The drive to discover alternate ways for a new company to raise money has birthed many experiments, but none more prominent than the 2017 rise of so-called Initial Coin Offerings, or ICOs.
The decades-old, tried-and-true way for a technology company to raise cash: A company founder sells some of his or her ownership stake in exchange for money from a venture capitalist, who essentially believes that their new ownership will be worth more in the future than is the cash they spent now.
But over the last year — and especially over the last four months — a new craze has overtaken some influential subsets of the technology industry’s powerbrokers: What if companies had a more democratic, transparent and faster way to fundraise by using digital currency?
So as the first ICOs surpass the $1 billion marker that typically jettisons a company to some Silicon Valley stardom, let’s explore what is going on.
What exactly is an ICO?
An ICO typically involves selling a new digital currency at a discount — or a “token” — as part of a way for a company to raise money. If that cryptocurrency succeeds and appreciates in value — often based on speculation, just as stocks do in the public market — the investor has made a profit.
Unlike in the stock market, though, the token does “not confer any ownership rights in the tech company, or entitle the owner to any sort of cash flows like dividends,” explained Arthur Hayes of BitMEX, one bitcoin exchange. Buyers can range from established venture capitalists and family offices to less wealthy cryptocurrency zealots.
Investing in a digital currency is extremely high-risk — more so than traditional startup investing — but is motivated largely by the explosive growth in the value of bitcoins, each of which is now worth around $4,000 at the time of publication. That spike helped introduce both fanatics and professional investors to ICOs.
How big a deal are ICOs?
We’ve seen over $2 billion in token sales in about 140 ICOs this year, according to Coinschedule, quieting arguments made by some that ICOs are merely a flash in the pan likely to fade any minute now when a new fad emerges.
It can feel like ICOs are everywhere — at least a few typically begin every day. Buyers during a presale period might email a seller and personally conduct a transaction. Later on, a purchaser tends to use a website portal, hopefully one that requires an identity check, explained Emma Channing, general counsel at The Argon Group.
“I don’t think that there’s been an obsession of Silicon Valley that has overtaken seed and angel investing in a single year,” said Channing, who helps companies execute ICOs. She argues: “I don’t think Silicon Valley has ever seen anything quite like ICOs.”
Channing said it is possible that more than $4 billion will be raised through ICOs this year. But she advises that ICOs are typically only successful for the very small number of companies that have “blockchain technology at their heart.” ICOs commonly fail when that’s missing or when the marketing and message are poor, she warned.
“The froth and the attention around ICOs is masking the fact that it’s actually a very hard way to raise money,” Channing said.
Who are its biggest proponents?
A number of more forward-thinking venture capitalists, such as Fred Wilson at Union Square Ventures and Tim Draper at Draper Fisher Jurvetson, have been some of the most vocal believers in ICOs.
Draper earlier this year participated for the first time in an ICO, buying the digital currency Tezos, a rival blockchain platform, in what was a $232 million fundraising round.
Wilson has not proclaimed it to be a panacea.
“Contrary to the hype machine working on ICOs right now, they are not simply a funding mechanism. They are about an entirely different business model,” Wilson wrote on his blog this summer. “So, while ICOs represent a new and exciting way to build (and finance) a tech company, and are a legitimate disruptive threat to the venture capital business, they are not something I am nervous about.”
Other leading ICO investors include Chris Dixon at Andreessen Horowitz and entrepreneur and self-described “crypto capitalist” David Sacks.
“Any startup that can ICO will ICO (barring a regulatory intervention),” Sacks tweeted last month.
What are its risks?
There are certainly some losers if and when ICOs win.
One group, as Wilson knows: Venture capitalists. Much of investors’ power derives from their supposedly superior judgment — they fund projects that are deemed worthwhile, and if the VC industry decides your startup isn’t promising, you’re left with little choice beyond bootstrapping or crowdfunding. ICOs offer another option to founders who are skittish about handing control of their baby over to outsiders driven above all else by financial return.
“Every VC firm is going to have to take a long hard look at the value they bring to the table and how they remain competitive,” said Brian Lio, the head of Smith & Crown, a cryptocurrency research firm. “What do they have other than prestige? What are they offering to these companies that are more advantageous than going to the community?”
But Lio noted that buyers are also possibly in peril and should be cautious: Risk is higher than buying stock, given the complexity of the system. And it can be difficult to vet an investment or the technology behind it. Other experts have long worried about fraud in this largely unregulated space.
Is the government okay with this?
In the U.S., the Securities and Exchange Commission requires private companies to file a disclosure whenever they raise private cash. After largely letting the ICO market develop with no guidance, the SEC this summer warned startups that they could be violating securities laws with the token sales.
How governments choose to regulate this new type of transaction is one of the big outstanding questions in the field. The IRS has said that virtual currency, in general, is taxable — as long as the currency can be converted to a dollar amount.
Some expect the SEC to begin strictly clamping down on ICOs before the cash is raised. That’s already happened in other countries, most notably China — which this month banned the practice altogether. ICOs, while hosted in a certain country, are not confined to a certain jurisdiction and can be traded anywhere you can connect online.
“Ninety-nine percent of ICOs are a scam, so [China’s pause on ICOs] is needed to filter the crooks out,” tech investor Chamath Palihapitiya tweeted this month. “Next phase of ICOs will be real.”
This article originally appeared on Recode.net.