Understanding And Investing In ICOs (Initial Coin Offerings)
Satoshi Nakomoto started Bitcoin with an email to some of his peers. From there, Bitcoin got big. These days, most new crypto coins start out with Initial Coin Offerings (ICOs).
This post is taken from a chapter in my latest book, The Crypto Portfolio: a Commonsense Approach to Cryptocurreny Investing. The contents have been modified to fit the format and style of this website.
Disclaimer: ICO investing is extremely risky. This article is for educational purposes only.
What are ICOs?
ICOs are the crypto version of crowdfunding. The crowd (people like you and me) send ether, bitcoin or some other type of payment to a team of developers who need money to launch a new crypto project.
In exchange for the money they invest in the ICO, the crowd receive crypto tokens for the project at a very low price – before other people can buy them on crypto exchanges. Later, when the tokens list on an exchange, the crowd can sell them at a potentially higher price or hold them as longer-term investments.
The next example explains the basic structure of an ICO deal in more detail. This is an extensive example that will give you a basic understanding of how ICOs work.
Example: a closer look at ICOs
Bob is the CEO of a new crypto project called Exchange Token (ET). He has a strong team of developers, partners and advisers working with him to help make ET a success.
The ET system works like this:
- ET is an exchange where people can buy and sell cryptos.
- If people buy other cryptos with Exchange Tokens (Ets) on the ET exchange, they pay lower trading costs than if they use other coins like ether or bitcoin.
- Et holders also get monthly ‘Et dividends’ for investing in Ets. These are paid out to investors as part of the profits made on the ET exchange.
Everything is programmed with smart contracts. All details of the project and the ICO are covered in the ET whitepaper, which investors can download on the ET website.
ET Funding needs:
For ET to prosper, Bob and his team want 10,000 ether (ETH) to grow the project, which they will split like this:
They also want another 10,000 ETH to pay the people who helped build ET from the ground up:
Finally, they need Ets to have a starting value so that people can use them to trade cryptos on the ET exchange. The team hope the value of Ets will go up after the ICO as more people buy the tokens.
The ET team would, therefore, like to raise another 80,000 ETH to give Ets a starting value.
To sum up, Bob and his team want to raise 100,000 ETH (roughly $50 million at the time) in total through the ICO crowdsale:
- 10,000 ETH to grow the project.
- 10,000 ETH for the founders, advisers and angel investors.
- 80,000 ETH to give the tokens a starting value.
ICO deal structure for investors:
To raise the 100,000 ETH, the ET Team will issue 500 million Ets to ICO investors. This is based on the exchange rate of 5,000 Ets per 1 ETH (or 10 cents per Et in dollars).
The team realize they might go above or below the 500 million Ets target depending on investor interest in the ICO crowdsale. In the whitepaper and on their website, they give more details:
To buy Ets during the ICO crowdsale, investors must send ETH to the ET Ethereum address during the ICO. Below are the deadlines:
- The ICO starts on December 1st and is expected to last for two weeks unless the 750 million hard cap is reached before then. Investors who don’t deposit ETH during that time can’t take part in the ICO crowdsale.
- After investors make the ETH payment, their Ets are held in escrow (a trusted third party) until December 25th, when investors get their Ets for Christmas.
- On January 15th, Ets can be traded on the ET exchange for USD or other cryptos.
- On January 30th, Ets will also list on other crypto exchanges. The ET team rightfully do not disclose which exchanges will trade the tokens. This is to protect them from any potential legal issues around token price manipulation.
Investing in ICOs
If you do your homework, you can make a lot of money investing in ICOs. If you don’t, you could lose every cent you put in. ICOs are the wild west of cryptos, which is saying a lot!
With ICOs, it’s possible for project teams (or companies) to raise millions of dollars much faster and more easily than it is through traditional funding avenues, such as Venture Capital. This is good for the companies and entrepreneurs raising the money as well as for ordinary investors.
The average Joe on the street can now easily invest in promising startup projects through ICOs. In the past, these opportunities were only reserved for a privileged few.
That said, dangers of equal measure come with the territory. ICOs are a thinly regulated (if at all) way for companies to raise millions from unsuspecting investors. Like a moth to a flame, this has attracted all kinds of shady characters promoting useless ‘scam coins’ to make a quick buck.
