Initial Coin Offerings ("ICOs") emerged in 2017 as a new means for projects to raise funds, and they did so dramatically – taking in over $5 billion that year. Bitcoin went into the stratosphere, then experienced a 50% correction. A few ICOs have flamed out spectacularly, the rest have plenty of money, but some are facing serious talent constraints due to the roaring market. Many people have expected the brakes to come on hard on this "fad". Instead there has been an additional $3 billion raised just since the start of the year.
Less than 1% of startups seeking traditional funding get money from angel investors and just 0.05% receive venture capital funding. Among ICOs, 25% meet their funding goals, and this is the case even though the average size was $15 million in 2017 and they've more than doubled that in 2018.
So with all this capital available, our customers at Inwage, an IT advisory and services firm for ICOs and Blockchain development, often ask questions like “Can my startup even do an ICO?”
The answer is that any organization can do an ICO, it's not just for those who want to create a new type of cryptocurrency. There are gold mining operations, tech Unicorns, Venezuela is the first government to do so, and many other nations are considering it.
A better question would be “What type of token offering is right for my startup?”
There are three core attributes of a token to consider with regards to your business model and how various stakeholders, which include potential users, investors, partners and regulators, will react to your offering. These are:
- Is the token more like a share of stock (investment), or is it meant to be used in transactions (utility)?
- Is your platform offering services centralized or decentralized?
- Are the services or products offered fungible or unique?
Investment vs. Utility:
Various regulatory agencies view some tokens as within their domain, while others are treated like currency or a new kind of tradable token. The defacto standard globally for determining whether or not a token falls within the regulated domain is the Howey test. Basically, an investment token is something you buy and hold because you believe it has a bright future, while a utility token is something you buy because you're going to use it to purchase or gain access to goods or services within a system where it is honored.
Examples of Investment tokens include:
- Equity Tokens: just like a traditional non-voting share of stock.
- Dividend Tokens: similar to a corporate bond.
- Voting Tokens: offering a say in operations, but not always including equity or dividends.
These should all be very familiar to anyone who has ever purchased a public stock, so I'm not going to provide specific examples. The utility tokens, on the other hand, need a bit of explaining. This is not an inclusive list, it's just some good examples.
- Loyalty Tokens: Airline miles are the classic example, they can be used to purchase services, transferred to others to incentivize certain behaviours, and there are schemes to trade them via intermediaries. A token example is Kickcity App, a combined event management and marketing platform. Using the platform for your own events, referring friends to other events, or providing affiliate marketing services for events are just a few ways to increase your personal stash of tokens.
- Discount Token: Ever see those promo code boxes during the digital checkout process of a product? Companies often discover promo codes that have become far more broadly used than they intended. A token based solution would make for trackable single use promo codes.
- Membership Token: A timeshare is great, until one day you’re sitting at Gymboree with a toddler, trying to work out the last time you managed to see the place, and you know it was pre-pregnancy. There are many sorts of things out there where one entity owns the asset, but there are a vetted group of members with permission to access it, one at a time or with a limited group size. Blockchain Hotels is creating a hotel franchise, with a timeshare coin for each hotel.
- Service Tokens: Those change machines in the arcade you remember as a kid gave out metal coins that couldn't be refunded, encouraging you to spend your whole purchase there. Service tokens require the usage of the token on a particular platform, but comes with the additional benefit of tradability. The most popular of which is Ethereum, which requires you to spend Ether as a gas to power all sorts of various applications, such as the launch and and trade of ICO tokens.
- Preorder Tokens: Crowdfunding titan Kickstarter says they won't touch ICOs, while competitor Indiegogo is taking a more forward looking position. Like a Kickstarter, such tokens give you a reservation for something new, but unlike Kickstarter a preorder token can be sold at any time.
