An initial coin offering, or ICO, is an event held by blockchain-based enterprises to raise capital and distribute tokens. They are similar to IPOs, or initial public offerings, in the equity market, with several notable differences.
The digital coins or tokens sold during an initial coin offering are the currency of the microeconomy that operates on each platform. They are a form of cryptocurrency but have a more limited use case than virtual currencies like Bitcoin.
ICOs are like a cross between an IPO and a crowdfunding exercise. While tokens are sold to investors, many of the investors are also potential users of the product or supporters of the initiative.
Who conducts ICOs?
In many cases, the term ICO is also used to describe an enterprise that runs on a blockchain or distributed ledger. This has come about because these platforms are not companies in the traditional sense, and there isn’t really another term to describe them, besides perhaps DAOs or Distributed Autonomous Organisations.
DAOs are enterprises that exist entirely on blockchains without a traditional management structure and shareholders. Instead, a token or digital coin is used to both buy and sell goods and services and to power the blockchain.
It’s easiest to describe such an enterprise is by way of an example. Let’s imagine a group of developers decide to create a video sharing platform like YouTube, but operating on a blockchain with a microeconomy powered by a token.
The advantage for content creators will be that they will own their content, and they will be able to monetize it in any way they want.
They can sell space to advertisers, they can sell subscriptions, or they could rely on tips from viewers. Subscribers and advertisers will both need to buy tokens to pay content creators. As more people use the platform, the value of the limited token supply will increase.
How do ICOs work?
Before an enterprise gets to the stage where it can conduct an ICO, it will usually be funded by venture capital funds. These funds, along with the founders of the project will reserve a certain percentage of the tokens for themselves. The remaining tokens will be sold to the public to raise the capital required to get the project to the point where it is self-sustaining.
For the example of the video-sharing platform, let’s say $5 million is required to get the project to the ICO stage. This capital allows the developers to build a blockchain for the token economy. However, they will need another $20 million to build the final platform and keep it running for three years. After that, they think it will be self-sustaining. A small transaction fee will be levied to maintain the platform, but for the most part, the users themselves will keep the ecosystem going.
The founders decided to create 100 million tokens, of which 20 million will be allocated to themselves, and 15 million will be given to the investors who provided the initial $5 million. Another 15 million tokens will be reserved for potential partners and to promote the platform. This leaves 50 million tokens to be sold to the public to raise the additional $20 million. The tokens will, therefore, be sold for $0.40 each.
Potential investors first need to register on the platform and create a wallet. They can then buy tokens using fiat currency or other cryptocurrencies. Once all the tokens have been sold, they are distributed to investor’s wallets.
Once the platform is operational, tokens can be used to access content or to pay for advertising. Tokens can also be bought and sold on cryptocurrency exchanges.
ICOs vs. IPOs
ICO’s raise capital by selling tokens or digital coins. These tokens will be required to transact on the platform. The rationale is that because the token supply is limited, the value of each token will appreciate as more people use the platform. Tokens do not, however, give the holder equity in the platform, and token holders have no claim on the assets or profits of the platform.
By contrast, an IPO in the equity market results in shares in the company being sold to investors. Each share gives the holder an equal claim on the assets on the company, as well as when dividends are paid out.
A company holds an IPO when it becomes publicly listed, and shares can immediately be traded on the stock exchange where it lists. ICOs do not guarantee that a token will be listed on an exchange—this is something that usually happens later.
ICOs are typically held before a platform is operational. This differs from IPOs which are usually held when a company is already operational, if not profitable. ICOs are therefore riskier as the concept has yet to be proved. In many cases, a company will have to have at least three years of financial statements before it can list on an exchange.
The first ICO was held in 2014 and ICOs quickly grew in popularity. By 2017, over 1000 ICOs had already been held. This was when regulators began to pay attention. It was determined in some of the significant jurisdictions that some ICOs violated securities laws. In cases where tokens were found to be securities, they needed to be registered as such.
To comply with securities laws, many platforms now hold IEOs (Initial Exchange Offerings) or STOs (Security Token Offerings). These events are similar to an ICO but are better structured to comply with regulations.