If you’ve been looking into cryptocurrencies, bitcoin, blockchain and trying to figure out how people make a profit off of these things, chances are you’ve run across the popular practice of ICO
or Initial Coin Offering.
There is no shortage of blockchain advocates out there talking about ICO’s are the way of the future and that the days of the IPO of old (Initial Public Offering) as done on Stock Exchanges are over.
Well before you toss all your savings into the flavor-of-the-day ICO hoping to become an overnight millionaire, read this article and let me clarify this point: ICOs and IPOs are COMPLETELY different things and there is very little in common from the investor point of view.
To recap, an ICO is a type of fund raising campaign teams developing blockchain run to, well, collect money and get their project going.
The idea is simple:
- Come up with a blockchain project
- Get a team together
- Launch a blockchain with its own token
- Do some marketing
- Sell your tokens to the public (against cash or bitcoin) at a price the company determines is good for them
- Use the money to grow
The process does work for many of the teams out there looking to raise funds, but does it work for you as an investor?
What are you actually getting if you buy into an ICO?
Let’s step back for a moment and look at how an IPO works on a traditional stock exchange:
- An established company already generating revenue decides to “go public” or sell off part of the company on the stock market to generate some money to grow
- The company gets their team of accountants to look over the business and show that it’s a good, healthy business with potential to grow
- The company fills out an application at their Stock Exchange of choice asking to be considered for an initial public offering (this is called the Listing process, by which a company gets listed on the Stock Exchange with a neat little code such as AAPL)
- The Stock Exchange investigates the company to make sure they are not lying, considers the value of everything the company owns, and either rejects them, or approves them for listing, putting a nice note on their profile explaining what kind of risk any buyer could be taking, roughly speaking
- The company and the Stock Exchange decide how many shares the company will be broken up into, let’s say for example 100 shares, and the accountants and actuaries determine what each share is worth in dollars compared to the value of the entire company
- The shares get listed on the Stock Exchange and on a specific time and date, anyone with an account at the Exchange can buy some, in fact buying a part ownership of the company. I.E. buying 1 share out of 100 from our example company would make you the owner of 1/100th of the company!
I don’t think I need to add very much to this explanation for you to realize that there are some pretty crucial differences between ICOs and IPOs at this point.
Let’s talk, however, about what the actual launch of the coin and the launch of the shares look like from the perspective of someone buying into them, rather than from the perspective of someone launching them to raise money.
Let’s consider how the value of the Token is determined.
If for example, I want to do an ICO selling IVO coins to fund my company, I could make my sales pitch and say “I’ll give you 1,000,000 IVO coins for every 1 Bitcoin you give me”. By doing this, I’d be relying on people trusting that there will be demand for my IVO coins so that they can sell them back later at a higher price and on people thinking “well, if 1 Bitcoin is 7000$ and it buys me 1,000,000 IVO coins, that means an IVO coin is worth 0.007$! Hey that’s less than a penny a piece and if it grows to just 1$, I’ll be a millionaire!”
So here I am, selling 5 Million IVO coins to “investors” and pocketing their Bitcoin. With the numbers in our example, that’s 35 Bitcoin for the lot, which I can turn around and sell on my favorite crypto exchange at today’s rate, 7000$, and pocket 245,000$.
Now I have a quarter of a million dollars and I haven’t had to even start a company, get a client or produce a product, just as long as I’ve marketed a compelling proposal of what my company and project will do, and a bunch of investors have, between them, 5,000,000 IVO coins.
Well it’s obvious to anyone that I can spend 245,000$ on pretty much whatever I want at this point, either for myself or for the project, and the only repercussions could be that I lose my credibility as an individual and businessman.
Please understand, the team selling coins as part of an ICO is under no obligation to demonstrate any ability to actually do the work they are claiming to be doing, nor are they bound by any law to deliver anything of value in exchange of the token.
So how do people make money on ICO’s then?
Well, for that to happen, either the issuer of the token has to proactively decide to buy back the tokens at a higher price, or the token has to get listed on a cryptocurrency exchange.
In all fairness, cryptocurrency exchanges do some due diligence before listing coins and tokens for sale on their marketplace, but what verifications they do is strictly up to them and they are not obligated to tell you how they pick.
