Welcome to Chapter 3 of Initial Coin Offerings 101: The Risks of an ICO. In this chapter we’ll break down the various issues and risks of an ICO that you need be mindful of.
Risks of an ICO
ICOs may sound like IPOs (initial public offerings). IPOs are fully regulated and compliant creation and distribution of shares in a public company. ICOs… well, no!
Remember that ICOs:
- are not necessarily enforced to be compliant,
- they are not regulated,
- don’t necessarily represent ownership or any stake in the company
- don’t pay dividends (some do provide earnings of another cryptocurrency/altcoin)
Note how Investopedia.com describes ICOs:
“An unregulated means by which funds are raised for a new cryptocurrency venture.
An Initial Coin Offering (ICO) is used by startups to bypass the rigorous and regulated capital-raising process required by venture capitalists or banks… “- Investopedia.com
Here’s what another popular website in the crowdfunding space describes and ICO:
“Lots of folks working in the blockchain world needed money to fund their project or startup. So they decided to invent their own “coin” variant and sold those coins to fund their project/startup, in exchange for some financial upside in the project.“
Lack of regulation
So one of the biggest issues lies in what some consider the biggest benefit to cryptocurrencies– no regulation. The unregulated environment does represent a great risk though. This risk is not just to institutes and governments, but to individuals as well.
Although a deregulated environment may have significant befits for the public, it also creates a higher risk environment. It also creates extreme uncertainty, and leaves more room open for fraud. This statement is backed up by one of the biggest issues that exist in the ICO space currently: scams.
What happens when regulation does not exist:
- Lack of transparency– without information being audited how do investors rely on the accuracy of information. How do they know that it is complete and true?
- Higher risk– what is stopping the entity from jumping ship? What is stopping the people behind the ICO from taking your money and running?
- Easier to conduct scams and fraud – is the underlying product or service legitimate? Do the founders even plan on rolling out the road map or is it just a scam? Who will verify and audit the entity behind the ICO?
- No help– no regulation means no central body specifically for cryptocurrency if you do need help.
As the technology develops further and adoption rates increase, ICOs will continue to under the spotlight for investigation. Hopefully this leads to a mutual balance where enough regulation exists to protect investors and users from scams while increasing innovation.
It will be important for regulators to keep enough flexibility in the system to allows startups and new projects to flourish without stringent bureaucratic exercises and laws that choke innovation.
The price of an ICO can really depend on the hype surrounding the ICO or the underlying token itself. Without genuine information dripping through, most of the hype can be based on false parameters or rumours. This is extremely dangerous as it increases the risks associated with an ICO.
The worst case scenarios include the token is either a scam, doesn’t really provide any real world benefits, or has a flawed business model. As seen recently it is very easy to create this hype.
The hype may also be based on actual facts. The coin may not be a scam, it may provide real world benefits, and it may be based on a solid business model. But as described above the lack of transparency and lack of audit requirements make it hard to verify any of this information.
So what happens when there is hype? As soon as it does happen, it generally overvalues the coin rapidly. The price shoots up dramatically. In return, this creates more curiosity and therefore further increasing the hype. Then more investors get on board.
The person(s) behind the hype then dump the coins at the high price. This creates instability in the market. The coins flood back into the market causing the price to drop back down.
The price drop happens fairly quick and most of the investors do end up buying high while selling low. These late stage investors usually end up losing significant amount of money because of this.
As the token or cryptocurrency is based on an idea generally, who is willing to wait for this idea till it fruits? There are generally too many risks associated with it. Most startups fail within the first year. Majority of the startups that survive the first year, end up failing in year two. This fact is no different for startups operating in the blockchain tech world.
ICOs can generally be over capitalised. How is that possible you ask? Well it’s easy.
The founders decides what amount they are looking to raise. They also decide on the number of coins to issue. The founder would be looking to get as much money into the pocket as possible. On top of this the ICO participants are also usually motivated by a profit potential if the project takes off and the tokens exceed the ICO price.
As seen in the recent ICOs, the initial number is almost arbitrary, could just be picked out of thin air. The whole ICO can be designed to meet the specific limits and parameters.
Say the founder decides to release 100,000,000 coins, each priced at 0.1ETH. That would give the project a market cap of 10,000,000ETH. This would clearly mean the the founders are over reaching with their capital goals. Especially if the project has no substantial product, market fit, or MVP at the least.
Assuming one year down the track, the project does take off, it has paying customers, and the business is growing. Is it still realistic for it to be 10,000,000ETH, should it increase? Realistically it should, but how much further can it really go when it’s already valued so high.
The above is obviously an exaggerated example. But it does represent what is currently happening in the crypto-sphere. In a real world scenario though the value of the coin in the example would drop instantly after the ICO. The market is what determines the price of the ETH.
What is it?
The token it self can represent almost anything. The biggest danger is if it is released as a non-security but turns out that it is .
“Selling unregistered securities without an exemption is considered a Section 5 violation of the Securities Act of 1933. It could result in either civil or administrative suits, in which the SEC could ask the courts for a section or remedy.
If the sale of securities is still happening, they might ask for an injunction to make you stop whatever it is that you’re doing, and could force you to undergo audits, accounting for frauds, or special supervisory arrangements.”- Source
Whether an attempt is made on purpose to hide the token as a security or whether it is done by accident. The risk of an ICO in this case can have serious consequences for the founder and therefore the holders of the token.
Regardless of if it is considered a security or not, the token can represent other things too. Remember, Ethereum allows someone to create:
“…a tradeable digital token that can be used as a currency, a representation of an asset, a virtual share, a proof of membership or anything at all.”- Source: Ethereum.org
So it’s important to read the fine print, the white paper, and any other materials available to judge what the token represents. This text can be found of on ICO regarding their tokens that:
“… do not have any rights, uses, purpose, attributes, functionalities or features, express or implied, including, without limitation, any uses, purpose, attributes, functionalities or features …”
In this case then you’d need to question, if the the token does not imply any of the above, then what is its use and does it have any real value?
The Benefits of an ICO
We went through the benefits in Chapter 1: What is an ICO. As discovered there, for the founder, the ICO offers great opportunities.
ICOs (Initial Coin Offerings) have become a popular way to fund cryptocurrency projects as they provide a way for the founders to raise money very quickly and efficiently for their projects.
The ICO usually takes place before the project is completed. It helps fund the expenses undertaken by the founding team until launch. For some of the larger projects, part of the ICO money goes into a foundation that provides ongoing support to the project. They also work as an initial distribution model for the cryptocurrency tokens.
Should I invest in an ICO?
So let’s take a look at if you should invest in an ICO and how you’d go about investing in one. If you do decide to invest in one, then what to look for in one.
Next Chapter: Should I Invest in an ICO
Previous Chapter: How does an ICO work?