Initial coin offerings (ICOs) are a fundraising model for startups and crypto projects. These ventures raise capital by issuing digital tokens or coins in exchange for cryptocurrency investments. ICOs remain highly speculative, and many operate beyond regulatory oversight. As an investment advisor, it is crucial to have a solid understanding of how ICOs function, their inherent risks, and the evolving regulatory landscape.

Key Takeaways

  • Initial coin offerings (ICOs) are a method of funding that involves issuing digital tokens in exchange for cryptocurrency.
  • Financial advisors need to understand the risks and regulatory considerations associated with ICOs.
  • ICO investments are subject to potential fraud, lack of investor protection, poor liquidity, and volatility.
  • Thorough technical and financial analysis is required to support any recommendation to participate in an ICO.

For clients interested in cryptocurrencies, ICOs may be an attractive early investment opportunity in a disruptive technology. However, advisors have an obligation to ensure clients fully grasp the risks involved and that their ICO investments align with their broader financial goals and risk tolerance. You can then set client expectations and uphold your ethical duties even in a newer investment area like cryptocurrency.

With the appropriate due diligence and a measured approach, advisors can navigate the fast-moving ICO landscape on behalf of their clients to give them prudent advice. This remains a “buyer beware” market still needing maturation and regulatory clarity. In the interim, advisors must vigilantly assess each offering and emphasize transparency with clients above all else.

How ICOs Work

The process for conducting an ICO often involves the issuer releasing a document known as a “whitepaper” detailing the project, goals, timeline, and use of funds. The whitepaper serves as an informal prospectus to attract potential investors.

Once the whitepaper circulates, the issuer sets a date for a token sale to exchange newly created crypto tokens for established cryptocurrencies like bitcoins or ether, usually with the expectation the tokens being offered will increase in value as the network and demand grow. The tokens are stored in digital wallets and are typically based on blockchain technology.

These newly minted digital tokens have two main varieties:

  • Utility tokens: These provide their holders with future access to a product or service on the platform being developed. Essentially, they grant usage rights or the prospect of such rights.
  • Security tokens: These entitle holders to an investment return, profit share, dividends, or other financial interest tied to an underlying asset. These are usually subject to securities regulations.

To date, the vast majority of ICOs are the utility type. Unlike company shares, these ICO tokens generally do not confer equity ownership in the issuing entity. Instead, they represent a digital asset specific to the project or platform.

For this reason, the value of utility tokens depends on the successful development and adoption of the project’s platform or service. If the project fails to materialize or gain traction, the tokens may become worthless. Alternatively, while offering potential financial returns, security tokens are subject to the regulatory environment of securities, which can add layers of complexity and compliance provisions.

From a technical perspective, ICOs rely heavily on ERC-20 tokens built on the Ethereum blockchain. Smart contracts automate the execution of token sales and distribute them based on set terms.

Key Differences Between ICOs and IPOs

While frequently compared with initial public offerings (IPOs) of company shares to the public, ICOs differ considerably concerning their regulation, structure, inherent risks, and investor rights. Here are some key differences:

  • Regulation: IPOs must adhere to strict rules in the Securities Act of 1933, which requires company disclosures, financial statements, liability for misstatements, and registration with the Securities and Exchange Commission (SEC). ICOs, meanwhile, mostly operate outside this framework.
  • Underwriting: For IPOs, underwriters like investment banks conduct thorough due diligence, receive fees, and act as gatekeepers to the public markets while marketing new shares to early investors. ICOs have no intermediaries screening or validating their offerings. Instead, the investing public must do their own research and build trust in the issuer, which directly markets the tokens.
  • Rights and privileges: Stocks bought in IPOs represent equity ownership in a company’s assets and entitle owners of shares to residual profits, voting rights, and the potential for dividends. ICOs rarely confer such rights, as they are typically utility-based tokens granting platform access and usage rights—or nothing at all.

These differences mean IPO investors have more transparency, oversight, and legal protections than those in the ICO market. Advisors need to underscore these contrasts so clients appreciate the heightened risks.

ICOs

  • Legal requirements: This depends on where the ICO is based.

  • Transparency: Information given in whitepapers is mostly voluntary; frequently unaudited.

  • Company stage: Early stage firms.

  • Accessibility: If you’re already familiar with crypto and blockchain, fairly easy. No underwriting gatekeepers or intermediaries between founders and the market.

