Initial Coin Offering (ICO)

What Is an Initial Coin Offering (ICO)?

An initial coin offering (ICO) is the cryptocurrency industry’s equivalent to an initial public offering (IPO). A company looking to raise money to create a new coin, app, or service launches an ICO as a way to raise funds.

Interested investors can buy into the offering and receive a new cryptocurrency token issued by the company. This token may have some utility in using the product or service the company is offering, or it may just represent a stake in the company or project.

How an Initial Coin Offering (ICO) Works

When a cryptocurrency startup wants to raise money through ICO, it usually creates a whitepaper that outlines what the project is about, the need the project will fulfill upon completion, how much money is needed, how many of the virtual tokens the founders will keep, what type of money will be accepted, and how long the ICO campaign will run for. 

During the ICO campaign, enthusiasts and supporters of the project buy some of the project’s tokens with fiat or digital currency. These coins are referred to the buyers as tokens and are similar to shares of a company sold to investors during an IPO.

If the money raised does not meet the minimum funds required by the firm, the money may be returned to the backers; at this point, the ICO would be deemed unsuccessful. If the funding requirements are met within the specified timeframe, the money raised is used to pursue the goals of the project.

SEC's Role

Although ICOs aren’t regulated, the Securities and Exchange Commission (SEC) can intervene. For example, the maker of Telegram raised $1.7 billion in an ICO in 2018 and 2019, but the SEC filed an emergency action and obtained a temporary restraining order due to alleged illegal activity on the part of the development team. In March 2020, the U.S. District Court for the Southern District of New York issued a preliminary injunction, and Telegram had to return $1.2 billion to investors and pay a civil penalty of $18.5 million.

Special Considerations 

Investors looking to buy into ICOs should first familiarize themselves with the cryptocurrency space more broadly. In the case of most ICOs, investors must purchase tokens with pre-existing cryptocurrencies. This means that an ICO investor will need to already have a cryptocurrency wallet set up for a currency like bitcoin or ethereum, as well as having a wallet capable of holding whichever token or currency they want to purchase. 

How does one go about finding ICOs in which to participate? There is no recipe for staying abreast of the latest ICOs. The best thing that an interested investor can do is read up about new projects online. ICOs generate a substantial amount of hype, and there are numerous places online in which investors gather to discuss new opportunities. There are dedicated sites that aggregate ICOs, allowing investors to discover new ICOs and compare different offerings against one another.

Initial Coin Offering (ICO) vs. Initial Public Offering (IPO)

For traditional companies, there are a few ways of going about raising the funds necessary for development and expansion. A company can start small and grow as its profits allow, remaining beholden only to company owners. However, this also means they may have to wait a long time for funds to build up. Alternately, companies can look to outside investors for early support, providing them a quick influx of cash — but typically coming with the trade-off of giving away a portion of ownership stake. Another method is to go public, earning funds from individual investors by selling shares through an IPO.

While IPOs deal purely with investors, ICOs may deal with supporters that are keen to invest in a new project, much like a crowdfunding event. But ICOs differ from crowdfunding in that the backers of ICOs are motivated by a prospective return on their investments while the funds raised in crowdfunding campaigns are basically donations. For these reasons, ICOs are referred to as “crowdsales.”

ICOs also retain at least two important structural differences from IPOs. First, ICOs are largely unregulated, meaning that government organizations like the Securities and Exchange Commission (SEC) do not oversee them. Secondly, due to their decentralization and lack of regulation, ICOs are much freer in terms of structure than IPOs.

ICOs can be structured in a variety of ways. In some cases, a company sets a specific goal or limit for its funding, which means that each token sold in the ICO has a pre-set price and that the total token supply is static. In other cases, there is a static supply of ICO tokens but a dynamic funding goal — this means that the distribution of tokens to investors will be dependent upon the funds received (i.e. the more total funds received in the ICO, the higher the overall token price). 

Still, others have a dynamic token supply which is determined according to the amount of funding received. In these cases, the price of a token is static, but there is no limit to the number of total tokens (save for parameters like ICO length). These different types of ICOs are illustrated below.

Image by Sabrina Jiang © Investopedia 2020

Advantages and Disadvantages of Initial Coin Offerings

In an IPO, an investor receives shares of stock in a company in exchange for her investment. In the case of an ICO, there are no shares per se. Instead, companies raising funds via ICO provide a blockchain equivalent to a share — a cryptocurrency token. In most cases, investors pay in a popular existing token — like bitcoin or ethereum — and receive a commensurate number of new tokens in exchange.

