Cryptocurrency, Utility Tokens, and ICOs: A 'Brief' Primer - Part 3

PART 3: Initial Coin Offerings

What are they? How do they work? ...and why do they matter?

Preface: This is the third in my three-part series on cryptocurrencies, utility tokens and Initial Coin Offerings or ICOs. Here are the links to parts ONE (Cryptocurrency) and TWO (Utility Tokens).

Again, this is by no means an exhaustive explanation and the reader is encouraged to do their own research and/or due diligence. I will try to keep it largely factual but some strongly held opinions are bound to creep in. Be mindful of them.

I hope those of you that are completely new to this brave new world will be helped by this, and that those of you who are already die-hard crypto-nuts will not be offended or put off by my gross oversimplifications.

NOTE: This one is necessarily kind of long. So you may want to go grab a cup of coffee or a soda before you settle in for the read.

So, Initial Coin Offerings or ICOs… To easily understand something as ‘next-gen’ as ICOs, we need to jump into our ‘wayback machine’ and take a little journey, to 1986.

Imagine that it is 1986 and video arcades are still a big thing. In those days it was completely normal to walk into an arcade with $10 in your pocket and expect to exchange that for tokens in order to be able to play the games within that arcade. Most days those tokens would be 4 for a dollar, but the arcade would typically offer deals like 4 for $1 or 25 for $5, maybe even 60 for $10.

Having its own internal monetary system allowed the arcade to change its exchange rate in order to incentivize customers to spend more up front. Also, tokens were often non-refundable so, once you bought them, that money was ‘locked’ into being spent at that arcade. If not today, then at some point in the future. In any case, in exchange for that increased valuation (allowing you to play more games than your original money [or, base currency] was, strictly speaking, worth) the arcade now had your money and you were not getting it back. …and no two arcades in town used the same tokens.

So, in exchange for the prospect of getting more for your money, you would willingly and permanently exchange ‘real’ Dollars for the arcade’s ‘made up’ tokens that could only be used to purchase goods and services within the arcade where they were purchased.

Cryptocurrency-based utility tokens work largely the same way, allowing digital token holders to participate in the activities of the token-issuing organization, except that they can be exchanged… (more on that in another article).

Now imagine that you have an idea for the best arcade ever, with all of the best games and a built-in pizza joint and ice cream parlor. …and you have assembled a team of people that seem reasonably capable of making that happen. 

One problem: You don’t have the financial means to pull it off.

You could try to get people with a lot of money to invest in your idea, but that may not be easy and, even if you knew a lot of people with a lot of money, you don’t really want to have a committee meeting every time you want to change the pizza recipe. What do you do?

Well, what if you could just pre-sell tokens, and a lot of them, to the very people that you know will want to play all of those awesome games and eat your mom’s famous pizza? You could take a small amount of money and rent a giant billboard in the middle of the entertainment district downtown proclaiming “Coming soon. The ultimate gaming experience! Pre-opening tokens available at a 40% (or 50% or 80%) discount over opening day prices.”

It turns out that roughly 20% of the 6,000,000 (at 6 for a Dollar) tokens that you quickly sell are to prospective customers (people likely to actually visit your arcade and eat your pizza) and the other 80% are purchased by people who are banking that they will be able to sell your tokens, purchased at such a discount, for more than they paid once you open. …and they plan to use the ‘exchange kiosk’ (again, more on that another time) down the block to do so.

Now for the kicker. You also proclaim that there will never be more tokens offered than the originally ‘minted’ 10,000,000 of which you have kept 40% to ensure a healthy supply – at least in the short term. If your place really does turn out to be that good, will the value of those tokens increase? ..and what if you help drive that ‘lift’ both by signing exclusivity contracts for all of the latest games and adjusting your purchasing incentives to favor people who buy more tokens? In other words: Will the value of your tokens increase as you execute on your business plan, doing everything possible to make your arcade the most desirable place to be in town? Maybe.

These are the basic economics behind Utility Token ICOs. They differ quite a lot from those of Equity Token ICOs and Security Token ICOs.

