ICO and its difference to IPO

In ICO, the word coin can mean a coin or a token. When a proposed blockchain project is to create a new cryptocurrency, coin will refer to a coin. If the new project is to build a platform for a product or service, then coin refers to a utility token. Many people do not separate the two cases and refer to both as utility tokens.

Most of ICOs are completed either via a crowdfunding event or via a private ICO. Before working on raising funds from an ICO, the founders of a blockchain startup write a document called a white paper describing the idea, the business plan, and the project. The paper will also explain the following:

• The amount of money needed to complete the project
• What cryptocurrencies and fiat currencies are acceptable
• What type of tokens are issued
• How many tokens are issued
• The duration of the ICO

Let's use a hypothetical blockchain project to explain how an ICO works. Suppose you are a motivated entrepreneur who plans to build a blockchain platform for facilitating private tutoring on university courses. This platform will match parties of tutors and students to enter a transaction. Here, a transaction refers to a student paying a tutor for providing the tutoring service. To raise money for financing the education project, you turn to ICO for raising capitals by issuing utility tokens called EduCoin. You will first set up an attractive website and write an appealing white paper to promote your ideas. You will then choose to either hold a public crowdfunding ICO, which is more common, or a private ICO, which is less common.

Let's assume you take the crowdfunding approach. On the internet, you will ask your potential supporters or investors to send you digital coins, for example, BTC and Ether, or fiat currency such as USD. In return, you send them EduCoin tokens based on a predefined valuation formula. The pre-sold EduCoin tokens are a small portion of all tokens, say 5%. Holders of these tokens can receive tutoring services in the future after you have successfully built your tutoring blockchain platform. The holders, however, do not own a share of ownership in your company. If you receive digital coins, you will sell them at a cryptocurrency exchange such as Binance or OKEx to convert them into fiat currency. You can then invest the money into the project. For investors, they hope your project becomes successful and the EduCoin tokens can be used. Consequently, the value of the token increases. Investors can then cash in their investments for a profit.

If the total money from an ICO fails to meet the minimum amount required for the project, the money that's raised will be returned to the investors. The ICO is declared to be unsuccessful. Otherwise, the money that's raised will be used in the project until it's completed or the money has been used up.

In July 2013, Mastercoin held their first ICO. Ethereum held its ICO in 2014 and raised 3,700 BTC, an equivalent of $2.1 million dollars (based on the BTC price at the time) during the first 12 hours. In 2017 and 2018, ICO became a very popular fundraising method. ICOs help to raise large sums of money.

This is eye-popping as, at the time when an ICO takes place, a startup does not have a concrete product. Its only product is an idea in a white paper! If any of the blockchain startups had followed a traditional funding approach such as raising capitals from an angel fund or a seed VC fund, the startup would be lucky to raise a small fraction of that from its ICO.

Blockchain startups have heavily relied on ICOs. ICOs skip the early fundraising steps and disrupt IPOs, which are heavily regulated and rigorously monitored. The lack of regulation and monitoring puts investors at risk of losing their investments. Before we proceed to a discussion about the issues with ICO, we will first talk about the differences between ICOs and IPOs:

• IPOs involve investment banks to provide essential services, such as matching founders with investors, conducting due diligence reviews, building the demand book, allocating shares, and arranging to list the new stock. Investment banks are paid handsomely, commonly with a percentage of the planned IPO size, for the service that's provided. ICOs do not involve an intermediary such as investment banks. An ICO site matches the founders with the public investors directly. In other words, ICOs are like decentralized IPOs. This method keeps the costs of raising capitals low. However, without the due diligence review and verification by a third party such as an investment bank, investors face a high risk.
• IPOs need to be registered with a regulatory agency, for example, in US with SEC, and are heavily regulated. ICOs are not regulated, leaving a door open to scams.
• Due to regulation and steps on verification, an IPO takes a longer time, for example, up to six months. An ICO takes a shorter time to complete, for example, up to one month.
• The IPO requires a company to file financial and regulatory reports after an IPO. An ICO does not require a startup to publish financial reports. Therefore, after receiving an offer, the costs of running these companies are different.
• The stock of an IPO company are traded at regulated stock exchange markets such as New York Stock Exchange (NYSE) or Nasdaq. The coins of an ICO startup are traded at unregulated cryptocurrency exchanges.
• Shares from an IPO represent ownership in the company. Tokens from an ICO gives investors access to a future product or service that's yet to be developed, not ownership of the ICO issuer.
• IPOs have high barriers for companies to enter. For example, a company has to satisfy certain financial and business requirements, such as a track record of earnings, stable cash flows, recurring revenues, and equity assets. ICOs almost have no barriers. All that's required is for founders to write a white paper detailing a new idea that is appealing to potential supporters and investors.
• IPOs are heavy in providing legal documents, for example, preparing a prospectus. ICOs do not have such a requirement. Founders can even start an ICO with a deck of PowerPoint slides.
• IPOs are usually targeted at institutional investors. Ordinary investors cannot access IPOs. ICOs are open to everybody.