In 2018, start-ups worldwide collected significantly more money through ICOs than young companies in Germany received through the traditional venture capital market. The new form of financing generated a staggering $16.7 billion. In contrast to €4.6 billion in venture capital that was raised in Germany in 2018 through traditional channels.
This rightly raises questions: – What is an ICO? Why do they bring in so much capital? And above all: What opportunities are there for investors? One thing, however, should be said in advance: investors have already lost immense amounts of capital through ICOs in recent months.
What is an ICO?
An initial coin offering (ICO for short; alternatively IPCO for initial public coin offering or token sale) is a form of financing for business models based on block chain technology.
Start-ups or young companies that want to implement such a business model sell so-called tokens for fiat money or established crypto currencies to generate capital.
The promised benefits of the tokens for the buyers can vary. However, from an investor’s perspective, the aim is always to participate in the future economic success of the company by owning the token.
Similarity to established financial instruments
In particular, the ICO is based on the principle of the Initial Public Offering (IPO), i.e. the initial issue of securities by a company. However, since they are often used to raise capital for the first time, it is more appropriate to compare them with venture capital (also venture capital or risk capital) than with stock market capital.
Venture capital is made available to a young company by an investor (business angel) as start-up aid. In return, the investor participates in the future profit of the company in the form of profit sharing.
Due to the large number of investors, some of whom invest only very small amounts of money, an ICO can best be described as a less regulated method of crowdfunding (in certain forms).
What types of ICOs and tokens are there?
Originally, ICOs were intended to bring new crypto-currencies onto the market. Initially, so-called utility tokens were offered for sale at low prices, which would later be traded as coins of the new digital currency. If the value of the tokens rose above the initial value, the buyers participated in the success by means of price increases. At no time, however, did the investors receive rights to the supported project. The first sale of such a token was already carried out by Mastercoin in July 2013.
Incalculable variety of possibilities
In the meantime, however, ICOs are no longer used exclusively to finance new crypto currencies, but primarily to finance start-ups that want to operate in the block chain sector. There are also ICOs of already established companies.
In such cases the sold tokens are not tradable as crypto currency. So new ways had to be found to allow investors to participate in the potential company profit. Tokens are thus increasingly becoming a kind of digital voucher. The possibilities for using them are now numerous and new variations are constantly being added.
For example, tokens can be exchanged at a later date for services or products such as storage space. But also voting rights, company shareholdings or the right to profit distribution, as is customary with shares, can be guaranteed with an ICO via Smart Contacts. Since 2017, ICOs have enjoyed growing popularity and new forms are constantly emerging, so that the range of products on offer has become quite confusing. A good overview of the different types of ICOs is given in this infographics.
What are the advantages of an ICO?
With a block chain, both the stock exchange and official financial authorities and their strictly regulated processes for raising capital can be partially circumvented. So far, there is no uniform legal basis for ICOs, as ICOs are still quite new and, moreover, due to their international character, are legally difficult to define at the national level. In Germany, however, security tokens are already available, which require a securities prospectus with the approval of the BaFin.
Nevertheless, ICOs have immense advantages, especially for young companies. Thanks to the low bureaucratic effort involved, ICOs enable simple, fast and cost-saving capital raising. In addition, the investment opportunity can be made easily accessible to a wide range of potentially interested parties. ICOs also allow companies immense flexibility and the minimization of their own financial risk, as equity capital is often not necessary without regulatory requirements.
What is the return on investment?
Investors on the other hand are attracted by high return opportunities, because successful ICO role models have already brought in horrendous sums of money.
An example of this is the Ethereum ICO in 2014, with which the crypto-currency ether was launched. A total of $18 million was collected with the tokens for $0.40 each. In January 2018 an ether was traded for up to $1,250. ICO investors who sold at that time were delighted with an absurdly high yield of 312,400%.
But by no means all ICOs are doing so promisingly. The Bancor ICO, which in June 2017 raised $153 million within three hours, has now lost over 80% of its original value. This also means an 80% loss for the ICO participants.
In the past, in some cases extremely high profits were made by ICOs and this explains the current hype. However, these success stories seem to be the exception rather than the rule and do not outweigh the immense risk for investors.
What are the risks?
