Initial coin offerings
Lesson in Course: Crypto (beginner, 9min)
What is an ICO and what do we need to know?
What it's about: Initial coin offerings are an opportunity to invest at the forefront of crypto.
Why it's important: Most of the organizations raising money through ICOs are going to fail.
Key takeaway: ICOs are extremely risky. Use caution and only invest with a complete understanding of what we're buying.
A large part of Ethereum's appeal is the ability for users around to world to create decentralized financial apps, or DApps, on the Ethereum blockchain. Software programmers worldwide band together to form decentralized autonomous organizations (DAOs) to develop new financial services. DAOs can create applications with their own assets on-chain, which can be stored and transferred like ether.
These assets are called tokens, and they must follow strict technical standards set by ERC-20. To start many DeFi projects, the DAOs raise money using an ICO to hire and pay for development expenses. When new tokens are created, many are sold to the public through initial coin offerings. For example, EOS raised $4 billion in a year-long ICO in 2019!
Are the crypto equivalent of IPOs. A company looking to raise money to create a new coin, app, or service launches an ICO to raise money by issuing cryptocurrency tokens to investors.
Ethereum was funded initially through an ICO in 2014. Buyers received ether in exchange for bitcoin. More than 7 million ether were sold in the first 12 hours for 3,700 BTCs, worth approximately $2.3 million at the time.
In an attempt to protect our money, regulators enforced new laws requiring descriptions for these tokens. Now a token can be either a utility token or a security token.
Utility Tokens
Many DAOs categorize their coin offerings as utility tokens because it allows them to bypass regulations.
However, utility tokens are inherently riskier because scammers often use ICOs to take our money and disappear. Additionally, utility tokens' value is speculative and entirely based on supply and demand.
A cryptocurrency that represents access to a service and can also function as a medium of exchange (currency) within an ecosystem
As lawmakers are starting to put the screws to these offerings, very few utility tokens pass the Howey Test - more on that below.
Security Tokens
When a company issues security tokens in an ICO, they grant the investor ownership rights and dividends.
From a legal standpoint, security tokens are identical to shares in the company. However, these tokens are less risky since they need to adhere to a set of compliance laws, and the value of these tokens is tied back to the value of the company/organization.
A cryptocurrency that represents financial assets and is regulated as such
Howey Test
Tokens that pass the Howey Test are categorized as security tokens, while those that fail are classified as utility tokens.
Four criteria established by the Supreme Court to determine if a token is a security.
- An investment of money
- In a common enterprise
- With the expectation of profit
- To be derived from the efforts of others
Actionable Ideas
As ICOs are becoming more regulated, helping boost confidence if you are interested in participating. However, this doesn't mean you are safe to let your guards down.
To help avoid ICO scams, you can go through the following checklist:
- Make sure that project developers can clearly define what their goals are. Successful ICOs typically have understandable whitepapers with clear and concise goals.
- Know the developers. You should strive for 100% transparency from a company launching an ICO.
- Look for legal terms and conditions set for the ICO. Because outside regulators generally do not oversee this space, it's up to you to ensure any ICO is legitimate.
- Make sure that ICO funds are stored in an escrow wallet. This is a wallet that requires multiple keys to be accessed. This provides valuable protection against scams because a neutral third party holds one of the keys.
Supplementary materials
Glossary
Are the crypto equivalent of IPOs. A company looking to raise money to create a new coin, app, or service launches an ICO to raise money by issuing cryptocurrency tokens to investors.
Represent access to a service and can also function as a medium of exchange within an ecosystem.
Many DAOs categorize their coin offerings as utility tokens as it allows them to bypass regulations. Utility tokens are inherently riskier because scammers can end up taking our money and disappearing. Additionally, utility tokens' value is speculative and is entirely based on supply and demand.
Represent financial assets and are regulated as such.
When a company issues security tokens in an ICO, they grant the investor ownership rights and dividends. From a legal standpoint, security tokens are identical to shares in the company. These tokens are less risky since they need to adhere to a set of compliance, and the value of these tokens is tied back to the value of the company/organization.
Four criteria established by the Supreme Court to determine if a token is a security.
- An investment of money
- In a common enterprise
- With the expectation of profit
- To be derived from the efforts of others