  • Rights and privileges: Often little or none since they are usually for utility-based tokens.

IPOs

  • Legal requirements: Registration with the SEC, compliance with rules for exchange listing, due diligence, and Know Your Customer, and anti-money laundering statutes.

  • Transparency: Prospectus that details finances, known risks, and legally required and audited information necessary for selling securities to the public.

  • Company stage: Typically, well established with years of audited financial statements available.

  • Accessibility: Demand frequently exceeds supply for attractive IPOs, limiting access.

  • Rights and privileges: IPO shares are equity in a company, entitling the buyer to potential dividends, voting rights, and residual profits.

Risks and Challenges of ICOs

Given the lack of mandatory disclosures, regulations, and standardization, ICOs present a high risk of fraud, misrepresentation, and cybersecurity breaches. Advisors should warn clients of potential red flags like statements guaranteeing high returns, fake founder credentials, plagiarized whitepapers, or pressure to invest quickly.

While many ICO issuers publish whitepapers, websites, and project details, there are no requirements for audited financials, disclosures of conflicts, or background checks. An elevated risk of fraud or misconduct, therefore, exists in ICOs.

While many ICOs are legitimate, the largely unregulated arena has been the target of numerous instances of fraud. Here are a few of the most notorious examples:

  • OneCoin: OneCoin was promoted as a new cryptocurrency that would yield high returns. However, it was eventually revealed to be a Ponzi scheme. Its founders have since been convicted of defrauding investors of billions of dollars. Red flags include overpromising future returns, overpromising on the company’s technology, and dubious credentials for their founders.
  • BitConnect: BitConnect promised high returns to investors but was eventually exposed as a Ponzi scheme. When it collapsed in 2018, it led to massive losses for investors spread out across the globe. Red flags include overpromising on high returns, a whitepaper that was murky at best, and a referral program that used a structure known from Ponzi schemes.
  • Centra Tech: The Centra Tech ICO was backed by several celebrities and raised $25 million in its offering. The founders later pleaded guilty to fraud and other charges, having made false claims about their technology and business relationships with major credit card companies. Red flags include overpromising future returns, overpromising on the company’s technology, unconfirmed relationships with major non-crypto firms, and the dubious credentials of executives (who didn’t exist).
  • Pincoin and iFan: These two ICOs, run by the same Vietnam-based company, Modern Tech, defrauded over 30,000 investors out of a combined total of $660 million. The scheme promised high returns, but investors were paid with tokens from a new ICO rather than cash. Red flags include overpromising on high returns (up to 40% monthly at one point), a pyramid scheme arrangement (returns paid in further tokens), and an opaque business structure.
  • PlexCoin: The PlexCoin ICO promised a 13-fold profit in less than a month but instead defrauded investors of millions. Red flags included overpromising future returns (1,354% profit in less than 29 days) and the dubious backgrounds of executives.

These cases highlight the need for due diligence and caution when investing in ICOs. The cryptocurrency space, especially over several years in the late 2010s, saw a proliferation of such schemes, taking advantage of the hype, lack of regulation surrounding digital currencies and blockchain technology, and investors wanting to get in on returns seen in legitimate ICOs.

But even legit ICOs have high failure rates. Their speculative nature means that ICO investments tend to have extreme volatility. The principal invested can decline significantly or go to zero after a startup failure. Studies, moreover, find that most ICOs lose substantially all their value over time, amplified by persistent delays, project abandonment, or lack of liquidity.

Another challenge is the limited historical data and lack of established valuation models for ICOs, making it difficult to assess their fair value or potential return rigorously. Traditional financial metrics and analysis methods used for stocks and bonds are often not applicable to ICOs.

Liquidity risk is another concern. Unlike publicly traded shares listed on major stock exchanges, many ICO tokens are traded on less regulated and less liquid cryptocurrency exchanges. This can make it difficult for investors to sell their tokens at a fair price (or at all), especially during market downturns.

Evolution of the ICO Market

In the 2010s, ICOs emerged as a method for blockchain-based startups to raise capital outside the traditional venture capital model. They were enabled by the increasing popularity and acceptance of cryptocurrencies, especially bitcoin and ether. The first notable ICO was for Mastercoin (now Omni) in 2013, which raised $5 million, an impressive figure at the time that demonstrated the potential of this new fundraising mechanism.

