Here’s why you should be wary of ICOs

In tandem with the surge in value of Bitcoin and other cryptocurrencies, Initial Coin Offerings (ICO), the new form of investment that relies on blockchain (the technology underlying Bitcoin), are also gaining traction. Blockchain startups are raising millions in ICOs without going through the tough and cruel Silicon Valley VC process, and every major media outlet is talking about them.

When we first covered Initial Coin Offerings on TechTalks past December, we weren’t very sure about their future. At this stage, they’re still widely viewed with skepticism (as is everything else that relates to cryptocurrencies). But it looks like ICOs are here to stay, unless they bubble as some have predicted.

Already this year, more than $107 million has been poured into blockchain startups through ICOs. Gnosis, a prediction market based on blockchain, raised more than $12 million in under 15 minutes. The project is now valued at $300 million.

In a nutshell, an ICO is fundraising through the sale of crypto tokens. A startup issues its own cryptocurrency on one of the mainstream blockchains (Bitcoin, Ethereum, NXT…) or its own proprietary blockchain. Investors who want to have a stake in the value of the company purchase those coins with various crypto or fiat currencies. Token holders will be able to vote and decide on the future of the company they’ve funded.

But for the most part, they have to wait and hope for the value of their coins to rise.

With all the hype and cash surrounding Initial Coin Offerings, there are reasons for you to be wary and think twice before investing in one. Here are some of the things you should know.

There’s no product

Initial Coin Offerings are often compared to Initial Public Offerings (IPO), a more classic way of raising funds for a company. But nomenclature and the fact that both raise money is almost where similarities between the two investments end.

It’s true that both offer the public the chance to invest and have a stake in the company, but an IPO takes place after a company has fully launched its product or service and has proven its worth. Snap Inc, the company that developed the famous Snapchat social network, went public five years after it was launched. Uber, which is valued at $70 billion 8 years after its debut, still hasn’t IPOed.

In contrast, ICOs happen before a product is even built, and startups use them to cover their development fees. You’re in fact investing in a concept, not a product. This makes them more akin to Kickstarter campaigns. In fact, many startups have managed to raise millions with little more than a promise, and naturally several have turned out to become total scams.

ICOs are not regulated

When you put cash in an ICO, you should know that you have virtually no legal leverage to protect your investment and hold the company you’re investing in accountable. Authorities such as the Security and Exchange Commission (SEC) have remained silent on ICOs, giving their issuers maneuvering space to avoid legal headaches in case they fail to deliver on their promise.

As blockchain expert Preston Byrne told me earlier this year, token sellers often disclaim any legal responsibility. He went as far as to classify a lot of them as Ponzi Schemes.

According to Smith+Crown, some ICOs are marketed as “software pre-sale tokens,” and use language such as “donation” or “crowdsale” to avoid legal issues.

There’s an argument that the lack of oversight actually enables innovation and evolution, which is partly true. But the same reason make ICOs a risky venture for investors that don’t have deep knowledge of the dynamics and mechanisms that govern ICOs and cryptocurrencies in general.

So the bottom line is, you’re investing at your own peril. You’re responsible for due diligence and research, and if the project fails, it’s tough luck for you. For instance, the DAO project, which raised over $150 million, fell victim to a huge hack, which brought $50 million of investor money and the integrity of the entire Ethereum blockchain into question.

But you can evaluate them yourself

Nonetheless, there’s no denying that lucky and savvy ICO investors are making serious returns on their investments. So if you have a taste for risk and have cash to burn, there are some ways you can assess ICOs and distinguish potential scams and hopeful projects. ICORating is a website that vets ICOs and rates them based on how solid they seem to be.

If you want to dig into it yourself and find out how reliable a blockchain project is, Nick Tomaino provides a very resourceful guide on how to examine ICOs. I strongly suggest you read the entire guide, but you can find the key points below:

  • The project shouldn’t be a duplicate of some other token or coin. Ethereum brought smart contracts. Zcash gave us anonymity. If you don’t see anything unique in the project, avoid investing in it.
  • The team should be fully transparent about the identity of its members, its headquarters, and its communication channels. Given the risks involved in ICOs and the fact that token holders can quickly cash out their cryptos, you should avoid giving money to murky development teams.
  • There should be more than a vision. While asking for a full or beta product contradicts the entire ICO concept, the team should at least show signs beyond a promise to deliver on its word.
  • The ICO shouldn’t be unlimited. When a development team makes it clear how much they need to fund their project, it’s a sign that they have a plan. If they’re trying to raise as much as they can and rake in cash with wild abandon, it’s a sign that they don’t know what they’re doing. Excess cash leads to bad habits, Tomaino says.
  • The team’s ownership of tokens should have limits on both ends. If a development team owns more than 50 percent of the coin, then they’ll be able to override others’ votes. If they have less than 10 percent, then they have little incentive to see the project to its success.
  • Liquidity shouldn’t be made available too soon. If a development team is looking to cash out its tokens early in the project, it’s a bad sign that they don’t have faith in their own vision. Avoid them.
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