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What is a token sale (ICO)?


Smith + Crown has developed a handout on ICOs. You can download it here: smithandcrown_ico_handout_v2.0.(1)






ICOs (Initial Coin Offerings) have become a popular way to fund cryptocurrency projects. An ICO is an event in which a new cryptocurrency project sells part of its cryptocurrency tokens to early adopters and enthusiasts in exchange for money today. ICOs provide a way for cryptocurrency project creators to raise money for their operations. Most ICOs raise money in Bitcoin or other cryptocurrencies.

The ICO usually takes place before the project is completed, and helps fund the expenses undertaken by the founding team until launch. For some of the larger projects, part of the ICO money goes into a foundation that provides ongoing support to the project. They also work as an initial distribution model for the cryptocurrency tokens, especially those with a proof of stake consensus algorithm.

The ICO participants are invested in the success of the project. They can help get the word out and raise awareness in the broader community. They also provide early liquidity for the cryptocurrency tokens when they start trading. The ICO participants are also usually motivated by a profit potential if the project takes off and the tokens become worth more than the ICO price.

Are ICOs like IPOs?

ICOs have been compared to Initial Public Offerings (IPOs) of corporations. There are some notable similarities – both of them are used to sell a stake and raise money, and both have investors who see the potential and risk their capital in order to make a potential profit.

However, there are significant differences as well. ICOs are mostly supported by early enthusiasts and not professional investors. In that respect, they are similar to ‘kickstarter campaigns’, but with the backers having a financial stake in the project. ICOs are also not regulated or registered with any government organization and there are usually no investor protections other than what is built into the platform itself.

Most ICOs today are marketed as ‘software presale tokens’ akin to giving early access to an online game to early supporters. In order to try to avoid legal requirements that come with any form of a security sale, many ICOs today use language such as ‘crowdsale’ or ‘donation’ instead of ICOs. They also use legal disclaimers and language to the participants that this isn’t a securities sale. It is unclear whether this is sufficient for global jurisdictions to treat it differently from a securities sale. To date, the matter hasn’t been litigated in a court of law.

The first indication (1) that a government agency was looking into ICOs came in mid-2016. This was in response to The DAO, a crowd-funded vehicle on the Ethereum smart contract being attacked and drained of funds. The SEC (the government agency responsible for protecting investors and capital markets in the United States) is said to be looking into The DAO.

History of ICOs

One of the earliest documented uses of ICOs for a cryptocurrency project was Mastercoin, which was crowdfunded on Bitcointalk forums (3). Mastercoin is a meta-protocol on top of the Bitcoin blockchain that provides additional features that the base Bitcoin layer doesn’t. The ICO took place during mid-2013. Mastercoin (MSC) raised over 5000 Bitcoin (BTC) at the rate of 100 MSC per BTC sent to an “exodus address” (4) during the ICO phase.

Then, the cryptocurrency project NXT had its own ICO on Bitcointalk forums (5), raising 21 BTC (valued around $6000 then). NXT created a cryptocurrency coded from scratch (i.e. not a fork of the original Bitcoin code) and implemented the first fully proof-of-stake system. The project was quite successful for the ICO investors, reaching a peak of ‘market capitalization’ of over $100 million, and currently over $10 million. This made it one of the most successful ICOs for investors.

The successful ICOs kicked off a frenzy of new ICOs during late 2013 to early 2014, which coincided with the largest price rise in Bitcoin. Unfortunately, many of the ICOs failed to live up to their hype or were outright scams. However, this period also saw several successful ICOs like Ethereum.

Today, Ethereum remains one of the largest ICOs to date, raising over $18 million with a current market capitalization of around $ 1 billion.

The DAO, one of the projects using Ethereum, created a smart contract that would take in Ether and fund projects in the cryptocurrency space as a traditional venture capitalist would. The investments would be decided based on participant voting. In June 2016, a bug in the smart contract underlying The DAO was exploited to drain around a third of all its funds (6). Later, the stolen funds were returned to original backers using a hard fork.

Evolution of ICOs

ICOs are a mix between a donation and an investment. Owing to a number of scams in the industry, the community has adopted self-governing best practices and principles with respect to ICOs. Platforms like Koinify (now closed) promised due-diligence of projects before listing them, and releasing the money to the project team conditional upon realizing some pre-defined goals. Community members also demanded that projects use multi-signature wallets to enhance safety.

Some ICOs use a single public Bitcoin address to raise funds, which is bad for privacy, but is good for a community audit of the health of the ICO and the money raised.

Several ICOs use existing cryptocurrency protocols to create their tokens on top of them. This helps simplify the token-creation process. The most notable such protocols today include NXT, Counterparty, Bitshares, and Mastercoin. Waves, which itself was developed through an ICO (raising over $16 million) (7) is also developing a token platform.

Some well-known cryptocurrencies that were developed through an ICO include: NXT, Mastercoin, Bitshares, Ethereum, Maidsafecoin, NEM, Synereo, Factom, DigixDAO, Lisk, and Waves.

How They Work

ICOs are typically announced on various cryptocurrency forums, notably on Bitcointalk. The announcement thread contains key information about the project, such a whitepaper (if present), project goals, timelines for ICO and project development, team involved, previous experience of the team members, notable features of the project, and other ICO details.

Funds are typically collected in Bitcoin, either via a global, public address (in which case the participants need to send Bitcoin from an address they control the private key for), or by creating accounts of each participant and providing them with a unique Bitcoin address. Best practices dictate that all funds ultimately be held in a multi-sig address that is made public.

The specific dynamics of an ICO may vary. They typically include a few weeks of raising money, at least, and try to raise as much as there is demand. Occasionally, some ICOs will instead cap the total amount raised (such as DigixDAO which capped the total fundraising at around $5.5 million). A small percentage of tokens are usually reserved for early promotion bounties, such as forum signature campaigns or social media and newsletter campaigns.

Once the ICO is completed and the project launched, the ICO tokens get listed of cryptocurrency exchanges to trade against other cryptocurrencies. The largest exchange by volume today is Poloniex. The price usually reflects the overall cryptocurrency market sentiment, project-specific news, and the addition of new features.

How to Learn about ICOs

For a list of current notable ICOs, check out Smith+Crown’s researched list (8).

Update: a previous version of this article stated that The DAO fundraising event wasn’t technically an ICO because the funds could be withdrawn. This reflected an earlier definition of a token sale. We have amended that statement. The DAO was a token sale / ICO. We exclude it from our analysis because we exclude all projects that ended in refunds.

(1) https://www.smithandcrown.com/wp-content/uploads/2016/06/smithandcrown_ico_handout_v2.0.pdf
(2) http://commodity-market-news.com/sec-official-says-ethereum-hack-illustrates-blockchain-concerns.html
(3) https://bitcointalk.org/index.php?topic=265488.0
(4) https://blockchain.info/address/1EXoDusjGwvnjZUyKkxZ4UHEf77z6A5S4P
(5) https://bitcointalk.org/index.php?topic=303898.0
(6) https://www.smithandcrown.com/?p=12214
(7) https://www.smithandcrown.com/?p=7875
(8) http://www.smithandcrown.com/icos

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Friday, June 16th 2017
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