Initial Coin Offering (ICO) is the latest fad for startup fundraising. In 2017 alone, there have been 201 ICOs that collectively raised over $3 billion, according to Coinschedule. Even a blind investment in ICO can fetch a 1,320 percent return. The unprecedented high returns and major “FOMO” among investors have instilled an instantaneous fear of a bubble. But it is not stopping institutional investors and hedge funds from dipping their toes in ICOs, bringing risk into the system. This contradicts the very creation of bitcoin as “an act of defiance” to the aftermath of the 2007 recession. ICOs are selling participation and speculation in a crypto economy. But are the token buyers facing the wolves of coin-street? The answer may not be that simple.
It is very difficult to do a market valuation of cryptocurrency through traditional analysis. Instead, investors have to rely on crypto market demand signals speculating transactional valuation methods. The price dynamic is basic market supply and demand controlled by network effects — that is, the more we buy tokens and the more we talk about it on social media, the greater the demand for them. In an ICO, startups set up token values on their own. The shareholders (mostly founding developers) keep roughly 10-20 percent of the initial tokens on a vesting schedule. It will be interesting to see post-ICO if these shareholders have enough incentives to put their hard work and sweat into building a company of distributed value. It’s like giving millions of dollars to your toddlers and asking them to study hard in school. Being a cash-rich startup does not ensure product success.
Most of these startups set up a foundation in a tax haven like Switzerland, and it is uncertain how these foundations oversee the startups. The non-profit Swiss foundation model was pioneered by the Ethereum foundation, whose initial funding in 2014 may have shaped the ICO model. The ability to attribute customized enforcement between parties in the blockchain has led a “legions of developers” to create smart contracts for ICOs. These tokens are then exchanged in a secondary market for immediate or liquid value by the retail investors.
“A token buyer participating in an ICO must take extreme caution.”
“This frequently acts as a near-scam; the startup sells its ICO coin to a bunch of qualified investors at a discounted rate, and then they sell the tokens at a higher price to people who couldn’t get in on the discounted sale. The ICO token buyers own it for about an hour, they get a nice markup with a nearly guaranteed profit; and the secondary-market buyers get dubious value for their money,” Ray Dillinger, who audited Satoshi Nakamoto’s white paper on bitcoin, wrote to me about his concern on ICOs. It is a way to make quick money without understanding the fundamental risks or the smart technology.
A token buyer participating in an ICO must take extreme caution and take measures such as moving your current crypto coins (BTC or ether, that you will use to buy the ICO token) to a wallet you control. It’s also important to store post-ICO tokens in a cold-storage paper wallet to save them from scouring hackers. On the other hand, startups need to make sure their ICO token issuing address is not susceptible to hacking. It’s just like buying from an online store that is already hacked. Now if you complain to your bank, they may identify you as a customer and look into your account, but the startups issuing ICOs cannot. Token issuers cannot identify whether two distinct purchasing addresses belong to same person. Most of the ICO tokens are issued without anti-money laundering compliances. Such an unsustainable position pushes regulations to move against anonymous crowd sales to prevent scams. “Merchants must be wary of their customers, hassling them for more information than they would otherwise need,” Nakamoto wrote in his legendary bitcoin whitepaper.
While ICOs are not currently regulated by the U.S. Securities and Exchange Commission, the agency has opened a new cyber unit for cryptocurrency violations. The problem is that it is not illegal to offer ICOs non-compliant with crowd funding regulations or federal securities law. To understand the legality of this token euphoria, one needs to understand the different types of tokens floating in the market. Beside the currencies like bitcoin and ether, there are security tokens that offer dividends, interests, and profit. Tokens that are issued in compliance with SAFT (Simple Agreement for Future Tokens) are securities. Most tokens are sold only to accredited investors and are exempted from SEC registration, but one can qualify under Regulation A+, a section of the JOBS Act that “allows companies that want to raise between $3 million and $50 million to do so from anyone.” There are also utility tokens that are issued to customers to finance future services rendered by startups on a fully developed commercial platform. But there are grey areas, these services are not fully developed yet and treating the token as a unit of service now is a speculative investment. There are also concept tokens backing illiquid assets like real estate, gold, and intellectual property. Ethereum has drafted an ERC20 tradeable umbrella standard to empower token functionalities.
“The possibility of trading your extra cloud storage or the unused solar energy from your power grid in exchange for crypto tokens is closer to reality.”
The current speculation, skepticism and fanfare over cryptocurrencies is reminiscent to what was happening with computers in the 70s and the internet in the 90s. Entrepreneurs create disequilibrium in the active market and push new profitable technologies, creating new market behavior that did not exist before. The ingenuity of open source blockchain, with features like interoperability and adoption incentive structure, has prompted startups to disrupt the top-heavy status quo. One such example of an incentivizing open protocol is to monetize user data, whose current gatekeepers are Facebook and Google-like companies. Such token incentives are customizing the crypto commodity trading market. The possibility of trading your extra cloud storage or the unused solar energy from your power grid in exchange for crypto tokens is closer to reality. Getting paid to text your friends and posting your whereabouts on social media — that’s a delight. Such tokens will survive the market correction in the long run because they are like stakeholders, financially invested in the business model.
Big venture capital firms were early adopters venturing into the presale of tokens, some taking board advisory roles. Startups interest retail investors with a technical white paper supposedly containing a detailed business and product development plan. As the company evolves, rarely do they condone their initial roadmap. Technology is cheap and accessible to innovators as well as scammers. Creating an ICO may be 25 lines of code, but exploiting regulatory loopholes for quick gain does not support the idea behind cryptocurrency. Raising money through traditional forums is hard, but it also necessitates feedback, due diligence and significant market advice that helps in iterations for building a valuable company. The pump-and-dump of tokens may have glutted the bullish approach, but when the bubble bursts, most of these startups may not survive the reckoning. Until then, enjoy the wild race if you have nothing to lose with your play money, before the regulators tame the wild horse ICO. The winner will be the blockchain with an “appealing fat protocol” that disrupts the startup business model forever, creating hope for a democracy of wealth.
Thanks to Ray Dillinger for his valuable feedback and comments in writing this article.
This article represents the personal opinion of Gayatri Sarkar and not of her previous or any current employers. She is an advocate of blockchain for climate control and an angel investor. She recently spoke about ICO and DAO risks in Global Blockchain conference 2017.