What is an ICO, or Initial Coin Offering?
In our latest explainer on cryptocurrency, we look at aspects like blockchain and Initial Coin Offering (ICO).
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(This is the second part in a BQ series on investment opportunities in blockchain and cryptocurrencies. Read the first one here.)
The world is abuzz with talk of Bitcoin, and a large variety of alternate coins, popularly known as Altcoin. Trading volumes for Bitcoin are through the roof, with its price having zoomed upwards of 30 times in the past 12 months alone.
It recently crossed $6,000 for a single BTC token, clearly showing that more and more people are realising what it is and waking up to a new reality.
What is a Digital Coin?
In order to understand what a coin is, or cryptocurrency as it is technically called, it is important to understand what currency itself is. I have previously discussed what money and currency is, and it can serve as a good background for this article.
In short, however, currency is a way to store and transfer value, allowing two or more parties to enter into transactions. For something to be a currency, a few conditions must be met.
For one, it has to be convenient to use. For another, it should be widely accepted as valuable. A digital coin, or a digital currency is a digital version of money. For something digital to be treated as money, it needs to satisfy another very important condition. It needs to be controlled in such a manner that it can’t be “copied” like other digital things.
Enter Blockchain
This is where a technology called blockchain becomes useful, allowing a secure, decentralised manner in which something can be controlled and mediated. This enables digital coins to not just satisfy the condition that it needs to be controlled and not copyable, but also makes it so that this control does not rest with a single central authority.
An example of a single central authority is a central bank in a country, such as RBI, that decides on various parameters of money supply, basically unilaterally.
Blockchain makes this central point go away, allowing everyone to share the task of being the authority. This decentralisation has many benefits, the chief of which is that transactions can be recorded accurately and without being hackable by an untrustworthy third party. This latter part is ensured by using complex mathematics and cryptographic algorithms, hence the name cryptocurrency.
Another important aspect of digital currency is the ability to forge smart contracts or self-executing contracts on the blockchain. These are immutable and execute automatically when certain conditions specified in the contract are met.
This eliminates the manual procedures and efforts required by two entities when they indulge in any form of commerce or business. Smart contracts not only define the rules and penalties around an agreement in the same way that a traditional contract does, but also automatically enforce those obligations on the participating parties.
What is Liquidity?
Liquidity is a measure of the health of any given market or economy. When there are a lot of transactions happening across the board, it is said to have a lot of activity, and the volume of transactions is said to be high. These words, volume and liquidity, both are a measure of this activity. Liquidity can best be understood by understanding a lack of liquidity.
Many small countries, for example, have suffered a liquidity crisis when foreign investors suddenly pull their money out of various investments, and/or hold off on transactions. This happens when there is a loss of confidence in the future of that country for whatever reason.
This sudden lack of liquidity, if it intensifies and persists, can cause all sorts of bad things. Good things happen when markets are liquid and trading volumes are high.
Cryptocurrencies and Liquidity
And how does all this involve cryptocurrencies? Basically, since a cryptocurrency is just money, it also needs liquidity and volume.
The usage of the coin as a currency is what makes it liquid — and the liquidity is what makes it a currency. In other words, what is a currency that has no liquidity?
Now, we’ll take a short detour, and will return to the crypto world. A short stop at understanding entrepreneurship and fundraising.
What is a Fundraise?
When a new business wants to start, it often needs capital to do so. Or, a going concern may need capital to grow. Or a successful business may want to acquire a rival competitor, and may need capital to do so.
These call for fundraising activities, and there are a whole range of ways for businesses to raise capital. Each has merits and demerits, and various situations decide what options are best suited to the business.
One of the ways in which larger businesses or more ambitious projects raise money is through something we’re all familiar with — raising money from the public via the IPO.
What is an IPO, or an Initial Public Offering?
Traditionally, when a business starts to grow larger and larger, it needs more and more capital to keep up the growth. One way to raise these larger amounts of capital is for businesses to directly go to the public for the money — in other words, incentivise individual investors such as you and me to fund the business.
This process is called a Public Offering, as the investing public is offered shares in the business in return for funds. An IPO is the first time a business directly raises funds from the public market, in an Initial Public Offering.
And how is this all relevant to our discussion? An ICO is very similar to an IPO, with some key differences.
What is an ICO?
An Initial Coin Offering is now probably self explanatory. It is the first time the investing public, you and me, is offered the chance to buy coins in exchange for funding.
ICO is also called a token sale, since it is selling tokens or coins. It is also called a crowd sale since it is raising funding from a large crowd of people — the general public.
ICO vs IPO
The major difference today between an ICO and an IPO is that the IPO process is regulated by various authorities in all countries. The ICO is an entirely new thing for one crucial reason — the tokens need not be shares in the company.
This means that the business may not actually be issuing stock against those tokens, and the investor is hoping that the appreciation of the token will come via buy-side demand on the trading markets.
In other words such tokens are pure-utility tokens, which do not offer any equity in the business at all. This is in contrast with a more rare type of ICO, one that offers equity-linked tokens, or equity-tokens.
But this leads to another insidious difference, and that is that because the business is not issuing stock, this process is not currently regulated. This means that unless one is careful, one can be misled into investing into the wrong project or wrong group of people.
So are there any safe ways to invest in ICOs?
Regulated ICOs
As we discussed so far, there is no regulatory authority today for ICOs. Therefore, there isn’t any such thing as a “regulated” ICO so far. Regulation itself is good for the industry, as it brings about dependability and predictability to things, not to mention some oversight that adds responsibility into the mix.
Having said this, there are several ICOs today that are doing things by the book, even though there is no book. They’re simply following the IPO rule-book. In other words, some “regulated ICOs” are simply faithfully complying with the law of the land where they’re domiciled, and behaving as if they were making an IPO. Of course, there is no under-writing process, so there continues to be that difference.
These voluntarily compliant ICOs (to the furthest extent that the intent of the rules can be applied) are a good way to seek out mature teams that are building products and services for the long run, as opposed to just trying to find a quick way to raise money without offering much in return to investors. Equity-tokens on the other hand are backed by actual stock in the business, along with certain rights as well.
An example of such an ICO is PressCoin, for the business is issuing equity and is offering PressCoin tokens that are backed by a share in the company. Further, the business is based in Zug, Switzerland, and is compliant with FINMA regulations for raising funds from the public.
ICOs as an Alternative Investment
The current demand for coin investments is only the beginning. There are several reasons why there is such an investor appetite, and also several reasons for why this will continue for some time. Two of these reasons are of note.
The first is that ICOs have become a very popular alternative for entrepreneurs to raise capital for their projects. This trend will continue dramatically, and has already surpassed investments made by the venture capital industry this year.
The second reason that this space will continue to see massive growth is the sheer potential of the underlying technology: blockchain. The application of blockchains, or distributed ledgers, is thoroughly transformative, and this innovation will drive wealth creation for the next couple of decades.
(Amit Rathore is the founding partner of HigherOrderVC, a venture firm focused on applying blockchain and cryptocurrencies to various fields; and the founder of Quintype.)
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