What Is an Initial Coin Offering (ICO)?
An initial coin offering (ICO) is the cryptocurrency industry's equivalent to an initial public offering (IPO). A company seeking to raise money to create a new coin, app, or service can launch an ICO as a way to raise funds.
Interested investors can buy into an initial coin offering to receive a new cryptocurrency token issued by the company. This token may have some utility related to the product or service that the company is offering, or it may just represent a stake in the company or project.
- Initial coin offerings are a popular way to raise funds for products and services usually related to cryptocurrency.
- ICOs are similar to initial public offerings, but coins issued in an ICO can also have utility for a software service or product.
- Some ICOs have yielded massive returns for investors. Numerous others have turned out to be fraudulent or have performed extremely poorly.
- To participate in an ICO, you usually need to first purchase a more established digital currency, plus have a basic understanding of cryptocurrency wallets and exchanges.
- ICOs are, for the most part, completely unregulated, so investors must exercise a high degree of caution and diligence when researching and investing in ICOs.
How an Initial Coin Offering (ICO) Works
When a cryptocurrency project wants to raise money through ICO, the project organizers' first step is to determine how they will structure it. ICOs can be structured in a few different ways, including:
- Static supply and static price: A company can set a specific funding goal or limit, which means that each token sold in the ICO has a preset price, and the total token supply is fixed.
- Static supply and dynamic price: An ICO can have a static supply of tokens and a dynamic funding goal—this means that the amount of funds received in the ICO determines the overall price per token.
- Dynamic supply and static price: Some ICOs have a dynamic token supply but a static price, meaning that the amount of funding received determines the supply.
These three different types of ICOs are illustrated below:
Alongside structuring the ICO, the crypto project usually creates a white paper, which it makes available to potential investors via a new website dedicated to the token. The promoters of the project use their white paper to explain important information related to the ICO:
- What the project is about
- The need that the project would fulfill upon completion
- How much money the project needs
- How many of the virtual tokens the founders will keep
- What type of payment (which currencies) will be accepted
- How long the ICO campaign will run
The project releases the white paper as part of its ICO campaign, which it designs to encourage enthusiasts and supporters of the project buy some of the project’s tokens. Investors can generally use fiat or digital currency to buy the new tokens, and it's increasingly common for investors to pay using other forms of crypto such as Bitcoin or Ethereum. These newly issued tokens are similar to shares of stock sold to investors during an IPO.
If the money raised in an ICO is less than the minimum amount required by the ICO's criteria, then all of the money may be returned to the project's investors. The ICO would then be deemed unsuccessful. If the funding requirements are met within the specified time period, then the money raised is spent in pursuit of the project's goals.
Who Can Launch an ICO?
Anyone can launch an ICO. With very little regulation of ICOs in the U.S. currently, anyone who can access the proper tech is free to launch a new cryptocurrency.
But this lack of regulation also means that someone might do whatever it takes to make you believe they have a legitimate ICO—and then abscond with the money. Of all the possible avenues of funding, an ICO is probably one of the easiest to set up as a scam.
If you're really set on buying into a new ICO that you heard about, make sure to do your homework. The first thing is to make sure the people putting up the ICO are real and accountable. One key thing to look for is the product's leads' history with crypto or blockchain. If it seems the project doesn't involve anyone with relevant, easily verified experience, that's a red flag.
Famous actors and entertainers like Steven Seagal also sometimes encourage their followers to invest in a hot new ICO. Boxing superstar Floyd Mayweather Jr. and music mogul DJ Khaled once promoted Centra Tech, an ICO that raised $30 million at the end of 2017. Centra Tech was ultimately deemed a scam in court, resulting in the two celebrities settling charges with U.S. regulators, plus three Centra Tech founders pleading guilty to ICO fraud.
Even if anyone can establish and launch an ICO, that doesn't mean that everyone should. If you are thinking about organizing an initial coin offering, ask yourself if your business would substantially benefit from an ICO.
ICO activity began to decrease dramatically in 2019, in part because of the legal gray area that ICOs inhabit. Investors can research and find ICOs in which to participate, but there is no surefire way to stay abreast of all the latest initial coin offerings. You can use websites like TopICOlist.com and websites that compare different ICOs against one another.
ICOs can generate a substantial amount of hype, and there are numerous sites online where investors gather to discuss new opportunities. Investors seeking to participate in ICOs should first familiarize themselves broadly with the cryptocurrency space and become educated about any ICO before participating. Because ICOs are barely regulated, prospective investors should exercise extreme caution when investing.
The Securities and Exchange Commission (SEC) can intervene in an ICO if necessary. After the creator of Telegram raised $1.7 billion in an ICO in 2018 and 2019, the SEC filed an emergency action and obtained a temporary restraining order, alleging illegal activity on the part of the development team. In March 2020, the U.S. District Court for the Southern District of New York issued a preliminary injunction, and Telegram was ordered to return $1.2 billion to investors and pay a civil penalty of $18.5 million.
