It’s undeniable that bitcoin and other cryptocurrencies have been turning the financial world on its head in recent years. These decentralized digital currencies are unlike fiat currencies in that they do not rely on a central bank or another major financial institute for their production and credibility, instead making use of a technology known as blockchains to keep track of transactions via a public ledger. Given how unorthodox the entire world of cryptocurrency use and investment already is, it should come as no surprise that those startups tasked with creating new cryptocurrencies are also using some fairly unorthodox methods to raise venture capital. One method that has been swiftly growing in popularity despite regulatory concerns is known as an Initial Coin Offering, or an ICO.
What is an ICO?
An ICO is a largely unregulated method for raising venture capital to get new cryptocurrencies off the ground. It allows startups to bypass the highly regulated alternative of capital-raising through venture capitalists and banks. Instead, an ICO campaign sells a percentage of its future cryptocurrency, known as a token, to early backers in return for either fiat cash or another established cryptocurrency.
The ICO Process
When a firm decides it wants to raise funds via an ICO, its first step is to create a project plan known in the industry as a whitepaper. This document describes what, exactly, the project is about, including how much money will be required to complete it, how many of the new digital tokens will be kept by the project’s pioneers themselves and its initial backers, and how long the ICO campaign is intended to be run. A firm’s whitepaper also lays out what needs their project is intended to fulfill once it is completed and what type of money they will accept in exchange for percentages of its cryptocurrency. If the firm manages to meet its minimum requirements for getting the project off the ground within the time frame specified in its whitepaper, it will then use its backers’ money to initiate or complete the creation of a new cryptocurrency.
Advantages Over Traditional IPOs
Some financial experts cite this process as being similar to that of a more traditional Initial Public Offering, or IPO, transaction; however, this new means of acquiring venture capital is still largely unregulated, making it potentially riskier than an IPO, which trades shares of the company rather than tokens. That’s not the only difference between ICOs and IPOs, though. IPOs are designed specifically with venture capitalists and large-scale investors in mind, while ICOs are open to anyone and tend to draw in small-scale enthusiastic backers rather than major players within the investment world.
Unlike the venture capitalists investing in IPOs, those who choose to purchase ICO tokens are not offered partial ownership of either the project or its parent company. They do, however, still stand to reap substantial benefits in the event that the cryptocurrency is successfully adopted within the larger marketplace.
Risks of ICOs
While investing in ICOs can be quite lucrative for those who choose their cryptocurrency startups wisely, the process is certainly not without its risks. Many enthusiastic investors are unaware that the development of ICOs as an investment strategy is still in its infancy, so they will not have the same protections as venture capitalists do when they invest in more traditional IPO shares. In fact, even the blockchain technology itself that lies at the base of all new cryptocurrencies is still in development, which has the potential to leave investors vulnerable to both unanticipated code errors and intentional theft by hackers.
Digital theft isn’t the only thing investors should be worried about, though; ICOs themselves are, as they currently stand, an ideal platform for fraudsters looking to prey on enthusiastic but ultimately ignorant investors. Unfortunately, even legitimate ICO providers are often less than transparent in offering information to potential investors, making it even more difficult for them to distinguish legitimate startups from fraudulent projects. When combined with the fact that tokens are exchanged on specialized trading platforms that are not currently subject to financial supervision, it should be clear that ICO investors face substantial risks even in the event that they choose to invest in a legitimate startup.
The fact that ICOs, as they currently stand in their largely unregulated state, offer a perfect opportunity for those looking to defraud investors has played a large role in some countries’ decisions to ban this practice entirely. China and South Korea have both unequivocally banned the use of ICOs for raising capital and have required those companies that have already completed their funding cycles to refund any fiat currency or cryptocurrency altcoins invested.
Other major players in the international business world, such as Japan, Singapore, Hong Kong, Australia, the United States, and the European Union, are tentatively allowing the use of ICOs despite their risks and are beginning to implement market regulations such as licensing, consumer protections, and designation of altcoins as a security rather than a currency.
The Future of ICOs
While critics, including many financial experts and government officials alike, say that ICOs constitute a serious risk to investors and should not be trusted, there are still plenty of proponents of this investment strategy who believe that ICOs are the wave of the future, but only if companies and investors start focusing on blockchain technologies rather than the cryptocurrencies themselves. Given that ICOs are both more cost-efficient and more time-efficient than traditional IPOs, and that they make global investment strategies much more feasible for a larger number of companies, they still constitute a practical means of raising venture capital for startups using blockchain technologies.
While ICOs currently constitute an extremely high-risk investment due to their current lack of regulation, their future as a feasible method for gaining venture capital still looks bright. Potential investors should be hesitant to jump on the bandwagon today but should keep an eye out for regulatory and market changes that may make ICO investment a far more reliable strategy for moving forward with blockchain technologies in the future.
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Cathy Berger is a member of the editorial staff at docurex.com