Initial Coin Offering ICO: A rocket fuel for the start-ups

Credits: Jernej Furman. Licensed under CC Creative Commons 2.0
“ICO – Initial Coin Offering acronym with marker, concept background” by: Jernej Furman. Licensed under CC BY 2.0

A new financing model is doing the rounds in the start-up scene. ICO (Initial Coin Offering) makes it easy to acquire large sums of investment in a short time. Does ICO have the potential to establish itself as a significant alternative to traditional financing methods or is it an investment bubble? Does the state need to intervene in a regulatory way?

What is an ICO?

Initial Coin Offering (ICO) is a variant of investment financing through the crowd. In an ICO, companies offer their own coins or tokens for sale. These tokens can be purchased against common cryptocurrencies such as Bitcoin or Ethereum. A blockchain, in most cases Ethereum, is used to process a purchase. Using the blockchain, investors remain largely anonymous.

The utility of the acquired tokens varies. It can represent a share in a company, be linked to voting rights or form the foundation for the establishment of a new cryptocurrency. Often, the tokens are used in the future product itself. There, they can be used as a means of payment in an emerging application. This diversity of functions is a significant difference from classic forms of financing. In addition, an ICO takes place in a largely unregulated framework. Ultimately, the buyer only acquires a promise that the tokens will one day have an appropriate value.

Financing innovations

As a rule, an ICO takes place in an early phase of a start-up. Most ICOs are intended to contribute to the financing of a product that is itself based on blockchain technologies. For start-ups, the big advantage is that a good idea alone can be enough to acquire considerable amounts of venture capital.

Indeed, buyers must also be found for the tokens. However, corresponding platforms support this (see platform economy). From the start-ups’ point of view, they are spared the comparatively more time-consuming search for external funding or going to venture capitalists.

Who benefits?

Within a year, ICOs have evolved from a rather unknown fringe phenomenon in the blockchain scene to a form of financing that raised well over three billion US dollars in 2017. Thanks to the lack of regulation, start-ups have a great deal of creative freedom. They are free to decide whether they want to limit the number of tokens, sell them at a fixed price or offer them via auctions.

Start-ups can also hold back a large part of the tokens to sell them later. The price development of the tokens is extremely volatile if a corresponding market form at all. The investments are correspondingly speculative. Instead of aiming for joint product development like other venture capitalists, investors can also be looking for very quick speculative profits. Investments in ICOs therefore require an enormous willingness to take risks, but then allow investors a high degree of flexibility if the investment is successful, because they can sell the tokens at any time. The start-ups profit from the sometimes-considerable inflows of capital.

Wild West in the crypto world

Critics see ICOs as pure speculative objects that bear no relation to the real value of a company. People invest anyway because investors are driven by fear of the unused opportunity of high profits. The first comparisons to the dotcom bubble at the beginning of 2000 are already being drawn. The whole environment is also a magnet for criminal activities of all kinds. Due to a programming error in a piece of code responsible for storing cryptocurrencies, several ICO-financed projects lost a three-digit million amount.

In another case, a startup’s website was hacked to manipulate account details for ICO investors, diverting funds to the attacker’s account. Once landed in the accounts of criminals, there is usually also no way to recover the money, as the revision of transactions is not provided for in a blockchain. Other cases of fraud aim to exploit the willingness to invest by only faking the development of a supposedly innovative product. The presented goals can be completely exaggerated, while the lack of a prototype is attempted to be compensated for with an elaborately designed website and technical buzzwords. The US Securities and Exchange Commission (SEC) has already uncovered several such cases.

In Europe, there is currently no precise legal classification of this new financing instrument. To classify a token, its purpose must be considered in more detail. Accordingly, the Federal Financial Supervisory Authority (BaFin) points out the high risks. According to this, due to the lack of legal requirements and transparency regulations, investors have so far been left to their own devices to assess the offer and check the identity, seriousness, and creditworthiness of the provider. For start-ups, too, the legal grey area harbours risks of unintentionally making themselves liable to prosecution, because aspects of financial market regulation can be transferred, for example.

Empirically, however, studies from the USA show that ICOs often have strong similarities with conventional securities sales. In China and South Korea, however, ICOs are now generally prohibited. It is unclear whether this measure is only temporary until a clear regulation exists. Further regulatory questions also arise as to how profits must be taxed or whether a VAT levy, as provided for goods and services, will come into play. It also remains open to what extent taxation can be implemented at all, since ICO financing initially guarantees anonymity for investors.

With the growing importance of ICOs, a legal classification becomes more urgent for both start-ups and investors. Legal risks can be a reason for startups to leave. At the same time, greater transparency must be ensured for investors. The state, in turn, must be able to track investments and levy taxes.

Evaluate the use of ICO principles for the public sector

Elements of ICOs can also be used in perspective for innovative projects in the public sector. The integration of tokens into own applications can serve as an incentive mechanism, for example, if the contribution of ideas is rewarded with tokens in e-participation projects that have a value within the application or beyond.

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