Maurizio Sironi | Blockchain Reply
Initial Coin Offering: what are we talking about?
A new revolutionary way of funding is introduced by blockchain technology. ICO, which stands for “Initial Coin Offering”, consists of the issuance of new tokens that are sold to investors in exchange of the transfer of funds. The sale of tokens is comparable to a crowdfunding campaign, with the difference that all subscriptions and issuance transactions are recorded on a public blockchain ledger.
Indeed, It is an emerging phenomenon but grew very rapidly. Just in the first three quarters of 2018, it was raised more than 17 billion dollars through ICO, more than twice compared to 2017. The biggest ICO ever concluded is EOS, which raised approximately $4 billion during one year.
One interesting property is how they ease access to capital: ICOs are instruments that considerably lower barriers to entry in the credit market, permitting everyone to propose an idea and collect money. Even if it seems an elementary task, the process of launching a business through an ICO is not that straightforward. The main steps are:
Drafting and publication of a white paper which describes the features of the token and all characteristics of the issuer and the project;
Sale of tokens in exchange of cryptocurrencies, which usually is divided in two phases, private and public;
Development of products and services delineated in the white paper that will be exploited by token holders.
ICO ecosystem is evolving rapidly and the most important open points are in how to regulate the phenomenon, especially in KYC and AML matters. The current regulatory stall is characterized by a not clear legal framework among the majority of jurisdictions. Observing the market during last two years we individuated the following trends:
Private rounds, in which known seeders take a stake in the project, are the preferred way to raise funds in the early stages;
Public rounds are becoming optional according the the amount raised privately. This is because it’s more onerous in terms of due diligence and compliance requirements to approach public investors;
These trends are particularly evident for big players which finds more interest from large investors in the private sale. For instance, Telegram canceled its public sale after it had raised $1,7 billion during a private round.
Token can have different economic functions: providing a classification is not only fundamental to understand their potential, but also helpful for regulation and fiscal purposes. An official three-side classification emerged among researchers and regulators in the first half of 2018:
Payment Tokens: they do not confer rights towards the issuer, but they are accepted as means of payment or transfer of value. This is the case of many cryptocurrencies like Stellar and Ripple;
Utility Tokens: they allow the utilization of products and services developed by the issuer or grant exclusive advantages and incentives;
Security Tokens: they represent assets, being them a claim against the issuer (bonds), equity investments (share) or promises of future capital flows (derivatives or other financial instruments).
Be careful: categories can overlap and one token can belong to more than one class or shift from one classification to another one over time. As concerns token models adoption, market trends suggest the following considerations:
Payment tokens are characterized by a high velocity and are less interesting as they usually don’t give particular advantages to holders;
Utility tokens are very intriguing as they allow to design sophisticated models of functioning and create a wide range of possibilities giving rise to the new and promising “Token Economy”. More and more projects attempt to let their token fall into this category, as it require less effort in legal and compliance aspects. On the other hand it is more risky as the borders delimiting categories are not always clear to be interpreted;
The use of tokens as securities is an emerging trend and probably the future standard for the financial market. It is comparable to traditional financial model except for its decentralized nature and the possibility to add special functionalities, such as predefined and immutable rules for the assets and automation. Traditional financial players are beginning to embrace this technology, in fact stock exchanges from Malta, Switzerland and Singapore expressed the intention to develop security token exchanges.
In the evolution of the new decentralized finance paradigm, Initial Coin Offerings will have a central role. ICO is a very promising instrument, but it needs adequate design and support. In particular, government and enterprises are still in the learning curve before exploiting it or taking regulatory initiatives. Starting our Pros vs Cons analysis, ICOs bring lots of advantages both for issuers and investors.
By the issuer’ perspective:
It is a cheaper source of funding compared to the emission of traditional equity and debt instruments and usually it allows to reach a bigger pool of investors;
It gives the possibility to immediately measure in the market the goodness of the value proposition;
Tokens can be personalized and, like cryptocurrencies, exploit innovative features, such as programmability (smart contracts), divisibility, split transaction;
Utility tokens, in addition to investors, is possible to acquire also a wide community of users before products and services are ready for provision.
From investors’ point of view:
Initial Coin Offering reduces the need of trust in the issuer thanks to full transparency in the usage of proceeds, because of transactions traceability, and to the possibility to regulate funds expendability through transaction programmability;
One possible evolution is DAICO that consists in the creation of a Decentralized Autonomous Organization (DAO) regulated through smart contracts which can autonomously manage funds raised during the ICO, for example the budget collected could be unlocked in trances basing on prespecified conditions or on the results of token holders voting procedures;
ICOs are characterized by less barriers to entry, seeing that there isn’t the need to own any special qualification in order to buy tokens;
Intermediaries are not necessary, tokens can be bought directly from the issuer and can be stored independently by the buyer;
Exchange services are available 24/7;
In addition, this instrument gives to private small investors the possibility to invest in promising projects since their early stages, which currently is really difficult in traditional financial market.
ICO, which is a young technological and financial innovation, currently presents also some risks which if not taken into consideration can undermine the flourishing of a campaign or result in the lost of fund for investors:
There isn’t a clear regulation on the topic, meaning that investors are not sufficiently protected and issuers are threatened by the future introduction of a more stringent regulation which can strongly impact their businesses;
The terms which regulate the purchase of tokens and the rights acquired with them are not always limpid and easily perceivable by investors, this can also undermine the reputation of the issuer in case of misunderstanding;
The scenario has been contaminated by lots of “scam” ICOs, that are misleading projects which cheat investors;
Tokens price is characterized by an high volatility and the risk to lose value in the long term.
More and more projects are raising funds through an ICO, but investors became less confident in last times, meaning that they are more selective in giving their ether. In fact, between 2017 and 2018 nearly 45% of launched ICO failed to raise capital. It is not an easy procedure, advanced technical and business competencies and deep experience in blockchain field are needed. Reply, thanks its expertise and the continuous monitoring activity, identified the following factors that are the key aspects which help ICOs succeed:
Blockchain-Oriented White Paper: a clear value proposition over a blockchain-based project;
Token functions: design of token features and provided services in order to motivate tokens utilization and retention, fostering its value accrual over time;
Team: selection of different profiles with high vertical tech competences, some of them are required to have multi-year expertise in the blockchain industry and a good reputation in the ecosystem;
Sales Model & Token Distribution: good sales models set fair price tiers among different funding stages, lock-up committed parties with vesting rules and adequately balance token distribution among stakeholders;
Legal Compliance: precaution is necessary in order to respect laws and regulations in all involved jurisdiction, follow KYC and AML best practices and obtain the express authorization to competent Financial Supervisory Boards. Taking into account these aspects is vital for the success of the project because failing in compliance, in addition to possible sanctions, bring to the impossibility to convert cryptocurrencies collected into fiat currencies, making impractical to go ahead with the business.
Reply collected these best practices in a coherent consulting approach, which is continuously refined thanks to real-work market tests. Chasing this purpose, Reply launched ICOMate.io, a consulting service for the development of ICO campaigns in all their phases, from early stage design phases up to platform implementation in a production-ready environments structured in the following 4 phases: