Economics of Initial Coin Offerings

ICO’s are a new form of project financing for distributed ledger technologies or cryptocurrencies. The process involves collecting funds in the form of fiat or crypto currencies in exchange for a “coin” or “token”. In order to fully understand why this financing model exists, we must first understand the fundamentals of distributed ledgers in relation to regular internet protocols, which you can read more about here.


While being seemingly similar to equity offerings, ICO’s typically serve a rather different purpose. An ICO can technically never be used as an exit method for the issuer, as the coins are technically issued during the ICO, meaning that it can be compared to a seed round of financing. In addition to this, an ICO’s don’t typically make use of underwriters, which is a primary characteristic of equity offerings


Investing in ICO’s

Investors may decide to participate in ICO’s for several different reasons, mainly as a pure investment strategy, but there may also be other sentiments at play. Examples or various sentiments may be access to a limited edition product, or even tokens which can be used in online games. If investing with a pure financial incentive, the investor must carefully analyse what drives the price or pay-offs of owning a certain coin or token.  Many tokens are built on top of public ledgers such as ethereum, meaning that the value they create may be absorbed by the ethereum blockchain rather than the token itself, other tokens may be value driven by events completely outside of the blockchain space - tokens pegged to the price of USD for instance. In addition to carefully considering the price drivers, and investor must also consider code quality, expertise level of the development team, and any other factors which may impact the success of the DLT. Regardless of the brief history of ICO’s, there are examples of 6-digit returns as well as complete value destruction, indicating that this is a relatively early and volatile market.

ICO’s are used to fund the development and maintenance of DLT’s, so a portion of the funds raised will typically be retained by the development team behind the DLT. The coin offerings themselves may have different quirks depending on the issuers goals, but typically they will have several shared characteristics.

• A limited time period: Coins are issued within a certain time interval, or for the duration of a certain amount of bitcoin blocks for instance.
• Minimum thresholds: A minimum threshold may be set, which signifies the minimum amount of funding required for the project to move forward.
• Capped or uncapped: Issuers may decide the cap the offering at a certain amount, or allow an unlimited amount of funding.
• Accepted currencies: Issuers may accept traditional fiat currencies such as USD or EUR, and/or major cryptocurrencies such as BTC or ETH.
• Whitepaper: Issuers will typically include a whitepaper outlining the mechanics of the DLT.
• Prospectus: The issuer will typically include a prospectus, outlining “market fit” of the DLT at hand. This may also include a presentation of the development team and any other relevant information.
• Roadmap: The issuer presents a development roadmap with goals and timelines for development.

In addition to the aforementioned characteristics, the issuer will typically reserve an allocation of the “coins” or “tokens” for their development team and/or a foundation dedicated to the development of the DLT. The reservation may be made in the form of creating a certain percentage of tokens at inception, or allowing a “pre-mining” period where the issuer can generate tokens for themselves via the regular mining model. This is the “incentive” part of ICO’s, making it a significant determinant to the success or failure of the DLT. As mentioned earlier, each token has a market value based on supply and demand of the token, a successful network will increase the value of tokens since the “goods or services” provided by the token will be considered more valuable, while an unsuccessful network will deteriorate the value of all tokens in the network.

In a successful ICO, there should be a fairly strong alignment of interest between all parties involved, meaning that the issuer will see a value increase in their stake if the technology performs well, and investors will see their stakes increase as a result of good performance.


Are ICO’s legal?

The legality of ICO’s was widely disputed at Consensus 2017. The general opinion within Blockchain circles appears to be that ICO’s should be legal, but also regulated in order to provide investors with a certain level of security and fraud protection. There are examples of ICO’s which have failed due to natural causes, but also cases of outright fraud, which harms the trustworthiness of DLT’s on a general level. As of today, no bespoke regulation has been set when it comes to ICO’s in particular, regulators also have trouble classifying the underlying asset - leading to even more complication.


How to participate

Investors will can typically participate in ICO’s via the issuers own website, simply by signing up and making a commitment towards the funding goal.  KYC is seemingly quite light, meaning that investors can participate with as little as an email address, one of the reasons behind a light KYC may be the lack of regulation. Several media outlets such as Smith + Crown maintain curated lists of historical, current, and future ICO’s.


Summary
​
The ICO model is an innovative form of financing which allows both issuers and investors to have “skin in the game” when it comes to the performance and adoption of a distributed ledger. The model itself is not very different from an equity offering when it comes to execution and incentives, but the asset class doesn’t fit into the categories of equity/debt/commodities, as it’s more of an economic system rather than an traditional asset. Regardless of the inherent risks and volatility, I remain cautiously optimistic concerning the future of ICO’s.

This article was first published on Crowd Valley blog.