There are many benefits to both types of tokens for ICO offerers and investors. There are many interesting projects of varying sizes seeking funding. There are few geographic barriers to involvement. Tokens are readily salable, so if an ICO loses your interest, you won’t have buyers remorse for very long. Projects seeking user uptake as well as funding can do innovative things to draw in small investors, who also happen to be future customers.
A typical utility token goal is to raise money from as many small investors as possible, since there is an expectation that the token is going to be used for transactions within the system. A good example of this is the KiK messenger's Kin, which was created to accelerate the existing internal economy of the platform's 300 million users. Their sale of $98 million in tokens reached over 10,000 purchasers and there were many small dollar players in the mix.
Investment tokens are typically considered securities, which definitely puts you under the regulatory purview of the Securities Exchange Commission when raising money from US investors, and may put you in a similar position in other jurisdictions. If you're too impatient to wait for my article on token regulation, you should Google the Howey rule to get a basic idea of what is going on, but the fact that you intend your token to be used in an active ecosystem is not sufficient to fend off SEC attention. Some lawyers I’ve spoken with, including Gordon Einstein, believe every token starts out as a security, until the ecosystem is “fully developed”. This mean the determination on whether the token is a security or a commodity depends on the SEC’s assessment of maturity of the virtual market where it’s used, rather than on forward looking statements in an introductory white paper.
This is not a situation where you can just wing it, you need proper counsel to ensure you're not creating a future compliance problem.
Centralized vs Decentralized
Another consideration for the token is whether or not the value of the token is backed by a centralized organization like a corporation or an LLC, or if you are truly creating a distributed organization, which is often run by a foundation whose only revenue model is donations and the rise in the value of the launched coin. The blockchain concept has the penetration it does due to decentralized, trustless projects – with Bitcoin being the first and most notable. But vast majority of ICOs in the future are likely to involve centralized entities tapping this new funding market.
And that is working just fine. Centralized browser project Brave raised $36 million in their ICO … in thirty seconds flat. There are plenty of other examples of centralized organizations that meet their funding goals, albeit in days, weeks or months, rather than seconds.
Do you think you have a decentralized use case? Maybe you do, but the first question here is “How will you find and retain the talent you need to execute?” While the fund raising numbers for decentralized projects are an order of magnitude larger than what centralized projects achieve, the risks are much more significant. Instead of a token on an already mature blockchain that expects to host such projects, your plan presumably involves forking an existing open source blockchain, making significant modifications, and then inducing large numbers of people to put up the capital for the miners and nodes required to support your project.
I'm not saying this is impossible, but there is a lot more due diligence and you pretty much need recognized players who've created a successful blockchain protocol implementation before you can get any traction.
A bit of an odd word, isn’t it? Fungibility is a term that one runs across in economics classes, and then it’s typically never seen again, but the concept is simple. Is a specific item readily exchangeable for another item of the same class, or is it unique? You’d readily trade a $20 bill from your wallet for one proffered by your seat mate on an airplane, but you probably wouldn’t be willing to swap your driver’s license.
Most tokens that have been created are fungible - they are currencies or securities, just representing a slice of something. The first non-fungible tokens I can think of are the Cryptokitties, an e-pet trading game that runs on Ethereum. There is a lot of serious work coming in this area, think digital identities - your personal information, car titles, anything where a unique entity needs to be represented is a candidate. It isn’t clear how to run an ICO with an offering of unique tokens, particularly if they are virtual identity documents, but a security tied to an organization producing such a solution, maybe a membership style token to be used in conjunction with the identity would be workable, or perhaps even an initial sale of the assets at a discount.
But How Do I Build My Token?
ERC-20, the Ethereum Request for Comments #20 token has become the de facto standard for ICOs, with 70% of ICOs running on top of Ethereum. This type of token rides on the same blockchain as the Ethereum cryptocurrency, taking advantage of the security enforced by miners with a combined electrical use equaling that of the country of Cyprus. While ERC20 is both simple and secure, currently powering billions of dollars of value, newer standards and platforms are competing to take a slice of this market as token use cases become more complex and new kinds of companies look into doing ICOs.
