Understanding Initial Coin Offerings (ICOs)
News outlets continue to blast headlines about ICO fundraising surpassing venture fundraising for early stage companies, but the lack of perspective and explanation in these pieces seem to reveal that there are lingering gaps in understanding ICOs. Add this to the general misunderstanding of cryptocurrencies in general in reporting, like Bloomberg not realizing that it is possible to buy a fraction of a Bitcoin as recently as November 2017, and confusion is inevitable. This piece sets out to explain what an ICO is, how it is conducted, and why it is chosen as a fundraising option.
What Is An ICO?
An initial coin offering (ICO) is a means of crowdfunding a cryptocurrency project. In an ICO, some quantity of the cryptocurrency is preallocated to investors in the form of “tokens,” in exchange for other cryptocurrencies (or occasionally fiat currency, like dollars), commonly Bitcoin or Ethereum. These tokens become functional units of cryptocurrency if the ICO’s funding goal is met and the project launches. ICOs help a cryptocurrency launch by gaining funds for development costs, attracting developer attention to the project, and increasing usage and adoption of the coin by increasing the number of people who hold the coin. Developer adoption is important because, once a cryptocurrency project is launched, the development process has just begun and having the help and support of a large community is critical to its long-term success.
How Do ICOs Work?
ICOs usually take place over a period of days to weeks and are split into a pre-sale period and a public sale period with a funding cap that must be reached for the project to launch. A pre-sale is a token sale round that is restricted to select individuals or institutions that are placed on a “whitelist” and allowed to buy coins before a public sale. Pre-sale rounds often give a percent bonus number of coins to participants and sometimes require a minimum contribution amount. A pre-sale is a way to reward early supporters by guaranteeing them an allocation of tokens and to build up attention for a project. The public sale period is usually longer than the pre-sale period and is open to all participants who register with the project and meet KYC (know your customer) compliance, which is in place to meet anti-money laundering regulations.
The lifecycle of an ICO is usually as follows:
A team will release a “white paper” which details the stated plans for a given cryptocurrency, including what it will do, why it is useful, the roadmap for building the project, and a plan to use the funding raised.
A project raising an ICO will have a webpage and some form of large group chat to keep people who are interested in the project updated about developments and important dates. These chats often take place on Telegram, a mobile chat application.
Before the ICO launches, the project will invite or allow people to register for the whitelist to gain access to the pre-sale round. For popular projects there is usually more interest than availability for the pre-sale white list so spots are allocated by the founding team or by a lottery, or some combination of the two.
When the pre-sale or public sale period happens people will contribute funds by sending Bitcoin (BTC) or Ethereum (ETH) to a designated wallet address. If the project reaches its funding goal, tokens of the new cryptocurrency will be sent in return when the coin is launched. If the project does not meet its funding goals, the contributed funds will be returned. In this way, the funding model is similar to crowdfunding.
Once a project has reached its funding goal and distributes the newly created coins, it will launch to an exchange where it can be traded live. At this point, holders of the coin can trade their stake and new buyers can participate.
Why Do Projects Choose To ICO?
Cryptocurrency projects choose to raise funds through an ICO for a number of reasons:
Perhaps the most underreported reason is that for some of these projects to succeed it is essential to get many individuals using the token and many developers building on top of the protocol created by the token. ICOs are a great way to do this while also raising funds for development, a win-win. This fact makes an ICO practically a requirement for some coins. Even the best projects must be adept at marketing and telling their story to gain funding and developer adoption; having a good team and a promising white paper (a document which details the goals and plans for a cryptocurrency project) is not enough.
ICOs are a low cost fundraising option because they avoid regulatory compliance and other interactions with intermediary financial institutions. This means that projects can keep costs related to launching low. Regulators are taking a closer look at ICOs and this may change, but for now there is no more cost effective way to raise money for a cryptocurrency project.
ICOs can raise funds quickly and save the development team time compared to raising funds through traditional means, like venture capital. While this is arguably both a good and a bad thing, it means that projects have the opportunity to get off the ground quickly which can be important for their momentum and success.
ICOs represent a new way to fund an emerging technology. It is almost certain that additional regulation will likely come to the space soon to prevent fraudulent behavior. However, ICOs will continue to offer unique benefits to cryptocurrency projects and, for some, may be essential to the coin itself succeeding.