So on the day a token goes on sale on a crypto exchange, many of the coin holders will want to sell at a price higher than they paid so they can make a profit. In our example, IVO coins were initially sold for 0.007$ so we could imagine that people would be trying to sell them for at least 0.01$. Whether or not anyone buys any at that price will depend pretty much strictly on the reputation of my company and what I plan to do with the IVO coins, which the “investor” can only know by the marketing and rumors floating on the internet.
Well, let me ask you then, what would prevent me from actually having held on to 1 Million IVO coins and telling the crypto exchange “Hey, I’ll list with you, but only if you set the opening price at 10$ and I’ll give you 20% of the money I make in the first 24 hours”.
Let’s be realistic: as dishonest as the picture I’m painting looks, in an unregulated free market, it’s a perfectly legitimate deal.
So say the exchange agrees, why wouldn’t they, after all, having my coin listed at such a high price will attract tons of “investors” who will make trades and pay fees, which is how the exchange earns its money.
Now D-day comes and my IVO coin opens for trading on my favorite exchange, starting price 10$ per coin.
You can be that I’ve got an order to sell all 1 Million of my tokens at market price above 10$, and if there is enough hype around my project, people will jump in and buy and sell at some price around that 10$ mark. The original “investors” who’ve paid a mere 0.007$ per coin will be ecstatic and run to twitter, facebook, reddit, to talk about the amazing TO THE MOON profits they’ve made on the IVO coin ICO and I’ll get to benefit from the sweet sweet FOMO (fear of missing out) of everyone rushing to buy some of these coins at 10$ thinking “Hey, if they started at 0.007$ and are already 10$, they could go up to 100$ in no time! I better buy some now!”
If this were happening in a public square, I imagine it would look like a riot of people running around, trading tokens for money, and as the issuer of the coin, I’d be standing on the side, with my cool 10 Million dollars in my hand and absolutely 0 obligation to provide anything in return.
As a matter of fact, there would be absolutely nothing preventing me from declaring the project a failure and terminating it a few weeks or months later and leaving all my “investors” out in the cold.
That, my dear readers, is the very grim reality of an ICO gone wrong.
If you’re being honest with yourselves and are still reading this, please ask yourselves this question “did I already know all that?”, because if you didn’t, I’d strongly recommend you think twice before buying into ICO’s.
“But wait, so what, all investments come with a risk, obviously, how are IPOs on the stock market any different?”
Well, if you remember the description earlier, in the process of doing an IPO, there are ton of people looking into the company, the project, the team, making sure that the price is set at a fair level before the company lists, and once the company is listed the shareholders are actually part owners of the company!
In real terms, that means that the shareholders have certain rights and recourses, and the team managing the company has some responsibilities they must live up to.
You may have heard the cynical perspective that “your employer doesn’t care about you, all they care about is their shareholders” and while that sucks if you’re working a 9-to-5, it’s extremely important if you’re an investor because that means that the team will go out of its way to make sure the shares you’ve bought are actually worth as much as they possibly can!
And since we’re talking about the world of regulation versus no regulation, it’s extremely important to underline the fact that the justice system will take any fraudulent activity by the listing company very seriously, investigations will be launched and the team can be bound by law to compensate the shareholders if a judge deems it fair.
Of course, corporate fraud occurs, money is embezzled, stolen, hidden and laundered all over the world every day, and more often than not, the public and small investors are left out to dry, holding the bill, but with all this information in mind, I think it should be pretty clear that as far as your safety as an investor is concerned, much more is done on traditional markets to protect you from what you don’t know and what happens behind the scenes than what you can count on in the ICO and blockchain world.
The reality is that many, many teams doing ICOs are genuinely good teams with honest ambitions, solid projects and the desire to do right by their supporters. Many if not most of the people buying into ICOs do so because they believe in the projects, in the teams, and want to live in a world where the projects they buy into are successful. These are the honest people, the knowledgeable people, the people who do their research, follow the news, think things through and make sure they only take on as much risk as they can handle.
There is a place in the world for ICOs and the teams that run them, they are actually an amazingly clever way of complimenting revenues for any business where coins and tokens are relevant, but they most definitely are not a substitute for traditional financial instruments from the perspective of an investor.
Look at it this way: if your idea of investing is having an advisor recommend stocks, bonds, ETFs for you to buy, you may want to consider how deeply you want to get involved into your finances before jumping into ICOS.
As always, be careful, pay attention and never forget: knowledge and education are the most valuable investments you can ever make for yourself!