In 2016, initial coin offerings (ICO's) raised US$103 million across 64 ICO's. In 2017, the amount raised is expected to reach US$1 billion. Some ICO's have been breathtaking in the speed in which funds have been raised, and the valuations they deliver to the underlying project. Gnosis raised US$12.5 million in less than 15 minutes, giving its ethereum prediction market a US$300 mn valuation.

What was once an esoteric offering with then the sole purview of a small and cultish number technology supporters and geeks, is fast becoming a magnet for frontier venture capital investing

Questions and issues abound - some elementary, some more complex. Let's take each one in turn.

What is blockchain?

ICO projects are built on blockchain technology, and inextricably linked with blockchain.

For the non-technical person, it is more important to understand the key features of blockchain than how it effectively operates. These are:

1.        No single person controls the data or information contained on a blockchain. It is not centralised.

2.        Each person on a blockchain has access to the entire database and its complete history. It is a distributed database.

3.        Communication on a blockchain occurs directly between peers, rather than through a central transmission channel.

4.        A transaction recorded on a blockchain leaves a permanent, irreversible record.

5.        The blockchain protocol can facilitate autonomous programming and execution. When blockchain transactions take place, smart contracts automatically execute themselves.

The result is an innovation in information registration and distribution that eliminates the need for a trusted central party to facilitate digital relationships.

There are a significant number of use cases for blockchain technology. Financial institutions, for instance, are looking at the attractions of secure permanent record keeping as a means of drastically reducing back-office cost.

What is an ICO?

An ICO is a hybrid between crowdfunding and capital raise. It is a method that developers use to raise funds for a technology venture that is typically blockchain based. The fund raise is often conducted at a pre-launch phase, and is conducted via a new digital currency in which new digital tokens are issued.

An ICO sidesteps the typical business model development – raise money, build product, build business model, drive to liquidity with angels, venture investors, advisers and bankers along the way. Instead, in its purest form, projects funded by an ICO represent funding by users in proportion to their usage, and rewards early adopters, network operators and developers.

The digital token is itself a means to have access to and use the project once it is launched and operating. Additionally, if the project is successful, then early investors will profit from a rise in the capital value of the digital token.

Since 2015, most ICO's are built on the ethereum blockchain. Ethereum provides an infrastructure for transacting digital tokens, and its innovation was also to provide an easy capability for using smart contracts to make the creation, distribution and trading of tokens easier.

What process is used to run an ICO?

The technology process for an ICO is deceptively simple. The new digital token is issued to a backer under a smart contract, upon delivery of and in exchange for the required amount of funding. The funds raised are usually provided by depositing a cryptocurrency (such as Bitcoin or Ether) with the start-up developers.

The documents prepared for an ICO invariably include a White Paper, which sets out general information on the blockchain project, the digital tokens to be issued, and other information. Sometimes this is accompanied by a Technical White Paper, which delves deeper into the technology aspects of the project and the ICO. The better structured ICO's may be accompanied by an Offering Memorandum, which will also describe various risk factors and the investment process.

Who launches an ICO?

Here are some examples:

Ethereum's development was funded by an online crowdsale during August 2014 that raised approx US$18.5 mn, for which approx. 11.9 mn ether coins were issued. The developer was the Ethereum Foundation, a Swiss non-profit, formed to support developers produce decentralised applications. Ethereum is a decentralized platform that runs smart contracts. The system went live on 30 July 2015, with 11.9 million coins, called ethers, "premined" for the crowdsale. This accounts for approximately 13% of the total circulating supply. Key founder: Vitalik Buterin

Gnosis will be a decentralised platform for prediction markets that uses crowdsourced wisdom sourced globally to make predictions typically giving anticipated binary outcomes to a question about the future. The ICO raised approx US$12.5 mn in a token offering via a Dutch auction, giving a valuation of US$300 million to the project. Key founders: Martin Köppelmann and Stefan George.