Over the next few years, the ICO landscape grew rapidly, culminating in a peak between 2017 and 2018 when billions of dollars were raised by various projects, including notably shady ones. The appeal was simple: it was a way for anyone with an internet connection to invest in projects that seemed to grow in value rapidly. For instance, Dragon Coin (DRG), a payments system targeting the Southeast Asia online casino market, raised $320 million in March 2018, though it has since lost more than 85% of its ICO value.

While many fail, several cases highlight the potential success ICOs can have. Perhaps the best known is Ethereum, which had its ICO in 2014 and raised over $18 million. It has since grown into the second-largest cryptocurrency by market capitalization. Ethereum’s success lies not just in its fundraising but in how it contributes to the cryptocurrency ecosystem more broadly. The platform’s introduction of easily programmable smart contracts changed the industry, laying the groundwork for decentralized applications and numerous other blockchain projects.

Another prominent example is EOS, which raised a record $4 billion in its yearlong ICO ending in 2018, though its market cap has since decreased to about $750 million by the end of 2023. These successes underscored the massive fundraising potential of ICOs and how these funds could be channeled to create platforms that aimed to improve the crypto space.

However, more recent trends in the ICO market indicate a shift toward more regulatory compliance and investor protection. The explosive growth and subsequent scams and failed projects caught the attention of regulators worldwide. This has led to increased scrutiny and the implementation of more stringent rules around ICOs. As a result, there has been a decline in the number of ICOs, with a noticeable shift toward security token offerings and initial exchange offerings, which are said to be better regulated and more secure alternatives. These trends could reflect a market that is gradually aligning with traditional financial and regulatory standards while maintaining the best aspects of the crypto space.

Considerations for Financial Advisors

ICOs require advisors to conduct extensive due diligence. Here are some of the most crucial elements in an ICO to evaluate:

  • Founder/company credentials and track record
  • Proposed product or service viability and competition
  • Token utility and use cases
  • Code audits and cybersecurity
  • Token valuation and sale structure
  • The planned uses for the proceeds
  • Market conditions and growth projections

Advisors should thoroughly vet whitepapers, interrogate assumptions, and assess alignment with client goals before endorsing any ICO investment. From a suitability perspective, clients should only use discretionary risk capital for ICOs they can afford to lose. Conservative allocations are prudent.

Ongoing client and advisor education is paramount so individuals understand what ICO investments entail. Transparency and knowledge builds trust in advising on novel areas like crypto.

Legally, advisors must follow all applicable regulations should they recommend ICOs, a largely unregulated space. Ethical obligations persist. As the market evolves, advisors must regularly advise clients on current trends, risks, and developments to make informed decisions on any ICO opportunities. Advisors should monitor the changing regulatory landscape, especially provisions around Know Your Client and anti-money laundering that can determine a client’s eligibility to participate in ICOs.

While risky, ICOs offer exposure to emerging technologies and business models that can diversify and contribute to an overall investment portfolio. Well-equipped advisors can guide clients to make informed decisions about this complex, rapidly evolving ecosystem.

When Should an Advisor Endorse or Recommend an ICO to Clients?

Advisors should not endorse ICOs unless they determine an offering is suitable after exhaustive due diligence. Even then, allocations should be minimal given the risks. A high level of caution is warranted.

What Blockchain Platforms Are ICOs Most Often Built On?

While some ICOs are issued via their unique blockchain, most today launch on the Ethereum network and issue ERC-20 standard tokens because of Ethereum’s maturity and smart contract capabilities.

What Are Secure Token Offerings?

Secure token offerings (STOs) are public offerings of security tokens sold in cryptocurrency exchanges. These tokens are subject to federal securities regulations, distinguishing them from ICOs. Aimed at more traditional investors, STOs are a more regulated, secure, and legally compliant way of raising funds and investing in blockchain projects.

What Are Initial Exchange Offerings?

An initial exchange offering (IEO) is a type of fundraising for new cryptocurrency projects like ICOs. However, in an IEO, the sale is done through a cryptocurrency exchange, not by the project team. Thus, the crypto exchange, which is supposed to vet the token, acts as an intermediary between token issuers and buyers. This added layer involving the established exchange is supposed to increase investor trust and reduce the risk of fraud, a significant concern with ICOs.

The Bottom Line

ICOs are an evolving method of fundraising that has opportunities and risks. Financial advisors must understand these dynamics, as well as the evolving regulatory environment, to guide their clients effectively in this space, balancing these investment opportunities with the need for due diligence and risk management.

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