Practical analysis for investment professionals
10 October 2018

Cryptocurrencies: Initial Coin Offerings (ICOs)

This is the third installment in the Cryptocurrencies series. It explores the structure, investment potential, and risks associated with initial coin offerings (ICOs). Previous editions covered the rise of decentralized money and the inner workings of blockchain technology.

What are initial coin offerings (ICOs)?

Initial coin offerings (ICOs) describe a borderless funding mechanism that raises capital for early-stage cryptocurrency ventures. ICOs often promise to leverage blockchain technology to provide an existing service or product in a decentralized way. A typical ICO includes  a whitepaper describing the blockchain-based product or service on offer, the background of the development team and ICO advisors, the product roadmap, and the allocation of ICO funds.

In general, ICOs raise capital by issuing digital tokens on such decentralized platforms as Ethereum. The tokens are then sold to the public in exchange for cryptocurrencies. Some ICOs have a pre-sale period during which (accredited) investors receive special discounts on the ICO price.

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Digital tokens are usually listed on cryptocurrency exchanges within months of the ICO, giving early investors access to immediate liquidity.

Each ICO is led by a team of developers and entrepreneurs and is often organized through a legal entity incorporated in a crypto-friendly jurisdiction. Switzerland and Singapore are among the more popular choices. The funds raised through the ICO are used to bankroll the research, development, and marketing of the related products and services.

The team can retain a share of the digital tokens as performance-based compensation. Sometimes these tokens have a vesting period to better align the blockchain developers’ interests with those of long-term investors.

The ICO Market

The worldwide explosion of ICOs has caught the attention of individual and institutional investors alike. Indeed, ICOs raised the equivalent of $6.2 billion in 2017 and over 20 billion thus far in 2018, according to Coinschedule.

Although ICO activity has tailed off of late, the earlier deluge has attracted enough capital and human resources to fund a number of promising projects well into the future.

In 2017, the top five crypto categories were digital infrastructure, finance, trading, communications, and payment solutions. These accounted for 64% of the total funds raised. The focus on infrastructure, in particular, makes sense since blockchain is still in the early stages of development and will require significant improvements before it is ready for widespread adoption. ICO-funded projects thus compete with one another to deliver these marginal improvements to blockchain technology, solidify its use cases, and capture value in the process.

ICOs by Category, 2017

ICOs by Category, 2017

Source: Coinschedule

As is often the case with early-stage technologies, many ICO-funded ventures will fail. But those that achieve their goals have the potential to transform industries and even create new ones.

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Utility Tokens: Is There an Investment Case?

The vast majority of ICOs are structured as utility token offerings. ICO investors normally send cryptocurrency to a smart contract that automatically transmits the tokens back to the originating address. Utility tokens do not entitle investors to explicit cash flows. Nor do they represent equity in real companies. They are not classified as debt or any other financial instrument with expected returns.

A utility token’s value is a function of the demand for the service or product that underlies it. In this respect, utility tokens are much like taxi medallions, airline miles, or Starbucks points, except they “live” on a decentralized platform, have a finite supply, and are globally tradeable.

And that is where their investment potential and risks lie.

If a digital token is successful, the value it generates is transferred directly from the buyer to the holder of the digital tokens. Unlike conventional enterprises with recurring operating costs, utility tokens do not have significant expenses.

A useful way to think about utility tokens is to reframe them as investors’ interest in potential revenues.

Utility Token: Value Transfer

Utility Token: Value Transfer

Source: Oqulent Research

Utility tokens should be treated as early-venture investments: Investors take all the risks — research, development, deployment — up front. But unlike with venture capital investments, utility token investors have access to immediate liquidity. Depending on the entry price, timing, and addressable market size, utility tokens could provide a significant upside for early investors.

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Of course, as a new and unregulated asset class, ICOs have technological, legal, and business risks that are hard to mitigate. The lack of quality research is a significant handicap, making the space more susceptible to fraud than traditional financial markets.

Technical Risks: On Ethereum, anyone with basic coding skills can create a utility token within 15 to 30 minutes. This helps explain why the ICO space has so many questionable offerings. Assessing ICOs requires an interdisciplinary study of the claims made by the ICO team and an understanding of computer programming, game theory, and cryptography to make an informed judgment.

Legal Risks: ICO investors lack the protections of the regulated public financial markets. ICOs are not governed by legally binding agreements. In extreme cases, ICO contributions are classified as donations, explicitly denying investors any recourse against those raising the funds.

Lack of Quality Research: Although many websites “rank” ICOs across a number of dimensions, they are often paid ICO promoters. Unlike traditional asset classes, which have established frameworks to judge their fair value, utility tokens require new valuation frameworks. This adds to the ambiguity of their upside potential.

Business Risks: ICOs fund early-stage ventures with more “unknown-unknowns.” Unlike early-stage start-ups that go through several rounds of milestone-based funding, ICOs raise considerable capital in the first round. This may or may not be enough to achieve the development milestones outlined in their roadmaps. Teams may abandon the project midstream or revise the roadmap. Then there is the risk of adoption. The product could simply flop despite the best efforts of the developers.

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There is inherent value in using blockchain-based trust to facilitate transactions, track assets, and process and store information. ICO-funded utility tokens can help unlock and capture that value.

But as investment instruments, utility tokens are unorthodox. Like frequent flyer miles, they represent access to products and services and depend on market efficiency to price them.

Assessing their fair value requires a new, multidimensional research framework. There may be an investment case for utility tokens, but there are also significant and difficult-to-mitigate risks.

So investors need reliable, unbiased research to understand both an ICO’s upside and downside.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer

Image credit: © Getty Images/ Traitov

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About the Author(s)
Umed Saidov, CFA

Umed Saidov, CFA, is the founder of Oqulent, LLC. He closely follows the developments in artificial intelligence and crypto-assets to help investors understand the emerging risks/opportunities from these areas. Prior to launching Oqulent, Saidov spent 10-plus years with International Finance Corporation (IFC) and EBRD, where he led and executed a number of high-profile infrastructure and renewable energy investments around the globe. He holds an MBA from INSEAD and has a bachelor's degree in general management from French-Russian Institute of Business Administration.

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