(originally written in Hebrew by Assaf Bahat on July 31 2017. Translated by Sarah Wiesner. Edited by me and posted here with permission)
Lately we have seen a deluge of token sales, known as ICOs, the acronym for Initial Coin Offerings. The term is based on the concept of IPOs - companies that raise investment from the public, in exchange for stock that represents ownership and grants several rights, such as taking part in profits.
In the world of Cryptocurrencies, things work a bit differently. The token phenomenon, like many others, comes with great opportunity as well as many dangers.
In this article we will try to give a background and a few rules of thumb that will help understand this new trend.
What is a Token?
Already in the early years of Bitcoin, solutions were developed for creation and management of tokens on a blockchain.
Protocols like Colored Coins and projects like Mastercoin and Counterparty allow anyone to create tokens in any amount they choose, name them and then distribute, send and receive them using a wallet program similar to Bitcoin itself.
Lately many of the tokens are issued on Ethereum with a standard called ERC20. Unlike Bitcoin, which is issued by miners in a decentralized way and according to clear rules, tokens are created and managed in a centralized manner by their issuer, and even though their blockchain gives them certain advantages, such as infrastructure and transparency, they draw their value only from the promises and actions of the issuers.
What is an Initial Coin Offering (ICO)?
A typical ICO is conducted in three phases:
- The group raising the investment publishes: plans, technical details (in a document known as a "white paper"), the manner it plans to use the funds, the story that ties the success of the project to the rise in the value of the token. Included also are terms of the issuing, how many tokens will be issued, when will the funding be open to the public, how long it will last and the cap of the token sale.
- At the designated time, the sale is open and the investors hurry to send their money, usually Bitcoin or Ether, to the issuers. The issuers on their part will send the inventors tokens according to the amount they invested.
The sale is closed when the specified time is up (usually a few weeks) or when the the funding cap is reached (which lately, has often taken just minutes). - In the next phase, the tokens reach the exchanges, sometimes after long months of product development, and many times immediately after the funding is over.
At this point the issuers start executing the plan they presented to the investors and hope for the arrival of more buyers to the exchanges than investors that want to sell so that the price of the tokens will increase.
What is the secret to the popularity of the ICO?
Even though these issuings aren’t a new thing, lately we are witnessing an ever increasing amount of them, with unprecedented amounts of money being raised. We can think of a few reasons for this:
- While the world of stock-exchange issuing is under heavy regulation, crypto token-sales allow avoiding many obligations that apply to traditional issuings. For the issuers as well as investors, ICOs open up an opportunity that is usually blocked for them in the traditional world – the ability to invest directly in a start-up company without being an accredited investor and with no demand of a minimum investment sum.
- Bitcoin, Ethereum and other cryptocourrency investors, whose investments have appreciated meaningfully lately, frown upon returning to the bank, to shekels and dollars, and prefer to diversify their holdings inside the Crypto world. The cryptocurrency market lately passed a valuation of 100 billion dollars (and then corrected downwards) and part of this money flowed into ICOs.
- It works for the issuers. Lately, enormous sums were raised within minutes.
- It works for the investors. Many times the value of the tokens takes off immediately after arriving at the cryptocuurrency exchanges.
The last two points create a self reinforcing cycle which has been fueling itself at an increasingly fast pace, and has started to show worrying signs of a bubble.
What should I look out for?
The lack of regulations is, as stated, one of the reasons for the popularity of the ICOs, but entails complete dependence of the investors on the good will of the issuers. Until there are relevant legal precedents there is no guarantee that the investor has legal protection. There have already been many cases in which the issuers didn’t deliver on their promises or used the investors money for peculiar purposes, opened new companies and abandoned the token holders - In short, they did anything that could conceivably happen when you give people money without them owing you anything.
That said, many of the ICOs have turned out, at least for now, as good investments, so it’s hard to recommend unequivocally avoiding any issuing whatsoever.
Here are a few recommendations to those who still wish to put their money on the line:
Invest only in teams that seem trustworthy
Lacking legal protection, it’s very important to understand who are the people standing behind the project, and to try and understand if they’re worthy of your trust. This isn’t a simple task, but you can try and get an impression from how they write and talk, from what they have done in the past, in what areas they were involved, and from asking questions in the relevant forums, watching them present on video or at a meet up, and searching for insights from experts and and other people who are familiar with this field.
Make sure you understand the role of the token in the project
Even if you perused the whitepaper, understood the essence of the project, and are convinced it’s going to take the world by storm, it’s important to check how exactly the token fits into the picture, and what mechanisms tie the success of the project to a rise in the token's value. Because it is prohibited to just distribute profits directly to the investors, many times we witness bending over backwards in order to create that connection. The connection has to be clear – how exactly does the demand for the token increase as the project grows and succeeds? Do the entrepreneurs have ways to direct profits in a way that circumvents the token? How easy is it to copy and activate the same model with a new token or even with no token?