In current-day terms this plays out something like this:

A company 'mints' (via a technological process too detailed to go into here) a finite number of their own new cryptocurrency-based token (either utility or security) and offers it for sale to prospective members, users, and/or investors. The company posts a 'white paper' disclosing the business concept, the advantages of their offering, the team members and advisors involved, a general use of proceeds for the funds raised, and a timeline for getting their product or service to market (if it is not already available). Cryptocurrency such as Bitcoin or Ethereum is exchanged for the tokens at whatever rate of exchange they are currently being offered at. The company goes about the business of creating and/or promoting their offering into the marketplace.

In the case of utility token ICOs, the company must also be prepared for (and the business model must support) the fact that a substantial number of those tokens purchased will eventually be exchanged for the goods and services of the company. In other words: The business model needs to account for the influx of tokens sold yesterday in exchange for for goods and/or services today. In a properly designed token-driven economy, this usage or 'turn-over' is actually what increases the value of the tokens.

Typically, 'good' ICOs conform to a Min / Max funding structure.

In other words: A minimum capitalization amount is disclosed, under which the company would not reasonably be able to achieve their desired business objectives. ...and a maximum capitalization amount (or number of tokens sold) is disclosed, over which no more tokens will be sold. If the company's ICO is based upon a 'smart contract' then the process is guaranteed and automatic. If the minimum is not met within a pre-defined time frame, then all cryptocurrency invested returns automatically to the digital wallets (buyers) from whence it came (typically less small network transmission fees). If, at any point in the ICO the minimum raise is exceeded then the funds become available to the company. Lastly, if the maximum raise (in terms of capital raised or tokens sold) is met, the ICO ends immediately.

What about fraud and the fact that there are no set standards, regulations or governing bodies?

Well, here again - just as with the argument that cryptocurrencies themselves were going to go insolvent because of the fact that criminals will always be criminals, the concern is valid, but grossly overstated. The news is already full to the brim of fraud and deceit in even the most highly regulated portions of the financial markets. From 'junk bond kings' defrauding little old ladies out of their pensions to top-10 banks, like Wells Fargo, defrauding millions of customers by opening phony bank accounts in their names, anywhere that someone can make a 'fast buck' there will be financial crime.

However, wherever brilliant entrepreneurs and highly available funding cross paths there is also a well-spring of innovation and world-changing new technologies, businesses and opportunity.

The SEC's basic argument, for almost 100 years, has been that common people are not to be trusted to make their own investment decisions, at least where early-stage opportunities are concerned. The well-meaning concept is that average consumers should only have access to investments that have already been 'approved' or 'vetted' as being safe enough that the individual is less likely to lose their principal investment, and that have met all of the applicable regulations, filings and documentation standards, This is noble, but it simply does not hold up.

With legitimate banks, brokerage firms and exchanges constantly coming up with new and more exotic derivatives, bundles, funds, etc... often distilling and combining fundamentally bad investments into A-Rated ones, and no longer being required to act as fiduciaries (responsible parties) on behalf of their clients, all of that so-called investor protection really just creates more opportunity for fraud and abuse of the system.

By proffering the illusion of safety, the perpetrators can operate in plain view.

The ICO model, and the mechanisms that drive it, encourages and requires individual investors to do their own due diligence and determine what they feel the merits are of any particular concept, team, and/or business model. No illusion of institutionalized safety is put forth, and none should be assumed. The model breaks when people: A) Refuse to actually DO their research before investing; and B) Invest far more than they can afford, hoping to ride the tide of some get-rich-quick scheme.

...and as the old saying goes... "You just can't protect against stupid."

Here are seven simple rules to at least help keep you safe (note: I am not a professional financial advisor so, again, please DO your own research until you are satisfied that you are 'the expert'):

