A friend of mine, a big fan of the Harry Potter series, recently planned to launch an initial coin offering (ICO) to fund a new Quidditch sports league. His new “Quidcoins,” valued at 0.009 bitcoins (BTC), would be exchangeable for discounted admission and food at select National Quidditch games around the country. He hoped to raise a maximum of 2,000 BTC ($11,000,000) over a 28-day offering period.
Unfortunately, before my friend could organize his company and raise money, he discovered that a group in Britain was in the midst of offering their own QuidCoins, named after the slang word for the British pound. While my friend was disappointed to find the name taken, perhaps it was for the best; despite sponsors’ hopes, QuidCoins traded for less than three months in 2014, according to CoinMarketCap.
ICOs promise big profits to investors, but with a failure like QuidCoin’s possible at any time, are they worth the risk? If you’ve been considering participating in an ICO, here’s what you need to know.
What Is an ICO Financing?
Entrepreneurs have historically financed their ideas by offering equity interests — or investment securities — in their ventures to external investors. Due to the abuses and corruption of financiers in the 1920s, Congress passed the Securities Act of 1933 and created the Securities Exchange Commission (SEC) the following year to enforce the Act.
In the decades since, the process of raising money from the public through an initial public offering, or IPO, has become well-established. Regulations dictate how the offering process must proceed, who is eligible to participate, when an offeror must provide information to potential investors, and what information they must provide. Failure to follow regulations can result in severe financial liability for the sponsors of an offering, including civil and criminal penalties.
An ICO is a similar fundraising tool in which an offeror sells futures in a cryptocurrency that does not yet exist. ICOs are designed to avoid the regulations that protect investors when buying or selling traditional investment securities. While an IPO must include an extensive prospectus, there are no regulations outlining what information must be provided to prospective investors in an ICO. Each offeror determines what, if any, details will be delivered and when.
Most ICOs have a website or white paper justifying the benefits of the investment, but they do not have an existing product. Offerors are startup operations, and the funds raised through the ICO will finance the development of the product — in this case, the cryptocurrency.
Prospective investors in an ICO need to recognize that a cryptocurrency is unlike an investment security, such as common stock or real estate. Regulators might not classify a digital coin or token as an investment security at all, but rather a simple contract between two parties. In 1936, the Supreme Court’s ruling in SEC v. Howey Co. established a test to determine what is and what is not an investment security. Under the test, an investment contract is a security if:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment is in a common enterprise
- Any profit comes from the efforts of a promoter or third party; the profit is outside the investor’s control
Before ICOs, entrepreneurs sought out venture capital from friends, family, and sophisticated venture capitalists capable of evaluating the business prospects of the product or service to be produced. An ICO lets an entrepreneur bypass traditional financing sources and get funding from members of the less-knowledgeable, less-discriminating general public seeking a piece of the next Facebook or Google.
To avoid regulatory scrutiny, some ICO sponsors elect to use an “accredited ICO” to take advantage of exemptions to the SEC registration requirements. For example, under Regulation D, a company can raise an unlimited amount of money if it meets the following standards:
- Limit on Number of Investors. The law distinguishes between investors based on annual income or net worth, the thought being that those with larger incomes or net worth are more capable of evaluating an investment appropriately. A person with an earned income exceeding $200,000 (or $300,000 with spouse) for each of the prior two years and a net worth of over $1 million (excluding their residence) is known as an “accredited investor.” Offerors may sell their securities to an unlimited number of verified accredited investors.
- Prohibition on General Solicitation. An offeror cannot use general solicitation or advertising to market an accredited ICO. However, they can broadly solicit and advertise the offering if all prospective buyers are accredited investors.
- Disclosure Information. An offeror can decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of federal securities laws.
- Access to Company Management. Offeror principals must be available to answer questions by prospective buyers.
- Financial Statement Requirement. Audited financial statements are required if they are available.
- Limits on Resale of Securities. Any coins purchased under a Regulation D exemption are restricted from sale for a year after purchase unless registered with the SEC.
Only a small minority of current ICOs are accredited, largely due to the expense, preparation time, and information requirements. As a consequence, each investor in an ICO should be capable of judging whether the financed project makes sense as a business, whether the experience and expertise of the principals warrant confidence, and if the project’s completion is likely to become a viable, growing business — before investing their hard-earned dollars.
In other words, will the coins or tokens reasonably deliver something that is missing or desired in the marketplace for which the public, or a significant portion of the public, is willing to pay? Would you be willing to use the coins as a currency or to get a unique benefit that’s not otherwise available? Are you considering investment in the hope that someone later will buy your investment for more than its cost, even if you don’t know how it works or why someone would use it? If so, it is a speculation, not an investment.
Risks of an ICO Investment
Initial coin offerings have exploded since the first offering of Mastercoin in 2013. Sponsors of ICOs raised over $1 billion for startups in 2016, $5.6 billion in 2017, and over $1 billion in the first two months of 2018.
Proponents of ICOs claim that technology is changing the way startups raise funding. An ICO costs less money, is often quicker than relying on venture capitalists or banks, and keeps decision-making and equity ownership in the hands of the founders. Supporters claim that ICOs are “a democratizing financial force that provides capital to projects unlikely to get it from established sources such as banks or venture capitalists,” as WIRED magazine puts it.
Critics are more focused on the potential downsides. CNBC reports that stock analyst and Elliott Wave theorist Elliott Prechter wrote in a July 13, 2017 newsletter that “[t]he price activity and manic sentiment that led to present [bitcoin] prices have dwarfed even the Tulip mania of nearly 400 years ago. The success of [b]itcoin has spawned 800-plus clones (alt-coins) and counting, most of which are high-tech, pump-and-dump schemes.”
If you’re considering participating in an ICO, you should be aware of the following risks.
1. Likelihood of Failure
The lack of understanding and skepticism around digital coins, combined with an inability to accurately assess the probability of long-term success, results in a high failure rate for new coin offerings. Fortune magazine reports a 59% failure rate for 2017 offerings in the first half of 2018, with losses totaling $233 million.
2. Illiquidity & Volatility
Cryptocurrencies are incredibly volatile and have limited liquidity, or the degree to which an asset can be bought and sold quickly without affecting its price. Cryptocurrencies like bitcoin are designed to be illiquid, focusing instead on value.
Also, cryptocurrency prices fluctuate wildly, with significant purchase orders driving up bids and sell orders causing offer prices to plummet. This volatility precludes them from becoming a mainstream payment system.
3. Uncertain Value
On May 22, 2010, Laszio Hanyecz completed the first bitcoin transaction by purchasing two pizzas from Jeremy Sturdivant for 10,000 BTC. At the time, this equaled $100. Today, the same coins would be worth about $60 million, leaving one to ask:
- How good was the pizza?
- Why would anyone in their right mind use or accept an asset with such volatility in a commercial transaction?
For an asset to have real value, someone must have a use for it. Because bitcoin is not widely used or accepted for payments, it has less value than other, more widely accepted currencies.
4. Lack of Oversight
The lack of regulation or professional scrutiny of cryptocurrency opens the door for fraud. Steemit, a high-quality content site initially funded by an ICO, posted a tongue-in-cheek article titled “How to Create an ICO Scam in 5 Simple Steps” that is both humorous and disturbingly accurate.
As the Harvard Business Review puts it, the ICO market has experienced “its fair share of outright scams, pumps and dumps, and blatant Ponzi schemes.” The SEC filed fraud charges in September 2017 against two ICOs, REcoin and DRC, operated by California businessman Maksim Zaslavskiy. Zaslavskiy feloniously claimed the operations to be fully operational companies with staff, lawyers, and retailer relationships. According to the SEC, the promotional literature for REcoin and DRC claimed the coins were backed by real estate and diamonds respectively purchased with $2 to $4 million of insider investments, although only $300,000 had been raised and no real estate or diamonds existed. While the criminal charges are yet to be settled, the presiding judge characterized Zaslavskiy’s conduct as a “grand misrepresentation.”
Even when fraud isn’t involved, investors must be wary of:
- Regulatory uncertainty
- High valuations and overcapitalization
- Lack of investor control over financials, strategy, and operations
- Lack of business use cases
A lack of oversight also makes possible goofy, impractical ideas. Dogecoin (DOGE) has a market capitalization of almost $119 million, yet Dogecoin creators Jackson Palmer and Billy Markus admit that they created the cryptocurrency without much thought or effort, let alone a master plan. Users have no real means to exchange Dogecoin for goods and services except to “tip” other Dogecoin enthusiasts when they do something nice or funny, which brings us back to the issue of cryptocurrency’s debatable value.
Should You Participate in an ICO?
Investment professionals are moving into the ICO market to capture their share of the good times and easy money before they end. The website Autonomous found 251 existing hedge funds investing in ICOs in mid-2017, while Hedge Fund Alert counted another 62 ICOs in the pipeline.
Should you invest in an ICO? It depends. Consider the following statistics compiled by Mangrove Capital Partners:
- Blockchain Projects Are Dominant in ICOs. Larger ICOs — those over $10 million — focus on services to support the blockchain economy or financial services industry. Any coin offering not based on blockchain should be carefully evaluated for its viability.
- Most Companies Using an ICO to Fund Their Businesses Don’t Have a Product Before the Offering. In other words, purchasers in an ICO are buying into startup operations similar to venture capitalists, with a low probability of success for any specific coin. Most venture capitalists diversify their risk by investing in numerous companies or coins.
- More-Successful ICOs Already Have a Base of Venture Capital Investment. An ICO with a group of professional investors is likely to have been thoroughly analyzed and concluded to have a better-than-average chance of success.
- The Average Performance of ICOs Through Mid-2017, Including Those That Failed, Was 1,032%. During the second and third quarters of 2017, the amount of funds raised through ICOs was more than four times the amount raised by traditional venture capital ($2.08 billion versus $507 million). Even bad offerings can make money if you’re nimble and not too greedy.
Reasons to Invest in an ICO
The potential gains from an ICO investment can be staggering. According to Quartz, the average price increase for the three best-performing cryptocurrencies (Ripple, NEM, and Ardor) in 2017 was 27,556%. A $100 investment in each of these at the beginning of 2017, or a $300 total investment, would now have a market value of more than $7.4 million.
Regulators around the world are exploring the best way to civilize cryptocurrency markets. Ten countries, including China, have banned ICOs and threatened stern penalties for those who continue to participate in the market. Other countries, recognizing the potential value of blockchain technology and the benefits of the new funding mechanism, are moving to regulate the technology rather than destroy it. Ridding the industry of fraudulent actors will increase the likelihood of ICOs becoming mainstream and having more market participants.
Reasons to Avoid an ICO
There is no doubt that the cryptocurrency bubble will eventually burst. The unregulated ICO market encourages a dangerous mix of fast-buck promoters, scam artists, and unsophisticated investors ill-equipped to evaluate the underlying business proposition of an ICO.
The lack of liquidity for most cryptocurrencies is ideal for pump-and-dump schemes even when the coin or token has a legitimate purpose. Existing coins and the exchanges they trade on have been subject to hacking and multi-million dollar thefts. Finally, investors who fail to follow the security procedures required by their crypto-wallets will lose some or all of their cryptocurrency’s value.
Cryptocurrencies have captured the imagination of investors worldwide, similar to the previous dot-com frenzy of the late 1990s. At that time, virtually any company associated with the Internet attracted speculators and investors eager to cash in on the promise of big profits. The names Pets.com, Webvan.com, and eToys.com won’t soon be forgotten by investors who incurred losses when the bubble burst — more than $1.755 trillion by the end of 2000 (over $3 trillion in 2017 dollars) in 280 internet stocks, according to CNN Money.
However, while some individual dot-com companies failed spectacularly, the enthusiasm for the impact of the Internet was not misplaced. The number of messages sent by email and online messaging dwarfs physical mail traffic today, social media has changed the global culture, and online shopping is growing at double the rate of on-site shopping. Those investors who selected the surviving Internet pioneers have enjoyed outsized profits. Many technologists believe that blockchain technology will have an even greater impact on business and the economy; the question is, which ICOs will survive the inevitable bubble burst?
There are unparalleled potential returns for those who watch and quickly react to market events and limit their investment in cryptocurrencies to no more than 1% to 2% of their portfolios. Remember that a winning lotto ticket has a great return on investment too, but the 292 million non-winning tickets purchased for that same drawing are worthless.
Do you own bitcoin or another cryptocurrency? If so, did you lock them away in hopes of a big payoff, or do you use them for your daily purchases? Would you recommend cryptocurrency to aspiring investors?>