ICO or Initial Coin Offering is a device for fundraising in which new projects sell their underlying crypto tokens in exchange for bitcoin and ether.
It is quite similar to an Initial Public Offering or IPO, in which investors buy shares of a company.
ICO is a relatively new phenomenon, but they have quickly become a dominant topic of discussion within the blockchain community and cryptocurrency market.
A lot of people view ICO projects as unregulated securities which allow founders to raise an unjustified amount of capital, while other people argue it is an innovation in the traditional venture-funding model.
The U.S. Securities and Exchange Commission (SEC) has recently decided on the status of tokens issued in the infamous DAO ICO which has forced a lot of projects and cryptocurrency investors to re-examine the funding models of many ICOs.
The most important criteria which should be taken into consideration is whether or not the token passes the Howey test. If it does, it has to be treated as security and is subject to certain restrictions imposed by the SEC.
ICOs are easy to structure as of technologies such as the ERC20 Token Standard, which abstracts a lot of the developing process, necessary to create a new cryptographic asset.
Most of the ICOs work by having investors sending funds (usually bitcoin or ether) to a smart contract which stores the funds and shares a similar value in the new token later on.
There are just a small number of restrictions on who can participate in an ICO, assuming that the token is not, in fact, security.
And, since you are taking money from a global pool of investors, the sums raised in ICOs can be astronomical.
The fact that some of them raise money pre-product is a fundamental issue with ICOs. This will make the investment extremely speculative and risky.
The counter-argument is that this fundraising style is particularly useful to incentivize protocol development.
Before we get into a discussion over the merits of ICOs, it is essential to have some historical context about how the trend begins.
History of ICOs
There are several projects which used a crowdsale model to try to fund their improvement work in 2013. Ripple pre-mined 1 billion XRP tokens, as well as sold them to prepared investors in replacement for fiat currencies or bitcoin. Ethereum raised over $18 million in early 2014, which is also the largest ICO that has ever been completed during that period.
The DAO was the first effort at fundraising for a new token on Ethereum.
It also promised to create a decentralized organization which would fund other blockchain projects, but it was unique in that government decisions would be made by the token holders themselves.
While the DAO was successful regarding raising money – over $150 million – an unknown attacker who was able to drain millions from the organization because of technical vulnerabilities.
The Ethereum Foundation decided that the best course of action was to move forward with a hard fork, permitting them to claw back the stolen funds.
Even though the first try to fund a token securely on the platform of Ethereum failed, the developers on the blockchain realized that by using Ethereum for launching a token would be much easier than just pursuing seed rounds into the typical venture capital model.
Exactly, the ERC20 standard makes it easy for developers to produce their cryptographic tokens on the Ethereal blockchain.
Some also argue that crowdfunding projects might be the “killer application” of Ethereum given the sheer size and frequency of ICOs.
There were never before pre-products startups been able to raise this much money and the little time. Aragon has raised around $25 million in just 15 minutes period, Basic Attention Token which raised $35 million in about 30 seconds and Status. I’m which raised $270 million in a just a few hours.
With just a few controls and such ease of use, this ICO climate has come under investigation from many in the community as well as various regulatory bodies around the world.
Are ICOs legal?
The short answer is maybe. Legally, ICOs have existed in an extremely gray area as arguments can be made both for and against the fact that they are just new, as well as unregulated financial assets.
The SEC’s recent decision, but, has since managed to clear up some of that grey area. In a few cases, the token is just a service token, which means that it gives the owner passage to some specific protocol or network; thus, it may not be classified as the financial security.
But, if the token is an equity token, which means that it is the only purpose is to appreciate in value then it looks a lot more like security.
While a lot of individuals buy tokens to access the underlying platform at some future point in the time, it is difficult to refute the idea that most token purchases are for speculative investment purpose.
This is easy to ascertain given the valuation figures for a lot of projects that have yet to release a commercial product.
The SEC decision may also have provided some clarity to the status of utility vs. security tokens, but there is still plenty of room for testing the boundaries of legalities.
For now, and until further regulatory limits are imposed, the entrepreneurs will continue to take advantage of this new phenomenon.