First of all, ICOs entail the risk of total loss of the capital invested. However, there are a number of other risks that you should be aware of:
Partially missing regulations
The partially unclear regulatory situation of ICOs is a major problem. ICOs outside Germany sometimes do not have investor protection and investors then bear the full entrepreneurial risk. In addition, there are usually no reporting obligations and no regulations on recourse claims in the event of insolvency. In addition, there are often no minimum requirements with regard to project information and issued documents such as the white paper and general terms and conditions.
In the meantime, the US Securities and Exchange Commission (SEC), the Federal Financial Supervisory Authority (BaFin) and the European Securities and Markets Authority (EMSA) are trying to get to grips with the problem and are looking for ways to regulate ICOs. So far, however, apart from the regulated security tokens, they have mainly published consumer warnings. BaFin stopped a planned ICO for the first time in February 2019.
Incidentally, the People’s Bank of China has already banned ICOs completely in 2017, retroactively. South Korea followed suit. In order to avoid possible future regulations from the outset, providers now often speak only of “crowdsales” or “donations” instead of ICOs. Particular caution is called for here.
Increasing cases of fraud
The often still inadequate regulation of ICOs attracts swarms of fraudsters. This became apparent, for example, when it became known that the encrypted messaging service Telegram was planning an ICO. Fraudsters took advantage of the hype surrounding the Telegram ICO and started fake sites with an alleged advance sale of the so-called Gram token. Shortly after the pages were online, they disappeared again and with them the collected capital.
Wired magazine published a list of five signs of ICO fraud:
- The team behind the project is completely unknown and inexperienced
- The white paper describing the project is short and incomplete
- The providers promise unrealistic goals and return chances
- Lack of transparency
- There is no demand for the product offered
- The SEC also tried to draw attention to the numerous fraud cases in a creative way by initiating a fake ICO itself. The Howeycoin is offered on a website. If the consumer clicks on “buy”, however, he or she is redirected and informed and warned about the fake.
But even serious ICOs have lost a lot of capital. Many of the young companies failed within a very short time.
A study by researchers at Boston College showed that more than half of the approximately 4,000 ICO start-ups investigated did not survive for four months in 2017.
The companies often fail due to software errors or hacker attacks. But a lack of the necessary expertise can also be the reason. The complex technical nature of ICO projects often requires a sound technical understanding, which increasingly unprofessional providers often do not have.
Internal inconsistencies are another reason. In the meantime, a number of cases have come to light in which the founders have fallen out and the planned project has been discontinued without repayment of the ICO capital.
This is also what happened with the largest ICO within Germany to date. In January 2018, the Berlin startup Endion AG collected a total of 100,000 € from about 30,000 investors to realize the environmentally friendly mining of crypto currencies. In August 2018, the Handelsblatt reported that the startup had not made any significant sales to date, as the two founders had fallen out.
What does the future of ICOs look like?
There is currently a hype and there are countless rotten eggs in the ICO basket. Nevertheless, meaningful investment opportunities could arise in the future – provided that ways of regulation are found and consistently implemented to ensure investor protection across the board.
The Stuttgart Stock Exchange announced in August 2018 that it would set up its own ICO platform to offer investors transparent and standardised processes. To ensure this, the Stuttgart Stock Exchange intends to cooperate with supervisory authorities.
An Estonian company also developed a cryptobased equity loan, the so-called Initial Loan Procurement (ILP). Here, investors conclude a cryptobased contract through the purchase of tokens, which guarantees them a share in the profits.
Crowdfunding as an alternative
Alternatively, investments can also be made in crowdfunding. Although no blockchain is required, there are very clear regulations by the BaFin in terms of the legally required investor protection.
The advantages of ICOs from the investor’s perspective are often cited as being the small number of shares and flexible trading. The real estate crowd investing platform BERGFÜRST also offers this to its investors: They can invest starting from 10 € and offer the investments for sale at any time via the trading platform.
Another argument for ICOs is the broad access to investment opportunities that are usually reserved for large investors. This is also made possible by crowd investing. This way you can provide mezzanine capital at BERGFÜRST – in the past this was also only possible for large investors.
The only difference is the return on investment that is promised. But they are much more realistic. At BERGFÜRST investors receive between 5.0 % and 7.0 % interest per year – fixed and regular.