When you say “cryptic”, you mean “mysterious, puzzling or incomprehensible”. For most people, that’s just what cryptocurrencies are — a big question mark that may yet flip the financial world on its head faster than you can say Bitcoin. Already, tech entrepreneurs are using cryptocurrencies and other digital tokens to raise funds for their startups via ICOs (Initial Coin Offering), bypassing the traditional venture capital route founders take to launch new companies.
Are you skeptical? You should be. In the wild wild west of ICOs, lack of transparency and regulation mean many deals are illegal scams, while the best investment deals are hard to find without technical savvy and insider connections. We spoke to a number of entrepreneurs and investors on both sides of the ICO market to help us differentiate the good from the bad.
What’s an ICO?
Digital tokens and cryptocurrencies such as Bitcoin are like cash but not exactly. In the same vein, ICO’s are like IPO’s but not exactly either. The parallel and esoteric world of cryptofinance may be hard to understand at first but everyone — including hedge funds, big banks, and repentant VCs — is taking notice. Despite being ridiculed in its early days, the cryptofinance industry is now valued at more than $120 billion, with several companies funded through ICOs already attaining unicorn status (a market valuation north of $1 billion). Some, such as OmiseGo and Qtum, have done so in just a matter of months.
An ICO is a milestone process where a business entity issues digital tokens to early adopters or investors via a permanent, secured ledger — called a blockchain — in exchange for money. These investors purchase the tokens using cryptocurrencies in the hope that the value of the tokens will appreciate in the near future, translating to real profits. Unlike buying shares of stock in an IPO, purchasing tokens does not equate to ownership rights nor entitlement to dividends. ICOs are also loosely regulated by government agencies — if at all.
The potential of ICOs for minting new millionaire investors is real. ROIs can be mind-boggling. Early investors who bought Etherium’s tokens (at 0.0005 Bitcoin apiece), for example, have profited by 10,000%, with ETH now valued at 0.05 Bitcoin. Value gains of 100% to 500% in BTCs are fairly common for successful ICOs, according to BlockGeeks.
But the risk of ICOs dragging you towards the poverty line is just as vivid. Like all nascent economies, the world of cryptofinance is fraught with both promise and peril. “ICOs are a bad idea from an investor perspective,” warns Zach Hamilton, a managing partner at General Crypto, a hedge fund focusing on cryptocurrency assets, “Very often there’s a lack of transparency, lack of technical understanding, lack of legality, and lack of recourse even if you know the people behind the ICO.”
Richard Dulude, investor at Underscore.VC, points out that companies behind ICOs face the same challenges normal startups do, yet manage to raise all of their lifetime funding at once. “Historically startups raise equity in stages as they prove out business value. ICOs are a pre-product, one-time financing,” he explains. “The failure rates are the same, but the amount of money raised upfront is significant. We haven’t seen many fail spectacularly yet since it’s early, but we will.”
We don’t want you to fall for any costly ruse. So if you’re planning to try your luck and wade in the murky waters of cryptofinance, here are some important things to digest:
The blurry lines between cryptocurrencies, utility tokens and tokenized securities
Open Garden co-founder Micha Benoliel sheds some light into the key — sometimes confusing — terms used in cryptofinance to denote and exchange value. Sharing his thoughts via Medium, Benoliel believes that there are three main types of digital tokens: 1) coins or cryptocurrencies; 2) utility tokens; and, 3) tokenized securities.
Cryptocurrencies such as Bitcoins are digital currencies minted (or mined) using encryption protocols that securely regulate unit production and monitor exchanges/transfer of funds. Cryptocurrencies (or coins) represent a value for a specific type of transaction and nothing else. While this type of digital token currently circulates independently of central banks, trends indicate that the blockchain platform they use are under scrutiny and may be appropriated soon by mainstream financial regulatory bodies.
Unlike digital coins, tokens are highly programmable and can be deployed and utilized for various use cases. Utility tokens, for example, may mimic the role of API keys given to early adopters of a paid subscription product. These tokens are purchasable units of services that have yet to be completed and released. Utility tokens are often used in crowdfunding projects and businesses during token offerings.
Meanwhile, tokenized securities represent shares of a business that have been issued digitally using blockchain technology. According to SEC rules, if a token meets all four key criteria of the Howey Test, then it may be a security and must be regulated under the 1934 Security Exchange Act. Such tokens can only be legally sold to accredited investors, though in many ICO raises they are sold to the general public without proper compliance with securities regulations.
The emergence of distributed, decentralized apps (DApps)
One of the key drivers of large ICO raises is the promise of distributed, decentralized apps (DApps). DApps represent a paradigm shift to what our digital selves have been used to for decades. Apps like Spotify, Messenger, and Gmail, for example, work from a centralized backend location which grants platform providers (Spotify, Facebook, Google, etc.) dominant control over the transactions app users perform as well as the data they share over the network. In contrast, DApps enable users to regain control of their data and process flow by connecting them directly with each other or with service providers without the need for a middleman.