In this post, we’ll go through some steps to help you:
- Filter out potential ICO scams and bad investments.
- Find genuinely good ICO investment opportunities.
Side note: an entire thesis could be written about ICO investing. In this post, we’ll just go over the basics. Before going ahead with any ICOs, make sure to do as much research as possible.
ICO investment research and screening
Here are nine things to consider when looking at a potential ICO investment:
ICO research consideration 1: project team
A great team is paramount to the success of any business venture, including ICOs. If you’re going trust them with your money, the CEO, founders, partners, developers and advisors should be a mix of entrepreneurial, business and crypto rock stars!
- Have strong experience that is relevant to the project.
- Have worked at reputable companies before or have been involved in previously successful entrepreneurial ventures.
- Are who they say they are.
- Have a lot to lose if they break investor trust by scamming them.
- Are easy to contact via various social media outlets and by email.
To cover your bases, you can:
- Google the team members.
- Make sure their Linkedin profiles match up with who they say they are.
- Make sure their Linkedin profiles say something about them being part of the ICO. If they don’t, the ‘ICO team’ could be made up of fake or random people.
ICO research consideration 2: product and technology
If the product doesn’t have any real-world value, it’s not worth your time. It’s a good sign if the product:
- Solves a real problem in a unique and compelling way.
- Has a prototype. Or better yet, is already being used today. This makes it more than just an idea on a whitepaper (see the next consideration below).
- Needs blockchain or crypto technology to make it work. If it doesn’t, the ICO team could just be trying to raise money for an idea that was already rejected through traditional funding, like Venture Capital.
- Has first mover advantage. The product could be great, but if there are already better products out there, it’s harder for it to succeed. If the product doesn’t have first mover advantage, then it must have a realistic chance of gaining market share from the first mover.
To research this:
- Read the whitepaper on the ICO website in detail.
- Watch any videos explaining how the technology works. These can be on the website itself or by third parties on YouTube.
- If you’re technical, read the project source code on github.com. If the source code isn’t on Github, the developers might have something to hide!
ICO research consideration 3: whitepaper
This is the blueprint for the project that you can download from the ICO website. The whitepaper should be easy to understand, clearly written and well presented. It should also match up with what’s on the project’s website.
ICO research consideration 4: roadmap
The whitepaper, website or both should explain the business model and give a detailed timeline of upcoming project targets. The roadmap should be realistic. If it looks too ambitious, it probably is.
ICO research consideration 5: token necessity
If the token isn’t needed to use the product, it’s price could go down once it goes on an exchange. Think back to the Exchange Token example at the start of this chapter. Traders can still use the exchange without Ets, but the lower trading fees and Et dividends are good incentives to use the tokens.
ICO research consideration 6: token economics
Put on your value investor hat to decide whether the tokens are a good bargain. This takes serious analysis and you will only get better at it by reading and researching lots of different ICOs. Signs of good token economics are:
- The hard cap is low for the project. If the team are raising less money, they are more likely to put it to good use because they will only have a limited amount of cash to work with. This also gives the market cap more potential room to grow after the ICO.
- Most of the tokens go to the ICO investors. If the team are taking too big of a cut, that’s a bad sign.
- Bounties, bonuses or discounts for investing in the ICO early. This helps the team achieve their funding needs and can be good for investors at the same time, who may be awarded extra tokens or receive a discounted token price in the ICO.
- Team and advisor reward tokens are vested. With each ICO, some of the tokens raised go the team and their advisers to reward them for their work. This is obviously fair and encouraged. But what’s to stop them from cashing out their tokens as soon as they raise the money? If their tokens are vested, they can’t sell their tokens straight after the ICO by dumping them on the exchanges.This also means the team have more skin in the game because their future wealth depends on the growth of the token. It’s a good sign if the team and advisor tokens are vested for at least a few years.
- Maximum purchase limit for each investor. This stops one investor buying too many tokens and then dumping them on the exchanges to crash the price.
- Fixed supply of total tokens: a fixed supply means long-term scarcity. If the token is scarce, it’s price could go up as more people demand the token.
Side note: token economics is technical. Comparing lots of different ICOs will help give you a feel for what’s fair and what isn’t!
ICO research consideration 7: Know Your Customer (KYC)requirements
Just like with crypto exchanges, the more KYC hoops you must jump through, the better. If you need to upload a photo of you with your passport to take part in the ICO, that’s a good thing. This helps stop potential money laundering.