It's worth noting just how easy it is for a company to launch an ICO to create tokens. There are online services that allow for the generation of cryptocurrency tokens in a matter of seconds. Investors should keep this in mind when considering the differences between shares and tokens — a token does not have any intrinsic value or legal guarantees. ICO managers generate tokens according to the terms of the ICO, receive them, and then distribute them according to their plan by transferring them to individual investors.

Early investors in an ICO operation are usually motivated to buy tokens in the hope that the plan will succeed after it launches. If this actually happens, the value of the tokens they purchased during the ICO will climb above the price set during the ICO itself, and they will achieve overall gains. This is the primary benefit of an ICO: the potential for very high returns.

ICOs have indeed made many investors into millionaires. For example, in 2017, there were 435 successful ICOs, each raising an average of $12.7 million. So, the total amount raised for 2017 was $5.6 billion, with the 10 largest projects raising 25% of this total. Furthermore, tokens purchased in ICOs returned an average of 12.8 times on the initial investment in dollar terms.

As ICOs have come to the forefront in the cryptocurrency and blockchain industries, they’ve also brought along challenges, risks, and unforeseen opportunities. Many investors buy into ICOs in the hopes of quick and powerful returns on their investments. The most successful ICOs over the past several years are the source of this hope, as they have indeed produced tremendous returns. This investor enthusiasm can also lead people astray, however. 

Because they are largely unregulated, ICOs are rife with fraud and scam artists looking to prey on overzealous and poorly informed investors. And since they are not regulated by financial authorities like the SEC, funds that are lost due to fraud or incompetence may never be recovered.

The meteoric rise of ICOs during 2017 drew backlashes from a series of governmental and non-governmental entities in early September 2017. The People's Bank of China officially banned ICOs, slamming them as counterproductive to economic and financial stability. 

The Chinese central bank prohibited using tokens as currency and banned banks from offering services related to ICOs. As a result, both bitcoin and ethereum prices tumbled, in what many regarded as a sign of more cryptocurrency regulation to come. The ban also penalized already completed offerings. In early 2018, Facebook, Twitter, and Google all banned ICO advertisements.

There is no guarantee that an investor won't be on the losing end of a scam when investing in ICOs. To help avoid ICO scams, investors should:

1. Make sure that project developers can clearly define what their goals are. Successful ICOs typically have straightforward, understandable whitepapers with clear, concise goals.
2. Know the developers. Investors should strive for 100% transparency from a company launching an ICO.
3. Look for legal terms and conditions set for the ICO. Because outside regulators generally do not oversee this space, it is up to an investor to ensure any ICO is legitimate.
4. Make sure that ICO funds are being stored in an escrow wallet. This is a wallet that requires multiple keys in order to be accessed. This is useful protection against scams, particularly when a neutral third party is a holder of one of the keys.

SEC Introduces the HoweyCoin

ICO activity began to decrease dramatically in 2019 because of the legal gray area they inhabit.

The U.S. Securities and Exchange Commission introduced a fake coin called the HoweyCoin to demonstrate to small investors the dangers of ICOs. The HoweyCoin is named after the Howey Test, which is a test to determine whether an investment is a security or not. The Howey Test is intended to determine that a transaction represents an investment contract if a person invests their money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.

The SEC used this standard to charge Kik, a messaging service that raised $100 million in an unregistered ICO, with unlawful sale of a security. The SEC has also taken action against Telegram, another messaging app that also ICO'ed.

According to the SEC, an ICO is no different from an IPO if the underlying token raises money for an already existing business and does not operate independently of that business.

Example of an Initial Coin Offering

As the ICO space got bigger and bigger, so too did the sums raised by the largest projects. When evaluating ICOs, one can consider both the amount of money raised in the ICO as well as the return on investment.

Sometimes ICOs with a remarkable return on investment are not the projects that raise the most money and vice versa. Ethereum's ICO in 2014 was an early pioneer, raising $18 million over a period of 42 days. Ethereum has proven to be crucial for the ICO space in general, thanks to its innovations with regard to decentralized apps (dApps). When it debuted, ether was priced at around $0.67, and as of Sept. 24, 2020, it trades at $348.99.

In 2015, a two-phase ICO began for a company called Antshares, which later rebranded as NEO. The first phase of the ICO ended in October 2015, and the second continued until September 2016. During this time, NEO earned about $4.5 million. While it is not one of the largest ICOs in terms of money raised, it has provided exceptional ROI for many early investors. The price of NEO at the time of the ICO was about $0.03, and at its peak, it traded at roughly $187.40. 

More recently, ICOs have generated significantly larger amounts in terms of total funds raised. During a one-month ICO ending in March 2018, Dragon Coin managed to raise about $320 million. More recently, the company behind the EOS platform shattered Dragon Coin’s record by raising a whopping $4 billion during a year-long ICO. 

Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.