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Cryptocurrency and blockchain technology 101: what is an ICO?

Posted on 10 September 2018 by Tom Grogan

Cryptocurrency and blockchain technology 101: what is an ICO?

Not a day goes by without a client asking about the possibility of conducting an ICO, but what does this mean? 

What is an ICO?

An ICO, which stands for an initial coin offering, is a mechanism by which a token (which may constitute a cryptocurrency) is first created and issued.  The tokens are usually issued in exchange for another cryptocurrency (e.g. Ether or Bitcoin) or fiat currencies (e.g. USD or GBP) and so issuers typically use an ICO as an early fundraising mechanism.

Preparing for an ICO is a multi-disciplinary exercise and generally requires legal, regulatory, tax, technical and PR input.  Issuers often decide to engage specialist ICO advisers or, depending on the jurisdiction of the token issue, ICO sponsors, to guide them through this process.  The various parties are often able to add value by providing suggestions and advice in relation to the 'tokenomics' at play – that is, the design of the token along with the size and logistical aspects of the ICO.

A significant amount of documentation may be required in order to put the underlying business on sound contractual footing but, in respect of the ICO itself, the key document is the whitepaper.  The whitepaper is a document which sets out the project's vision, blockchain solution and on-going governance arrangements.  In particular, it will clearly set out the fundamental tokenomics: how many tokens will be issued; who the tokens will be issued to; how an investor might subscribe for tokens; and when the issue is expected to take place.  Traditionally whitepapers were academic treaties but more recently they have become glossy marketing documents which seek to appeal to the mass market.  Accordingly and to avoid alienating less sophisticated investors, issuers often prepare separate technical papers where the underlying blockchain solution is particularly novel or complex.  The whitepaper, along with all other communications by an issuer in respect of its ICO, must be comply with all applicable regulatory frameworks, which I briefly touched upon in a previous article.  We regularly review and advise on whitepapers from a legal and regulatory perspective and, together with our colleagues in Mishcon Cyber, we also provide technical input and oversight.

There are a number of ways of conducting an ICO including token swaps, discounts and crypto for fiat arrangements but, in their most basic form, investors send cryptocurrency (e.g. Ether) to a specified digital wallet address in return for the ICO token.  This transaction is typically governed by a smart contract at a predetermined exchange rate.  The investor now holds x number of ICO tokens in his or her own digital wallet.  The investor can then either (i) hold the tokens in their digital wallet until the associated platform or underlying asset is operational and the tokens can be used, spent or the derivative benefits enjoyed, or (ii) sell their tokens on a secondary market (e.g. a cryptocurrency exchange).

What are the benefits of conducting an ICO?

An ICO is an attractive fundraising option for many issuers, as it enables them to raise significant monies without diluting their ownership, as would be the case in traditional equity investments, or burdening themselves with debt by way of bank loan or bond or loan note issue.  The appetite for ICOs has been significant, with $6.3 billion raised in Q1 2018 alone.

In addition, ICOs also allow issuers to build a dedicated community and garner support from early investors who, it is hoped, go on to become users of their platform.  For this reason, the issuer's PR and social media strategy is incredibly important to not only its ICO but its business' life and success post-ICO.  Early adopters are active across a number of social media, including Telegram, Reddit, Twitter and Discord and issuers are advised to maintain a presence across all of these.

What are the drawbacks of conducting an ICO?

An ICO is not always the cheapest form of financing.  Depending on the regulatory analysis of the token, a successful ICO can cost upwards of £150,000 or, if an aggressive PR and marketing plan is pursued, £500,000.  This cost can be managed by negotiating conditional retainers and, in the case of ICO advisers and PR agencies, agreeing to pay for services out of post-ICO proceeds, either in fiat or ICO tokens.

Finally, one of the biggest advantages of conducting an ICO, that is the dedicated and active community that they can attract, can also be a disadvantage or, at least, a distraction.  While token holders do not hold shares in the issuer, they are nonetheless key stakeholders who will speculate, analyse and criticise the issuer's action (and inaction) post-ICO.  Issuers are advised to carefully consider how best to communicate and interact with token holders, so as to promote engagement while not undermining the long-term success of the project.

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