering or ICO. The chart from Google Trends below shows the sudden explosion in searches for the term “ICO”. By including results for “ICO Token” we can separate searches for icons from those looking for initial coin offerings.
This trend started with standalone blockchain projects – like Waves and Rise – with most or all of their coins pre-mined and offered for sale. Then we saw projects releasing tokens via smart-contracts on the Ethereum chain. Next came the projects created solely to offer a way for a company to manage an ICO. Some, like Ardor, even launched their ICO platforms with an ICO. At present we have over 600 tokens across a dozen chains, and while they aren’t all the result of an ICO, the majority are.
The Problems With ICOs
ICOs draw many similarities with Initial Public Offerings. They allow the public to fund a company as an investor and profit from the success of that company by selling their share or token at a profit in the future. The shares or tokens purchased can also be traded. That, however, is pretty much the extent of the similarities. The differences are where the problems lie.
Almost Anyone Can Create An ICO
Very few countries have regulated ICOs but IPOs are regulated in most of the world.
Here in Australia, the ASX requires that companies meet certain requirements to qualify for an IPO. The majority of ICOs that have occurred thus far would not be able to meet these constraints. In most cases their tokens were sold to fewer than 100 big whales with the smaller buyers getting less that the $2000.00 minimum required to be considered for the shareholder spread. Almost none of the companies behind these ICOs would qualify for the profit test nor would they have enough working capital to pass the asset test. They might, however, be able to meet Company Size criteria based on the projected sale of their tokens, if they can raise more that $15 million. This depends on when you take the measurement of the market cap, before or after the float.
For an ASX IPO, you need to be floating 20% of your company, and your company needs to have a market cap of $15 million or more. With a $15 million valuation, you are offering $3 million in shares. You have a product or functioning business that people are actually able to put a price on.
To meet these, or similar, criteria a company may have pre-ICO token sale. They announce the pre-sale and allow investors to register interest. Then they sell a small amount of tokens at reduced price to build a documented market valuation. This market valuation is fabricated though. It’s freshly established, and has no basis. It’s unlikely the company even has a minimally viable product (MVP) or a functioning business. They just have an idea, usually published in a PDF on a website – often labelled as a white paper.
You Don’t Own Any Part Of The Company
Once you have the token you bought, the link between you and that company is severed. You have no voting, shareholder, or stakeholders rights. They have no obligation to report to you on their progress or earnings. You didn’t buy part ownership of the company, you bought a token and they’ve given you the token. The company owners can now legally disappear with the funds you gave them.
You Have No Say In The Sale Price
As explained in this Forbes article, when company shares are sold in an IPO, the invest banks make requests for purchases. The company calculates and averages the price from the requests and settles on a price per share. The investment banks then execute their offers. Once the IPO is open, the investment banks then sell the shares on the market, where the public get to make bids and participate in the price discovery.
In an ICO, the company tells buyers how much the tokens cost and sells them privately. There is no open market and no price discovery. They decide they want $200 million, and so they sell 50 million tokens for $4 each, or 400 million tokens for 50 cents each.
You Have A Skewed Perception Of The Project
Early investors want a good return on their money, regardless of the investment. With IPOs there is little hype and lots of information available ahead of the IPO. With ICOs, it’s the exact oppsite.
The Build Up To The IPO
With an IPO, the return on investment (ROI) often comes many years after the IPO. For the average IPO Investor, they hear about the float a month or so ahead of time. They do their research in to the business – are people using the product, does it have potential for growth, and is it profitable. Then they reserve some funds to make the purchase, and when the IPO opens, they put in a bid.
The ICO Hype Train
The average ICO investor expects large ROI the moment the token hits an exchange. For them, they heard about the ICO a few months ahead of the pre-sale, and made sure they had some BTC or ETH ready to buy the tokens. They registered for the pre-sale as soon as it was possible. Because of the frenzy surrounding a lot of ICO pre-sales, there isn’t much time to research the company, the product or the market space. The investor reads the whitepaper and sinks money in to the pre-sale. Once the pre-sale has closed the wheels of the hype train need to start moving.
The investor opens Twitter, Discord, Slack, Reddit, 4Chan, Facebook, SteemIt, Medium, YouTube, Instagram and Snapchat and starts to post about this awesome new project they are looking in to. They shill this ICO with all their energy. By shill, I don’t mean someone who merely mentions a coin or token, as has become the accepted definition of the word. I mean they are making up features or promising profits, and they simply won’t stop talking about it. They refuse to accept any warnings or heed any advice. They’ve sunk money in to the project and they want their lambo.
Before long searching for the project returns only biased investor hype. More patient investors who wanted to research a project before buying now have to sift through mountains of shill droppings to get any solid information.
A month later, ICO opens and people start asking about the project. The early investors are there and waiting to answer their concerns with promises of fat profits. Stage one of the ICO closes, and these investors join the pre-sale investors on the hype train. More investors join in with the shilling of the project. The hype builds until the token is listen on an exchange. If the early investors have done a good job, they are able to offload their tokens above the purchase price before the market realises the hype is unfounded.
The Solution To The Problem
The easiest and quickest way to solve this issue before it ruins the digitial currency market place completely is to invite regulation of ICOs. These ICOs should be treated as either IPOs or venture capital investments. The token holders should be given voting rights in the companies. The tokens sold should not be the same as the ones that facilitate transactions within the project. This would be similar to what Sia did with SiaNotes/SiaFunds. It’s worked well and hasn’t generated much negative backlash for them – none that I have seen anyway.
The next option is to convince these money hungry start ups scrap the ICO altogether and form a company and seek funding via venture capital investments as usual – which is the path LBRY took – but that may be easier said than done. While this route is working well for LBRY, for every successful startup there are ten or more that failed. Most of these failures can be boiled down to it took longer to get the product to market than the funding allowed. This is why the allure of an ICO with massive amounts of money raised in a short time with little or no obligation to the investors is so great.