ICO research consideration 8: hype, ratings and market opinion
These can all have a big impact on the price of the token once it lists on the exchange. Some things to look out for include:
- ICO Telegram Chat status: Telegram Messenger is a social media tool where thousands of people can join the same chat group. ICO teams use Telegram to make announcements leading up to, during, and after each ICO. If the ICO chat group has thousands of people on it, that’s a strong indication of market interest in the project. Always sign up to the Telegram chat of any ICO you are considering investing in. Scroll through the comments in the chats from the members to help assess the hype of the ICO in question. Also, see how the team responds to questions from chat members to gauge the team’s efficiency and credibility. Never send cryptos to an address that appears on the Telegram chat as they are easy targets for scammers impersonating team members.
- Public appearances: it’s a bonus if the CEO of the project appears on Bloomberg, Yahoo Finance, CNBC or any other mainstream financial media outlet. It’s a bigger bonus if they confidently and concisely answer every question the show presenter asks them.
- Crypto forum comments: see what people are saying about the ICO on Reddit, bitcointalk.org and CryptoCompare forums. As with all crypto forums, sometimes people try to ‘pump the ICO’ with false news, so always research the validity of the comments online if things sound too good to be true. This applies to all cryptos, not just ICOs!
- Reviews by ICO authorities: there are blogs, websites and YouTube channels dedicated to researching and reviewing ICOs. These reviews can have a big impact on the hype of the ICO.
ICO research consideration 9: the name
It might sound silly, but a good name can add huge hype to an ICO and a cryptocurrency. Neo, Next, Ethereum, Stratis, Golem and Waves all have great names (in my opinion) and their ICOs did rather well.
Quick ways of spotting ICO scams
As mentioned before, ICOs aren’t regulated in the same way as traditional investments, so they are appealing to scammers. At the same time, many project teams are genuinely trying to start a business and improve the world with new and exciting crypto-based technologies.
As the ICO market matures, it is likely to become much more heavily regulated. But for now, you need to do your own regulation to sniff out the scams. The ICO investment screening process I described above can help with this – although there are no guarantees.
Apart from that, the following red flags should at once set off your ICO scam detector:
- The project promises or ‘guarantees’ returns to investors. if it sounds too good to be true, it’s a lie!
- Careless typos or poor grammar on the website and whitepaper: this suggests the ICO marketing was hurried.
- No online presence of the team members: if you can’t find them on Google or Linked in, they probably don’t exist.
Strategy for ICO investing
The first and most important thing with ICO investing is that you research the project as much as you can. If after that you’re happy investing in the ICO, you can then take further steps to help reduce the risks. I’ve outline four of these in the boxes below:
ICO risk reduction tactic 1: only invest money you can afford to lose
This goes without saying. Here’s why you should only invest a very small amount of money into a single ICO:
Using data from icostats.com and coinmarketcap.com, the next table shows the percentage returns you would have earned if you had invested $10 in some of the best performing ICOs of the past. This assumes you bought in at the ICO price and held the investment until the end of December 2017:
The above numbers are just for illustration and are not meant to be taken as a suggestion that you should invest in ICOs. Most ICOs don’t do anywhere near as well as these. As always, past performance is no guide to future returns.
ICO risk reduction tactic 2: spread your ICO bets with the venture capital approach
Venture capital (VC) funds invest in lots of different startup projects at once. They know that many might fail, but only need some of them to reach their full potential for the VC fund to do well.
For example, if you have £500 to invest in ICOs, it’s less risky putting £50 in ten different ICOs then going all in on just one. If only three good ICOs are happening at the same time, you would just invest £150 in total (or £50 in each of the three ICOs) and wait until better opportunities come up before investing the remaining £350.
ICO risk reduction tactic 3: take a small amount of profits (if there are profits) shortly after the ICO tokens hit the exchanges
A common strategy amongst ICO investors is to get in and get out as soon as they can. This is because, very often, the price of the token peaks shortly after it first lists on the exchange and never reaches new highs.
That said, you shouldn’t invest in an ICO just because you think the price will pump straight after it lists on an exchange. Instead, you should invest in it because you think the project has good long-term value. However, even if you believe in the long-term value of the token, you could still sell a small portion of your tokens if the price pumps soon after it lists on the exchange. You can assess this case by case for each ICO.