Waves is a crypto-platform for token issuance, transfer, and trading on blockchain. raised 29,634 BTC (approx US$16 mn) in its ICO in July 2016 in exchange for 85,000,000 coins (WAVES).

Golem is a global, open sourced, decentralized supercomputer made up of the combined power of user's machines, from personal laptops to entire datacenters. At the time of its ICO, Golem was the second-fastest ICO in the history of cryptocurrencies. Golem raised approx. 820,000 ether, equivalent to approx. US$8.6 mn within 20 minutes on 11 November 2016.

OpenANX is a proposed open source, decentralised digital asset exchange: This is a project from Hong Kong. The OAX token sale launched on 22 June seeking to issue up to 30 mn OAX, roughly equivalent to US$22.5 mn. 

Who invests in an ICO?

In the early days, investors in ICO's were a small group of blockchain evangelists. They viewed the contribution as a financial support to start-ups, formed as non-profits, to empower them to build open source blockchain technologies. An ICO does not give an equity or property interest in the underlying business. Participating in an ICO was perceived as allowing the developer to prioritise the general good over immediate financial return. Those days are gone.

Key investors include:

Pantera Capital, the first US Bitcoin investment firm, exclusively focuses on investing in block chain technologies. Pantera has made investments in Z Cash, Ripple Labs and coins.ph

Blockchain Capital, formed in two thousand thirteen, was the first VC fund to accept capital calls in Bitcoin. It continues to focus on investments in the Bitcoin and blockchain ecosystems. Notable investments include Coinbase and Wave.

Digital Currency Group is an investment firm that is notable for having supported a number of blockchain companies in Asia, including Melotic, Luno and BTCC.

Fenbushi Venture Capital is the first China-based venture capital firm that exclusively invests in Blockchain-enabled companies, and has invested in Abra and Symbiont.

Why are VC's interested in ICO's?

The foundation of the VC interest in block chain technologies is in understanding the "fat protocol" thesis. This contrasts investments in Internet technologies with blockchain technologies. In Internet technologies, the shared protocols produced great value, but this value was overwhelmingly captured in applications on the protocol. So, Google, Facebook and Uber became valuable, not the creators of the underlying HTTP or SMTP protocols.

This is reversed in blockchain, where value concentrates in the shared protocol layer, not the applications. Digital tokens mean the creators of a blockchain protocol can monetise the protocol directly. This is typically done by reserving a portion of the digital tokens for the developers, early investors or early adopters. As the protocol project launches and reaches levels of success, that early group of supporters can create a positive investment feedback loop and market support for the digital token itself. Successful applications built upon the blockchain protocol serve to attract interest in the underlying block chain protocol, for which there is a ready market available. As the price increases, the market cap of the protocol should grow faster than any applications.

One feature to consider when considering an ICO is whether it is in respect of a protocol or an application. Ethereum is a protocol. Golem and Gnosis are not. They are applications sitting on the Ethereum blockchain and they can compete with other applications sitting on the same protocol.

Venture investors typically enter at or just before the point where product market fit has been established, but there is still a long journey from then until liquidity occurs via an IPO, a trade sale or a secondary exit. One of the major attractions of ICO's is that the digital token issued by the developer is tradable. It can be traded for other digital currencies (such as Ether or Bitcoin), and then into fiat currency through a digital exchange. This provides liquidity.

Are ICO's regulated?

Rarely at present, but this poses the question of whether ICO's should be regulated.

Many of the characteristics of an ICO have an uncanny similarity to securities. The documents issued with an ICO are loosely based on similar documents issued for an offering of securities. Even the phrase "initial coin offering" is similar to "initial public offering".

Those that argue ICO's are not securities highlight these factors:

  • An ICO does not offer equity in the blockchain venture.
  • An ICO only offers discounts on cryptocurrencies. Cryptocurrencies are not a security.
  • An ICO is a global instrument, not a national one, and is not controlled by any central authority or bank.
  • A digital token issued in an ICO is a usage token, that can be applied and used in the blockchain protocol being developed.

