Start-ups have found a new and unregulated source of funding for their ventures. The new form of funding is the extension of an idea to presale coins of a cryptocurrency or a token of a blockchain project. Evolving as a highly successful mode of raising funds, Initial Coin Offerings or ICOs are estimated to have witnessed total cumulative investment of around $3.8 billion, with the bulk having been invested in 2017.
While the total volume is very low, in comparison to the total venture funding of $60 billion in 2017, it is in line with early stage VC funding levels. So, what are the reasons for the popularity of ICOs and how exactly do they work?
A source of funding that bypasses the regulatory set up for capital raising by venture capitalists or banks, ICOs are becoming highly popular amongst cryptocurrency and other ventures. In an ICO campaign, a percentage of the cryptocurrency is sold to early investors or backers of a project, in exchange for legal tender or other cryptocurrencies, generally Bitcoin or Ether.
A cryptocurrency start-up generally creates a plan or a white paper about the project, listing all its details, objectives and goals. The paper also outlines the portion of virtual tokens to be kept by the promoters themselves, what type of money will be accepted and the total duration of the ICO. Once the campaign is launched, supporters of the firm’s initiative buy some of the distributed cryptocoins with virtual currency. The sold coins are referred to as tokens, and are similar to the shares of a company making an Initial Public Offering or IPO.
Now, each ICO has its own special pricing, which is normally divided into multiple stages. After each stage, the price per crypto token increases, so investors who join earlier get a better price per coin. Once these investors have acquired the crypto tokens, they can trade them on cryptocurrency exchanges.
So, what happens if the start-up is unable to raise the desired amount? In case the money raised is less than the minimum funds required by the firm, the amount raised is returned to investors and the ICO is termed unsuccessful. However, if the fund requirements are fulfilled in the stipulated timeframe, the funds raised are used to initiate or complete the scheme.
The reason investors are motivated to buy cryptocoins is the hope that once the plan becomes successful, it would lead to a higher value for the cryptocoin. A perfect example of this is the Ethereum platform for smart contracts, which offered Ethers as its coin tokens. Launched in 2014, the Ethereum project’s ICO raised $18 million or $0.40 per Ether. Once the project went live and was successful, Ether’s value surged to $14 in 2016, rising above $700 in December 2017. The platform is now being used by more and more start-ups to raise funds for their projects.
A major benefit of choosing the ICO route for funding a project rather than venture funding is the absence of any governance rights to an ICO investor. While a venture capitalist investing in a project would demand a board seat or rights to ensure that the firm’s capital is spent wisely, an investor in an ICO offering does not get any kind of governance rights. This advantage has, however, been used by several fraudulent companies, who launched an ICO and virtually disappeared thereafter.
Another unique advantage of ICOs is that the process itself drives the adoption of the product (cryptocurrency). Start-ups in such cases not only raise capital but also get their first few customers. But this may not work for all start-ups.
Since the cryptocurrency industry is largely unregulated, start-ups raising investments via ICOs face the risk of potential regulations in the near future. Regulation of ICOs could result in some financial and legal risks for investors. Also, the cost and efforts involved to comply with the regulations may reduce the advantages offered by the ICOs over traditional means of funding.
To conclude, ICOs have emerged as an attractive option for raising investments. But investors need to be aware of the potential risks, including the risk of being defrauded. The key to wise investing is asking questions, demanding clear answers and applying good old common sense while investing in new age currencies and ICOs.
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