The graph below (source cryptocompare.com) shows the performance of EOS versus bitcoin since its ICO on July 26th, 2017. Soon after EOS started trading on Bitfinex, its price rose through the roof. Taking some profits here (by selling some EOS for bitcoin, for example) would have been a good call.
Any yet, EOS is now ranked 7th on Coinmarketcap.com as I write this, and it could turn out to be a good long-term investment. Keeping some of the cheaply bought ICO tokens for a few years would also be sensible in this case.
The above chart is priced in bitcoin. In USD, the price of EOS has gone from $0.925 at ICO to around $9 at the end of December 2017.
As a side note, the price of new tokens can increase each time the token is listed on a new exchange, so pay attention to the Telegram Channel to stay updated on new exchange listings.
If you are awarded bonus tokens in the ICO, it’s often the case that you receive them after the tokens you paid for are already listed on the exchange. A simple strategy here could be to:
- Sell some of the tokens you paid for if the price spikes soon after the ICO.
- Keep the bonus tokens (which were free) invested for the long-term.
ICO risk reduction tactic 4: factor in market sentiment for Ethereum
These days, most ICOs want payment in ether. This means you sell ether for the ICO token. If ether is doing well at the time, other investors might prefer keeping their money in ether to investing in an ICO. This can reduce the overall success of the ICO as fewer people invest in it.
Some ICOs also accept payment in other cryptocurrencies like bitcoin, litecoin or neo. The same logic applies here.
Process for ICO investing
The process of investing in an ICO can seem intimidating at first. In a nutshell, here are the five steps you would usually take:
ICO investing step 1: check if you can participate in the ICO in your home country
You should be able to find this information on the ICO website.
ICO investing step 2: sign up to the ICO ‘whitelist’ as early as possible
Do this before you have completed your research. This will ensure you can take part in the ICO if you later decide to invest in it. Sometimes, ICOs can sell out quickly or even before the ICO date if the participants list closes to new investors.
You can usually get on the whitelist by entering your email address to a form on the ICO website. If you sign up early enough, there’s a chance you could take part in the pre-ICO at an even lower price than the ICO price. But be warned, this can be riskier than ICO investing as there is usually less information to go on!
ICO investing step 3: sign up to the ICO Telegram chat or announcement channel
This way you stay updated on all things related to the ICO. For example, when the tokens will list on an exchange. You can also use the Telegram channel to question the ICO team members.
ICO investing step 4: do the KYC early on
If you do the KYC up front, you’ll be ready to invest as soon as the ICO goes live. KYC doesn’t take long – you usually need to upload a photo of your passport or ID and a photo of you holding it to the ICO website.
ICO investing step 5: deposit ether, neo or bitcoin to your cold wallet before you invest
Regardless of which cryptocurrency you buy ICO tokens with, it must be sent from your cold wallet address.
To sum up
ICOs aren’t for the fainted hearted. But if you do the research, you could potentially earn high returns on your investments. If you invest in ICOs, make sure it’s with money you can afford to lose. In the future, ICO investing (or something similar) is likely to become more common and much better regulated. Understanding how ICOs work today could put you at a financial advantage further down the road.
This was a long post, so I’ve included a quick bullet point summary of the key points below:
- ICOs are a way for companies and project teams to raise money from ordinary investors (people like you and me) so they can launch new crypto tokens.
- In exchange for investing their money in ICOs, investors get tokens at a low price. If they can sell those tokens later at a higher price on an exchange, investors can make money.
- If you know what you’re doing, you can make a lot of money with ICOs. You can lose a lot of money if you don’t!
- When researching potential ICO investments, your first job is to filter out the scams. Next, look for projects with good long-term growth potential. The more research you do, the better.
- Use the venture capital approach when investing in ICOs. This means investing small amounts in different ICOs, rather than a large amount in just one.
- The best ICOs often sell out fast, so get on the whitelist and send your KYC early on to secure your place in the ICO. You can always change your mind later and decide not to invest.
Jonathan Hobbs, CFA, is an author and financial blogger. He invests in stocks, mutual funds, startup companies, gold and cryptocurrencies. He believes strongly that nobody can predict the future of financial markets, so he prefers to simplify his approach to investing with basic investment rules and strategies that work well over time.