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Five big problems with initial coin offerings – and how to avoid them

By Connor Freitas

Initial coin offerings are insanely risky – and many have made substantial losses. Here are five big problems with ICOs and how to avoid them.

Back in 2017, initial coin offerings (ICOs) were all the rage. To raise tens of millions of dollars, all a start-up needed to do was mention the words “crypto” and “blockchain”.

Oh, how times have changed. The following year, the ICO bubble well and truly burst. Hundreds of billions of dollars have since evaporated from the crypto world’s total market capitalisation and countless investors have been left licking financial wounds. Here, we look at five big problems with ICOs – and, if you’re still determined to get in on the ground floor of one of these offerings, what you should be wary of.

1. They are insanely risky

In October 2018, the professional services firm EY released a report which looked back to see how the biggest ICOs of 2017 were performing 12 months later. Overall, these start-ups represented 87 per cent of the funds raised through ICOs that year.

EY’s findings on ICO risk made for sober reading – and as the authors said, their performance “did little to inspire confidence”. A whopping 86 per cent of coins were trading below the price they had listed at, with 30 per cent practically losing all of their value. The company estimated that an investor who purchased a portfolio of these ICOs would have lost 66 per cent of the money they put in.

Just 10 of the ICOs it monitored actually realised gains, and most of these start-ups were focused on developing blockchain infrastructure. However, the report noted that they had all struggled to reduce the dominance of Ethereum. Of course, past performance is not an indication of what is going to happen in the future – and there have been cases where ICOs have led to the creation of thriving companies – but the research suggests that such instances are few and far between.

2. Many ICOs don’t have a product… or a market

When a business begins to pursue an initial public offering, it normally already has a product or a service that’s already out in the marketplace. The purpose of its fundraising drive is to accelerate expansion by ramping up production, innovation, and expanding into new territories.

The ICO market is a different beast altogether because, more often than not, they are fundraisers for an idea — something that’s going to be built or developed – without anything tangible for investors to see and scrutinise. Even after an ICO is complete, and financial targets have been met, there’s no guarantee that a functioning product will emerge quickly.

EY’s report found that, a year on, just 13 per cent of ICOs had resulted in a working product and 26 per cent had reached the prototype stage. This meant that 71 per cent had made little progress in moving beyond a pipe dream. In terms of how this compares with young companies who pursue other funding routes, the authors said: “Typically, within one year of a traditional venture-backed software start-up, you would expect to see a significantly higher percentage of companies with a functional early stage product.”

Many companies also end up undermining their own utility coins by beginning to accept other currencies, rendering them less valuable. But perhaps the biggest problem that has been seen with ICOs is the fact that they often reach a non-existent market. Because they offer products and services that few are interested in, it can be difficult to make a profit on top of the millions of dollars raised because they have been overvalued.

3. There are regulatory concerns

The Organisation for Economic Co-operation and Development (OECD) released a report in 2019 which explored the pros and cons of initial coin offerings for financing small and medium-sized businesses. It cited research suggesting that more than two in three ICOs failed to mention anything to investors regarding their regulatory status – something that’s crucial given how bodies such as the United States Securities and Exchange Commission has issued multimillion-dollar fines to businesses that have held unregistered ICOs.

Questions have also been raised concerning whether smart contracts, which are often used to deliver coins and tokens, are legally enforceable. This, when coupled with uncertainty surrounding taxation and the issuance of tokens across borders, means there are substantial grey areas when it comes to ICO structure. Overall, the OECD warned that it could be exceptionally difficult for investors to obtain compensation if initial coin offerings they were involved in went wrong.

4. Many ICOs are scams

The exact figures surrounding how many ICOs turn out to be scams are unclear – and estimates vary wildly. The OECD has cited a study that suggests anywhere between 5 and 25 per cent of initial coin offerings are fraudulent, and another study which claimed an astounding 81 per cent are scams.

There is precedent for ICOs duping investors out of hundreds of millions of dollars in one fell swoop. One of the biggest involved a Vietnam-based company called Modern Tech. It held ICOs for two crypto start-ups called Pincoin and iFan, but it is now believed that these fundraising initiatives were multi-level marketing scams, with 32,000 victims losing out on an estimated $660m.

Exit scams have been rising in prominence, where those who organise ICOs disappear with their investors’ funds. Seemingly reputable businesses have vanished overnight. The analytical firm CipherTrace has claimed it is “the year of the exit scam,” with $3.1bn lost this way in the first half of 2019 alone.

5. There are more effective fundraising methods out there

Just because ICOs are so problematic doesn’t mean there aren’t other effective fundraising methods out there for businesses, including those operating in the crypto space.

Security token offerings (STOs) have been gaining prominence, in part because they blend elements of ICOs and initial public offerings. They comply with regulations, and each security token is backed by an asset. There are greater barriers to entry associated with STOs and this helps to weed out those who may have been attempting to dupe investors with a fraudulent opportunity. The assets that security tokens represent can include an ownership stake of the company, real estate, or even artwork.

Initial exchange offerings, otherwise known as IEOs, have also been gaining popularity. This is where a crypto exchange is responsible for auditing start-ups before they reach the fundraising stage, as well as organising a token sale.

Still want to invest in an ICO?

If you are still determined to get involved with an ICO, it is crucial that you perform due diligence. Make sure that their website seems legitimate, and that executives and their credentials are listed in detail. An anonymous team is normally a big warning sign in indicating something is afoot.

You should also scrutinise the white paper thoroughly. Make sure they have researched the market properly, and that their figures stack up. Be wary of ICOs with typographical errors and unrealistic budgets.

FURTHER READING: How to invest in cryptocurrency

FURTHER READING: Top cryptocurrencies

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