Fabian Vogelsteller, who worked with Vitalik Buterin to develop the ERC-20 standard explains, “ERC-20 is popular because it was the first broadly adopted token standard. However, there are now two extensions of the ERC-20 standard, ERC-223 and ERC 777, which function in the same way as the ERC-20 token, being just as easy for exchanges and wallets to integrate, but also allow the tokens to interact with Ethereum smart contracts, which were not built directly into the initial ERC-20 token.”
What this means is that not only do these newer tokens get the benefit of sharing Ethereum's broadly distributed blockchain, their smart contracts can talk directly to Ethereum smart contracts. The token creator can focus on making it do its specific job well, while leaving some of the heavy lifting in terms of transactions in the hands of very mature Ethereum smart contracts. Is that explanation too circular? One of the first ICOs was The DAO, which was famously robbed of nearly a third of its funds due to a one line flaw in a smart contract. These new tokens can leverage well tested smart contracts developed by and audited by experts, greatly reducing the potential for mischief like that.
ERC20 and its offspring are not the only game in town. There is an up and coming system focused specifically on the use case of initial coin offerings, the Waves Platform.
I spoke with Sasha Ivanov, CEO & founder of Waves Platform, to learn more, “Waves’ primary use case is to make it very easy for anyone to create blockchain tokens and build their own applications using that functionality. The Waves Platform has over 10,000 tokens at the current count. Many are test tokens or frivolous applications, but there are plenty of real-world businesses that use Waves, from crypto trading platforms like Simdaq to shared office space initiatives like Primalbase. Ethereum's smart contracts are a powerful scripting language, but it’s complicated – and with that complexity comes risks. Waves allows you to create simple blockchain tokens very quickly and easily, without any specific programming expertise.”
There are several other platforms that host ICO tokens looking to take on the customization and flexibility of Ethereum's new standards or the simplicity of Wave’s tokens. These include NEO, NEM, Stellar and EOS. However, for companies new to this kind of technology, it is often best to take a more conservative approach from a security standpoint by working with Blockchain IT specialists or sticking to simple ERC-20 tokens that have been audited. Almost 10% of the ICO funds from 2017 ended up in the hands of hackers, and you definitely don't want to add to that statistic.
You should now have some idea of what type of token you're going to create, but that's only the first step. Next, you have to make sure you're not going to have a regulatory problem with various regulators, with the Securities Exchange Commission being the most aggressive in the ecosystem. Finally, you are going to have to actually execute the fundraising plan.
I had a long talk with Juan Llanos, Consensys financial & regulatory technology lead and my company's compliance advisor. From a high level, the current state of affairs is a lack of regulatory clarity, strong efforts by the industry to educate regulators, and tales of what mistakes lead to enforcement actions. Unfortunately, his insights are too broad to fit into this article, so you will have to wait for my upcoming article on token regulation.
Once your ICO plan has been sharpened by regulatory review, you've got to actually get people to give you money. I've talked to many investors over the last four years but one of the most innovative and perceptive is Mike Costache, cofounder of the d10e conference series. Talking to Mike is like trying to fill a tea cup from a fire hydrant. He was bubbling over with the tale of his latest success, the creation of a $27 million ICO for the Gibraltar Blockchain Exchange. The d10e road show has an event every month and Mike heads the 120 member Blockchain Investment Consortium, so we'll be leaning heavily on his leader of the pack position to get a view into what's happening in the funding realm for a future article.
Six months ago I published Your Guide On How To Run An ICO For Better Or Worse, which which explains the various aspects to consider once you have decided on the kind of token you want for your ICO, from security risks and regulations, to how investors evaluate projects before investing. I suggest you take a read.
I originally posted this article on Forbes. You can check out this article and other forbes articles I wrote at https://www.forbes.com/sites/jonathanchester/
Disclosure: I am an advisor to both Kickcity and Blockchain Hotels, which were mentioned in this article.