Check if there is code and a basic product
In some of the latest token sales huge sums were raised without the issuer making even a basic effort to prove seriousness and ability. Avoid investing in projects that all they have done can be summed up in a website for running the token sale. Serious projects usually work on a product, are already active in their field and didn’t appear out of the blue just to raise funds.
In the field of cryptocurrency it is customary to operate with open-source code, which allows readers of the code to get an impression of the level and pace of developments, the number of contributors to the code, etc. If you are not able to do this yourself, it’s worth while searching for and relying on the impressions of those who are savvy.
Mind the Cap
A basic question for every investment is: What is the total valuation of the project I am considering. As the valuation of the company or asset rises, the share the investor gets in exchange for a given sum goes down.
In the world of the ICO there is an extraordinary dynamic – when the gates open, the investors hurry to send their money, and sometimes only when the dust settles, do they find out how much money was raised, and accordingly what is the share they got.
The bigger the token sale, the harder it is for the price of the tokens to climb when they get to the exchanges. There are more potential buyers needed to raise the price, and more potential sellers than can push it down.
To protect investors from too big a token sale, it’s customary to install a cap – a ceiling that limits the sum of the ICO and stops the funding when it’s reached. Make sure the ceiling is there and that it is clearly defined, and that it represents, in your opinion, a reasonable valuation.
Check the terms of the ICO
There is an abundance of creativity in ICO structures. In many cases the terms are complex and hard to understand, and this is no accident.
How many tokens are issued to the company itself? Are part of them gifted directly to the entrepreneurs? If so, are they locked and for how long? Are additional token sales allowed in the future? Will tokens be sold to close associates. and if so, how many and for what discount? Will you be able to move the tokens immediately and if not, when will it be possible?
It’s important to understand the terms beforehand and also to make sure they were indeed filled as stated during and after the ICO.
Read the contract before you sign it
Many ICOs raise money with a “smart contract” in Ethereum that details the terms of the token sale and the features of the tokens after the issuing. Smart contracts (which are computer programs) in Ethereum are meant to be relatively readable in order to allow people with experience in program development to understand them and make sure they’re doing what they’re supposed to do. If you know how to read smart contracts, do it yourself. If not, find someone (objective!) that does. Make sure that the computer program actually does what is promised as described in the written words of the ICO proposal before you sign. There is no turning back if you later realize there is a discrepancy.
In addition, make use of professional audits that are sometimes published before token sales in order to make sure there were no security loopholes in the contract. This can cause loss of funds, as happened lately in a couple of ICOs.
An ICO that uses a smart contract should publish it at least a few days before the beginning of the token sale in order to allow the investors to read it. A project which does not do this is flashing a warning signal.
Beware of aggressive marketing
Focus on the content and not the appearance: the white paper is more important than the site design; a good and clear presentation is more important than a glitzy convention. Experienced developers and reliable entrepreneurs are more important than a list of advisers whose only connection to the project is their photo on the project site. Avoid projects that pay the users to promote them on social media. Aggressive marketing before the token sale stage is usually a warning sign.
Demand full transparency
The work doesn’t end at the end of the token sale. If you hold tokens that cost you money, follow the development of the project and demand to understand how and when your money is invested. Many projects hedge the money raised by converting part of it to other coins and to fiat money, a process that allow disappearance of funds into the pockets of the promoters.
Serious projects will publish clear reports on the location of the funds, the exchange rates at which they were converted, salaries, various payments, etc. Remember that accepted regulatory obligations don’t apply to ICOs and there is no one else to take care of your interests.
The regulator awakens
Recently an interesting indication has come from the SEC in a report that addresses a specific token called theDAO which has already disappeared after a smart contract that controlled it got hacked. The SEC clearly stated that it fell under their jurisdiction and therefore was illegal. Even though in this instance there was not a recommendation for prosecution, this could be an explicit warning to the ICO industry.
It is important to notice developments in this area because a more aggressive intervention of the regulator seems reasonable, and in that case they may prosecute entrepreneurs, cryptocurrency exchanges and even the investors themselves.
Beyond the legal dangers, this step could negatively affect the price of the tokens.Don’t pop along with the bubble
While the ICO phenomenon probably isn’t going to disappear soon, it’s very likely that the current dynamic in which companies raise tens and hundreds of millions of dollars based on an internet site won’t be with us much longer.
The world of ICO will improve and become more sophisticated, but right now it seems there are more entrepreneurs creating companies in order to create an ICO, than those who are creating ICOs in order to build companies. Be careful, and don’t invest more than you can afford to lose.