There is no guarantee that an investor won't be on the losing end of a scam when investing in an ICO. To help avoid ICO scams, you can:
- Make sure that project developers can clearly define what their goals are. Successful ICOs typically have straightforward, understandable white papers with clear, concise goals.
- Look for transparency. Investors should expect 100% transparency from a company launching an ICO.
- Review the ICO's legal terms and conditions. Because traditional regulators generally do not oversee this space, it is an investor's responsibility to ensure that an ICO is legitimate.
- Check that ICO funds are stored in an escrow wallet. This type of wallet requires multiple access keys, which provides useful protection against scams.
Another further consideration is that you typically need to own another cryptocurrency to invest in an ICO. Because new tokens issued in an ICO can often only be purchased using an established cryptocurrency such as Bitcoin, ICO investors need to already have two cryptocurrency wallets:
- One crypto wallet to store another cryptocurrency such as Bitcoin or Ethereum
- An additional cryptocurrency wallet to hold the token or currency being sold for the ICO
Initial Coin Offering (ICO) vs. Initial Public Offering (IPO)
Initial public offerings of stock raise money for companies that are becoming public and result in the distribution of shares of the company's stock to investors. For ICOs, crypto companies raise funds through the sales of coins or tokens. In both cases, investors are bullish, whether about the company or the cryptocurrency, and invest based on some belief that the asset's value will increase over time.
The primary difference between an ICO and an initial public offering of stock is that investing in an ICO doesn't secure you an ownership stake in the crypto project or company. ICO participants are gambling that a currently worthless currency will later increase in value above its original purchase price.
IPOs are highly regulated by government organizations such as the Securities and Exchange Commission, while ICOs are largely unregulated. This lack of regulation coupled with the often decentralized nature of crypto projects means that an ICO's structure can vary significantly. By contrast, the structure of most IPOs is largely similar.
Though IPOs are funded by generally more conservative investors anticipating a financial return, ICOs may receive funding from risk-tolerant supporters who are keen to invest in a new, exciting project. An ICO differs from a crowdfunding event because it offers the possibility of financial gain over time, whereas crowdfunding initiatives essentially just receive donations. ICOs are also referred to as “crowdsales” because of the possibility of financial gain.
Advantages and Disadvantages of Initial Coin Offerings
Online services can facilitate the generation of cryptocurrency tokens, making it exceptionally easy for a company to consider launching an ICO. ICO managers generate tokens according to the terms of the ICO, receive them, and then distribute the tokens by transferring the coins to individual investors. But because ICOs are not regulated by financial authorities like the SEC, funds that are lost due to fraud or incompetence may never be recovered.
Early investors in an ICO are usually motivated by the expectation that the tokens will gain value after the cryptocurrency launches. This is the primary benefit of an ICO: the potential for very high returns.
But the legality of cryptocurrency or digital assets is not guaranteed to persist. In 2017, the People's Bank of China officially banned ICOs, slamming them as counterproductive to economic and financial stability. The Chinese government in 2021 went on to ban cryptocurrency mining and declared all cryptocurrency transactions illegal.
SEC Introduces the HoweyCoin
The SEC in 2018 introduced a fake coin called the HoweyCoin to demonstrate to individual investors the dangers of ICOs. The SEC's HoweyCoin is named after the agency's Howey Test, which is a test to determine whether an investment qualifies as a security. The SEC then used the Howey Test to charge Kik, a messaging service that raised $100 million in an unregistered ICO, with unlawful sales of a security.
The first instance of the SEC cracking down on an ICO occurred on Dec. 11, 2017, when the agency halted an ICO by Munchee, a California company with a food review app. Munchee was attempting to raise money to create a cryptocurrency that would work within the app to order food. The SEC issued a cease-and-desist letter, treating the ICO as an offering of unregistered securities.
Examples of Initial Coin Offerings
Ethereum's ICO in 2014 is an early, prominent example of an initial coin offering. The Ethereum ICO raised $18 million over a period of 42 days. In 2015, a two-phase ICO began for a company called Antshares, which later rebranded as Neo. The first phase of this ICO ended in October 2015, and the second continued until September 2016. During this time, Neo generated about $4.5 million.
In another example, during a one-month ICO ending in March of 2018, Dragon Coin raised about $320 million. Also in 2018, the company behind the EOS platform shattered Dragon Coin's record by raising a whopping $4 billion during a yearlong ICO.
Sometimes ICOs with remarkable returns on investment are not the projects that raise the most money, and vice versa. The amounts raised by ICOs reached a peak in 2017 and 2018 and have declined in recent years. When evaluating the success of an ICO, you can consider both the amount of money raised in the ICO and the return generated on investment.
Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Because each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.