1. ICOs are like any other start-up. The majority of them are going to fail. Try to think like a venture capitalist and spread out your investments. Invest in things that make sense to and/or would be of value to you. You can't reasonably evaluate either a company or a technology that you don't understand.
2. DO YOUR RESEARCH!! Unlike 20 or 30 years ago, there is almost limitless information out there just for the taking. You can, and should, research not just the projects you are considering investing in, but every single member of their team as well. With start-ups you are investing just as much in the people as in the business concept. NOTE: Most people have never even Googled their broker or financial advisor's name, trusting instead upon the fact that 'somebody at Edward James gave them a desk, so they must have my best interests at heart.' Ummm... Really?
3. Watch out for promises of massive or rapid returns if you can't easily figure out (or it is not properly disclosed) where they are supposedly coming from. While short-term debt/equity deals often offer generous financial incentives (as does my own current pre-ICO Private Placement Memorandum), no company can likely sustain long-term guaranteed growth in the 100s of percentage points.
4. The best businesses are pretty simple. The company has, or expects to have, a product or service offering that people are going to want. There is something that makes their product or service substantially 'better' than the other guy's. There is a market for (or one can easily be imagined) the product or service offering and people willing to pay for it. ...and there is a business model that shows attention to both sustainability and growth.
5. Utility tokens never offer ownership in, or returns from the activities of, the business and are never guaranteed to go up in value - though they may. They must first exist for the sake of use within the business and, therefor, the company must have a sensible business model in order to be of any value... then 'tokenomics' takes over and the market will work out their value.
6. Any current ICO offering belongs in the 'high risk' tier of your investment portfolio. 'Ground floor' opportunities often offer the genuine possibility of immense growth. But they also offer the genuine likelihood of complete loss of capital. Invest only what you can reasonably afford to lose.
7. Oh, and... DO YOUR RESEARCH!!

Again, my broker says that this is all just a bubble and that everyone is going to lose all of their money.

Not likely. ...but there will definitely be winners and losers, some of them massive on both ends. Also, your broker will likely change their mind just as soon as their firm figures out how to profit from you in all of this.

Are many valuations inflated right now, and is there a great deal of volatility in the marketplace? Absolutely. Does that signify a looming financial apocalypse? Of course not.

Is the current situation really any different than the early days of the industrial revolution, or the early era of the automobile when there were over 250 auto makers in the U.S. alone? ...or maybe the late 1990s and early 2000s when the Internet was going through it's 'boom and bust' process? No. So... what if you had bet on Standard Oil, General Electric, GM, Google and/or Amazon?

The fact is that whenever there is a sudden leap in technology and a corresponding rush to innovate within that space, there will inevitably be a bit of a 'gold rush' mentality that will drive both valuations and failure rates up in the early days. However, there will also emerge new industry leaders and commercial giants, and the incredible new levels of wealth created by and for those who backed them.

At the moment, most of this is now mute for U.S. citizens anyway as the vast majority of ICOs are, out of a sense of self-preservation, electing to exclude Americans from participating. This will, of course, protect many average Americans from losing their money by betting on the wrong horse(s). But, more importantly, it will virtually ensure that the vast majority of the wealth created in the new world of blockchain technologies and crytpocurrencies, will be created elsewhere.

For most ICOs, this exclusion of U.S. Citizens is not, as many pundits have put forth, because they are too lazy, too cheap, or too 'shady' to conform to stringent U.S. regulations and protections intended to safeguard the American population from scams and charlatans of every shape and color. It is because there is no clear guidance, that is not based upon laws written in the 1930s or landmark cases from the 1950s, that is both concrete and applicable to this new era. Key uncertainties, like what exactly represents a 'common enterprise' in the new networked economy, mean that is is simply easier to avoid the looming specter of prosecution than to try to figure out where one stands within the aging U.S. laws.

This is precisely why, even though we are in good faith doing everything in our power to satisfy what we believe the SECs consumer protection expectations to be (in the absence of any formally issued guidelines), my own ICO-backed venture, BLOXOTIC, is being formed as an EU company out of Estonia and is also considering the merits of excluding all U.S. participants. As a proud U.S. citizen, the irony is not lost on me.

Still, despite all of the controversy, and the now nearly universal exclusion of U.S. participants, in 2017 more innovative blockchain and crypto-technology-based ventures were funded through ICOs than were funded by traditional venture capitalists. Over U.S. $3 Billion worth. This virtual fountain of available capital is, without doubt, going to greatly and permanently change the landscape of both technology and wealth migration over the next two decades.

In summation: ICOs matter because, at this time, there is simply no better source of capital than the ICO and no better business or economic model upon which to base the development of many new crypto-centric ventures.

So, now you know why our upcoming ICO is so critical to my own new venture which you can learn all about at https://bloxotic.io. Click on the ‘View The Primer’ link in the upper right-hand corner to learn more.

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