DApps are built upon blockchain technology, a digital ledger of records organized in cryptographically linked, decentralized blocks that are managed via consensus of all participating entities. Blockchain technology preserves all transactions, establishes full transparency over all events affecting the ledger, and maintains resilience against unilateral or unsanctioned changes. Rather than buying software or paying for an online subscription, you exchange tokens issued by DApps for value on their platform, whether that be access to digital file storage (FileCoin, StorJ) or a license to use creative work (Po.et). Virtually all functionality provided by technology companies today in a centralized manner could be implemented as a DApp on the blockchain, but apps based on peer-to-peer transactions see the most potential and traction.
Entrepreneurs probe the good and the bad in ICOs
While pundits disagree publicly on the future of cryptocurrencies and blockchain technologies, key players even in industries deeply entrenched in legacy platforms and conservative paradigms are slowly opening up.
Credit Suisse, Barclays, Goldman Sachs, and other financial institutions are exploring ways to cash in on the Bitcoin trade and harness benefits of blockchain-driven systems. Maersk, the planet’s largest shipping company already uses blockchain to track cargo while US-based retail giant Walmart uses the technology to monitor its supply chain.
Across the board, different use cases of blockchain technology clearly portend a significant role in our digital future. At the moment though, should everyone view ICOs through a similarly optimistic lens?
Doc.ai Co-founder and COO Sam De Brouwer points out the key benefit of ICOs: “Companies who have great ideas don’t have to come all the way to Silicon Valley to woo investors.” Providing a conversational platform driven by natural language processing and machine learning, Doc.ai extends the remarkable capabilities of AI into the healthcare system, allowing for on-demand insights on genomics, microbiome, blood, environmental, and anatomical data. To fund its Neuron project, the firm’s ICO has already raised around 109 million NRN (at 0.10 USD per unit) as of this writing.
“But, an ICO must fit with your business model,” De Brouwer clarifies. “The most important driver of value is how you structure token economics and network efforts so that your token is more valuable as your network grows.” Colleague Marina Titova agrees. Leading the firm’s ICO, Titova gives strategic insights about the economic drivers behind large raises: “Increasingly more large institutional investors are entering the ICO market. Hedge funds, family offices, and other investment firms represent a very significant pool of demand that makes large $200M+ raises possible.”
How do startups like Doc.ai ensure successful ICO funding? “Engaging the blockchain community is critical for a successful ICO,” Titova explains. “You need to start at least 2-3 months before your crowdsale to engage both big names and crypto whales like Anthony Diiorio, one of Ethereum’s Founders and one of our investors, and smaller investors to build buzz.”
Meanwhile, Trane AI cofounder and CEO Tomer Dicturel revealed they are using Trane’s ICO primarily to solve a business problem, not merely to raise capital. “We offer distributed AI training by enabling anyone around the world to answer binary questions that help label data for machine learning algorithms. There’s no way more secure than blockchain to pay people globally in such small amounts.” Dicturel does not measure ICO success based on dollar amount raised, but rather on community adoption and activity on the protocols. “Right now we have 2,900 machine learning engineers who want to build on top of our protocol, 10,000 people working as AI trainers by labeling data, and hundreds of data scientists uploading data sets for analysis.”
But, for every legitimate ICO supporting a real business, there are dozens of fraudulent cases. Tiana Laurence, Chief Marketing Officer at Factom, highlights possible abuse and oversight of ICOs. “There are people like Paris Hilton using their celebrity to raise a ton of money via ICO without qualifying the ideas behind their token. If you invest in that, you could be buying literally nothing,” she remarks. LydianCoin, the token Paris Hilton initially supported, has drawn wide criticism for being led by an entrepreneur with a history of domestic abuse and for being at risk of violating securities laws.
That’s why business fundamentals are still important for evaluating ICOs. Dulude of Underscore.VC emphasizes that in addition to the token design and economics, traditional startup characteristics such as team and product-market fit are still critical to separating good investments from bad ones.
The Future Of ICOs
Very few millennials remember the desperate sound of an Internet modem as a computer loads a visually disheartening 1990s-era web page. The Internet had to go through a lot of growth pains before being able to provide the compelling and immersive experiences we now take for granted.
The same goes for blockchain technology and the allied products — cryptocurrencies, smart contracts, and ICOs — it spawns. Dulude is confident that we will continue to see use of ICOs as fundraising mechanisms as standards and regulations improve. “We’ve never had a situation where anyone internationally has an opportunity to invest without any restrictions. Even crowdfunding is generally defined by national borders.” Right now the terms of investment, dynamics, and clauses surrounding ICOs are not standardized, but he believes the blockchain industry, SEC, and successful entrepreneurs and investors will come together to define standard terms.
“I have no doubt that ICOs will be here for good,” he concludes.