Why are ICOs a growing asset class? What are the risks and opportunities associated with them?
An Initial Coin Offering (ICO) is a type of crowdfunding using cryptocurrencies. Hence, the company or project that wants to raise money is issuing a so-called coin or token, which might represent a security, unit of account or a voucher. When an investor is investing into an ICO, he is in turn receiving the token, which is a virtual asset.
Leaving true cryptocurrencies, that serve as a general mean of payment, aside, one usually differentiates between so-called utility token and security token. Security token are all those coins that represent a true share in the company’s cash-flows, whether through equity, debt or mezzanine capital. Utility tokens provide users with future access to a product or service, hence work like vouchers.
The value of the token is derived twofold. At first, the value might be equal to the fundamental or inherent value. For a security token, this might be the true share of the cash-flows that the investors receive when owning the coin. For a utility token, this might be equal to the value of the service that the investors can buy using the token. However, as most tokens are traded on one or multiple marketplaces, the current value of a token might strongly deviate from this inherent value due to demand and supply. Hence, those virtual assets are also used for trading and speculation.
On the other side, the company issuing the token is usually in a very early stage. Often, those company´s neither have a product nor customers or revenues. The documentation that comes with an ICO and the investor information materials can mostly be described as letters of intent, describing the product or service that shall be offered sometimes in the future. Hence, while there are a few examples to show the opposite such as Kodak or Telegram, ICO´s are typically a way of funding a pre-seed company or project.
This might partially explain the recent rise in ICO funding. While start-up funding was so far an asset class that was only available to high net-worth individuals, family offices, venture capital funds or institutional investors, ICOs are opening this asset class for retail investors. Thereby, investments in start-ups are often associated with phenomenal returns, marked by examples such as Amazon, Google, Facebook, etc. ICOs also allow investors to take part in the development of a base technology of the future. This leads to a further increase in the mid- to long-term return potential of ICO-investments. Last, it must not be forgotten that there is currently a hype around blockchain and ICOs that might create peer pressure or a Fear Of Missing Out. Do you really want to miss this opportunity if all your friends are talking about the returns they made investing in cryptos?
For the companies doing an ICO, it seems to be an easier way of gaining funding than the traditional route. The current hype around ICOs makes it comparably easy to attract funding via an ICO. Moreover, as long as the company does not issue a security, less documentation is needed and the company might be able to gain user- and investor-attention at the same time. Even for issuing securities, ICOs might be a more efficient way to gain funding than the traditional ways of issuing securities. Doing an ICO, the company cuts the middle-man as there are currently almost no market-maker involved in the preparation of an ICO. Hence, while a typical IPO costs between 10% - 20% of the money raised, it seems to be possible to raise money via an ICO at a cost of 3% - 5% of the money raised. These higher net proceeds make ICOs more efficient for both, the company and the investors who want to fund a company, not the investment banks involved.
However, while there are several opportunities associated with ICOs, such as the social status, peer pressure, being “in” on the current trend topic and potentially high returns, there are also downsides to be taken into account.
First, ICOs often take part in an unregulated fashion, especially when the company is issuing a utility token. This can lead to scams, where people raise money and run away with it afterwards, such that the entire investment is lost. While this is a criminal behaviour, ICOs are also risky when every party is behaving lawful.
Companies that raise too much money too early often have a moral hazard problem due to information asymmetries. Hence, when the management suddenly has sufficient capital available to fund their company or project, why should they undergo the risky investment into the project instead of paying out the proceeds of the ICO to them as salary over time? While in the standard finance literature, the management would be motivated by the need to raise funding at a later stage, this is reasoning is not valid when the entire funding is raised before the project even starts.
Moreover, there is also the risk that the project or product does not take off. There might just be a lack in the product-market fit. While even experienced early-stage investors are happy when less than 90% of their investments fail, this might be even more true for ICOs as the funding is provided at a much earlier stage and with less due diligence. Overall, ICOs are a high-risk investment and everybody investing into ICOs should be prepared to lose part or all of their investment.
Finally, there is also a regulatory risk as all governments and regulators recently began to observe and regulate ICOs more closely, which might also lead to a shut-down of some companies. This seems to be especially true if the company is violating investor protection rights or invites investors to money laundering and tax evasion.
To alleviate these concerns, it seems to be necessary to establish central services that review the quality of the ICO projects and of the investors. While reviewing the ICO projects to assure that the incentives of the management are aligned with the investor incentives is fairly tricks, a governance index might at least lead to some assurance of good management practices. This governance index could, for example, check that certain escrow accounts are in place such that a scam is almost impossible. Going further, it could also include that the money can only be withdrawn if certain predefined milestones are reached by the start-up.
On the other side, ensuring that the investors are serious investors already starts by having mandatory KYC/ AML – procedures to check the investor identity and the origin of their funds. Moreover, investors, as well as projects, could be rated within a closed platform or using the blockchain.
One project that aims at providing such services to the ICO-community is HELIX Orange. HELIX Orange is an ICO platform for investors and ICO projects built on Blockchain Technology. The platform establishes an ecosystem for international investors and global ICO projects to make ICOs and token sales safe, smart and efficient. Both sides, investors and ICO projects benefit from proper KYC/ AML and from sophisticated investor matchmaking processes. The platform is thereby targeting the need to fulfil the regulatory requirements for any ICO. HELIX Orange reviews the relationship of ICO projects and relevant investors, providing a clear and transparent audit trail for regulatory authorities and thus increasing legal certainty for all parties.
Intro Max:
Maximilian is a finance expert with a strong tech & legal background. While studying at the Frankfurt School and University of Oxford, Maximilian has been working for different funds and investment banks.
Besides his current role as co-founder of the LitigationCoin project, Maximilian is also an advisor for HELIX Orange.
Disclaimer:
There might be a conflict of interest, as the author of this article is also advising HELIX Orange. Moreover, the author might be invested into the project himself. This article is not meant and shall not be used as an investment advice, but shall only reflect the personal opinion of the author. Everybody who is interested in investing in one of the aforementioned projects or any other projects should undertake his or her own effort in investigating the respective project. Investments in Initial Coin Offerings are very risky and there is a high chance of losing part of or the entire investment.
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