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What is an Initial Coin Offering?

What is an Initial Coin Offering?

The new controversial method of raising millions in seconds

19th February 2018

The rise of blockchain technology has opened up a wide range of new business opportunities. Among those attractive opportunities includes something called an ‘Initial Coin Offering’ (ICO). In fact, according to recent studies, more than US $3.7 billion have been raised via ICOs by late 2017. Clearly, ICOs present a hot yet also controversial opportunity for raising millions in seconds. But what is an ICO? What are its perks? Why is it controversial? Read below to find out the answers or contact a business lawyer for professional advice on this matter.

What is an ICO?

Before we explain the ICO, it is important to understand ‘blockchain’, so check out our previous article for an easy explanation of blockchain.

In short, an ICO refers to the use of blockchain technology to achieve either one of two purposes:

  • to create a new coin which has its own unique features, or
  • to raise funds for a new project or startup on the blockchain.

First purpose – new crypto coin

The first purpose is straightforward – here, the creator of the ICO creates a new crypto coin which has a unique name and characteristics, and sells that new crypto coin to investors for bitcoins. This explains the name of the ICO – it is the ‘offering’ of a new crypto coin to the public for the first time (‘initial’). Thereafter, just like any crypto coin, the new crypto coin can be exchanged on the blockchain.

Second purpose – fundraising

Meanwhile, the second purpose of ICO is a bit more complex, though it is the one that we (and many investors) are mainly interested in.

In this scenario, the creator of the ICO is usually an entrepreneur on the blockchain who wishes to raise funds for their project or start-up. To do so, the creator creates a ‘white paper’ which outlines the key details of the project or start-up, and distributes the white paper to potential investors. The creator then initiates the ICO campaign during which he or she sells ‘crypto tokens’ to investors (who rely on the white paper to make their decisions) in exchange for crypto coins of the creator’s choice (such as bitcoin, ripple, ethereum, etc). ‘Crypto tokens’ (also known as ‘crypto assets’ and ‘crypto equity’) are similar to company shares in that they confer on the investor some ownership, right or control to the future profits generated by the project/start-up. In addition, the investor may choose to sell crypto tokens for crypto coins in order to make a profit. Going back to the ICO campaign, once the crypto coins raised meet the minimum funding goal required by the creator, only then the creator can use those crypto coins to fund the project or start-up. Otherwise, if the minimum funding goal is not met, the crypto coins are returned to the investors and the ICO is deemed to be unsuccessful.

A useful way to think about ICO is that it is a hybrid between ‘crowdfunding’ and an ‘Initial Public Offering’ (IPO) in the stock market. ICO is similar to an IPO in the sense that it essentially involves investors buying new stakes (i.e. crypto tokens) of a blockchain startup, but without the rules and regulations of a stock market. At the same time, an ICO involves supporters investing in a project much like crowdfunding; however unlike crowdfunding, the investors of an ICO are motivated by prospective returns rather than giving away crypto coins as donations. For these reasons, ICOs by its second purpose are often referred to as ‘crowdsales’.

What are the advantages of ICO?

Many of the advantages of ICO can be attributed to the pro features of the blockchain technology including its transparency, efficiency and the doing away with third party intermediaries. In addition, compared to an IPO, an ICO is easy to set up and investments can be made at a click of a button. This allows for rapid fundraising, helping you achieve your project or start-up goals at a faster pace.

A successful case example would be the smart contract platform, Ethereum. The Ethereum ICO campaign, which started in 2014, raised over $18m in Bitcoins from the sale of ‘Ether’ as its crypto tokens. The Ethereum project soon launched in 2015, and is currently the leading blockchain platform for smart contracts, which are now disrupting today’s business deals and transactions.

What should I be careful of?

Scams

Despite its fast fundraising functions, perhaps the biggest concern with ICO is the absence of regulation. There have been cases of fraudulent ICOs (such as the Tezos and AriseBank) in which the project was never delivered and the funds lost in the ICO could never be recovered. In addition, ICO creators are not obliged to distribute white papers, let alone create accurate and truthful white papers, to investors. Some ICO scammers may also create really high-quality fake websites and fake LinkedIn profiles to make their fraudulent project seem authentic.

Thus, in the light of the serious concerns about ICO scams, in 2017, the Chinese Government banned ICO fundraising, highlighting the serious concerns about ICO scams. In the same year, the Securities and Exchange Commission (SEC) in the United States ruled that “crypto coins” for sale are actually securities—and are subject to the agency’s regulation. Even so, there seems to be limited enforceable rights and remedies for Australian investors in the event of an ICO scam.

Security Issues

Despite the perceived security of the blockchain, there is always a possibility, however small, that an ICO may be hacked. In fact, Ernst and Young estimated that 10% of funds raised by ICOs by late 2017 have been stolen by hackers.

Conclusion

ICO is a fast way to fundraise for your project or start up. However, recent regulation and security issues highlight the high risk for ICO investors. Accordingly, if you want to create or invest in an ICO, it is recommended that you contact a business lawyer who can advise on the benefits and risks of a particular ICO project. Until then, when it comes to ICO, it is caveat emptor.

Need to find a business lawyer? Contact a LawPath consultant on 1800 529 728 to learn more about customising legal documents, obtaining a fixed-fee quote from our lawyer marketplace or any other legal needs.

Author
Ray Sun

Ray is a Legal Intern at Lawpath working with the content team. With an interest in Legal Technology, Contract Law and Equity, Ray is currently completing Bachelor of Laws at the University of Technology Sydney.