Those that believe ICO's are securities point to the fact that ICO's can fulfil the traditional criteria of what defines a security. Purchasers in an ICO are acting with the expectation of profit. Once something is offered for investment or speculation (rather than use), there is a higher chance that it will be considered a security. Higher regulatory interest is piqued once the offering is made to the public.

The position in Hong Kong is unclear. The definition of securities in the Securities and Futures Ordinance does not immediately admit an ICO as a security. However, the Securities and Futures Commission can prescribe a class of interests, rights or property as a security by notice. Likewise, the securities offering regime extends to regulated investment agreements, which are agreements that provide a profit or return calculated by reference to changes in the value of any property. This broad concept could be interpreted to include digital tokens issued in an ICO.

What are the risks?

ICO's presently are commonly launched at a very early stage of development, sometimes barely passed the concept stage. Any investment into an early stage enterprise is inherently highly risky.

Blockchain is a nascent and developing technology. There is a lack of sophisticated investment coverage over the blockchain sector. This is not suited to investors who are accustomed to professional intermediaries who monitor public information and manage their investments in a regulated environment.

Many ICO's are conducted with a loose application of KYC or AML standards where a range of investors contribute funds for a common purpose.

The ICO infrastructure does not provide for any oversight on how funds are deployed, or accountability on the development of the underlying blockchain project. In its simplest form, there is nothing to prevent the developer from absconding with the ICO proceeds.

ICO's are gaining a higher profile. In future, they will attract those who wish to raise capital in an unregulated environment with little accountability, and more public investors without a deep understanding of the underlying investment risks. This is a potentially dangerous cocktail.

The regulatory position is very uncertain in relation to ICO's. Those initiating an ICO, or promoting one, may find themselves subject to regulatory sanction if new rules are introduced or existing rules interpreted so that they apply to ICO's.

What lies ahead?

ICO's are here to stay. Many commentators see the real value of ICO's in the usage applications of the tokens issued. This ties into the fat protocol theory underpinning blockchain technologies. ICO's combined cost efficient funding with building a motivated network of supporters. This addresses the pain point of the large funding gap that exists globally for private companies before a liquidity event happens.

The challenge ahead is to improve the current environment in which ICO's are conducted. A starting point is self-regulation by the industry to a higher standard. One example is Tokenmarket, which has teamed up with the Stock Market of Gibraltar to offer KYC and AML compliant ICO's. The ICO process could be raised to a higher standard to take into focus issues such as assessing those who may participate in an ICO, the legitimacy of the source of funds raised in the ICO, and the deployment of those ICO funds for the relevant blockchain project.

Regulators will continue to keep a watchful eye on ICO's. Regulators in Hong Kong and elsewhere are already including blockchain technologies in their regulatory sandboxes so they can see how the technologies operate and what the risks may be. Silence or inaction by regulators should not be construed as consent. It may well take a notorious case with significant retail investor loss to trigger direct regulatory intervention.

In the meantime, those organising ICO's would do well to build measures into their ICO process that may mitigate their liability if regulators come down hard on ICO's. These mitigating measures could include:

  • Delaying distribution of tokens until the underlying network is up and running.
  • Only use tokens that have a use value, and avoid tokens that are simply speculative investments.
  • Build with open source software and use an open and transparent blockchain.
  • Run the process as if it was a regulated investment, including risk disclosures, investor assessment, AML and KYC processes, and investor reporting.
  • Reserve a portion of the digital tokens as a reserve fund to meet any licensing obligations (if required) or regulatory costs and fines.

ICO's are a wild west of financing. But, previous frontiers have been tamed and civilised. The careful and proper development of capital raising by ICO's hold the prospect of less friction and more participation and liquidity in blockchain protocol ventures. This could be a brave new world in fund raising.