ICOs: What Investors Should Know Before Buying In

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Initial coin offerings have been one of the biggest stories in investing this year. We will remember 2017 as the year that ICOs went mainstream, courting interest from institutional investors and scrutiny from government regulators.

We will also remember 2017 as the year that many individual investors made fortunes by riding the highs of Bitcoin, plus several other currencies like Ether, Dash, Litecoin and Monero.

If you are looking to get into this highly speculative class of investments, then this guide is for you. Here is an overview of the risks and due diligence you’ll want to perform before putting up any money. We’ve visualized our advice as an infographic, below, that you can keep for quick reference.

ICO cheat sheet

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ICOs vs. IPOs

An initial coin offering isn’t quite the same thing an initial public offering of company equity. As the team at legal firm Smith + Crown note, ICOs are a little more analogous to Kickstarter campaigns, “but with backers having a financial stake in the project.”

Further, many of the ICO tokens are designed to give users and supporters early access to the software being developed, whether that’s a game, a smart contracts platform or whatever else the company is building.

Finally, ICOs aren’t regulated (yet) the same way that the SEC in America regulates IPOs. This adds a certain level of risk, which we will explore later in this guide.

How Do Investors Participate in an ICO?

Buying into an ICO requires a little tech savvy. At minimum, you’ll need to understand how to open a Bitcoin wallet, move funds around, exchange cryptocurrencies and secure your coins using accepted best practices.

Ouriel Ohayon at Hackernoon lays out the basics:

  1. Own or buy some BTC. You might have to exchange your BTC to ETH (Ether). Either way, you cannot buy into a sale with fiat money like US Dollars.
  2. Put the desired amount of BTC or ETH into the wallet specified by the organizers of the ICO.
  3. Be available the moment the ICO launches.
  4. Send in your contribution.
  5. When the ICO is done, you should get a notice about how many tokens you’ve acquired, and they will be sent to the original wallet that you moved your funds to in Step 2.

Tokens vs. Coins

This is a tricky distinction for people unfamiliar with the cryptocurrency world.

Originally, Bitcoin was developed to be a digitally native currency. That means it is fungible and can act as a store of value. Think of it the way you think of a US Dollar. Tokens, however, have additional applications. They can be fungible and act as stores of value, but they are native to the decentralized application environments they were built for.

It’s a crude comparison, but think of gambling chips at a casino. You couldn’t trade the chips at the Rio’s blackjack table for chips at the Wynn’s blackjack table. You would first have to cash out your Rio chips for dollars, then buy in again at the Wynn.

Now, there are two types of tokens: usage tokens and work tokens. Usage tokens function a lot like those casino chips. Work tokens, however, don’t act as currency so much as they give token holders voting rights within a distributed application environment.

This distinction allows for a couple of types of ICOs, which the team at Blockgeeks does a nice job of explaining.

First, there are currency ICOs. These are the classic examples of someone issuing a new kind of cryptocurrency. Investors buy in with established coins such as BTC, which serves as the capital to fuel the project, whatever that project is. Then, investors hold the new currency in the hopes that it will increase in market value.

There are also project ICOs, which allow you to buy work tokens so that you can have voting rights inside of the project’s environment. These tokens can also have market value that rises and falls in response to demand.

Risks

As mentioned, the fact that ICOs don’t fall under any single jurisdiction and thus aren’t regulated by any one organization presents some risks. For one, there is no one to appeal to if you are the victim of a fraudulent ICO. Further, as InvestmentBank.com points out, country-level regulators do have an incentive to impose restrictions on ICO activity.  China has already banned ICOs, for example.

So, a rollout of wider regulation is coming. What remains to be seen is what those regulations will be, how effective governments are in enforcing those and what effects those rules will have on the market.

Two other risks worth noting:

  1. Bubble dynamics: Too much hype around any one ICO can cause investors to valuate a project far beyond the project’s true economic value.
  2. Fraud: No one offering a coin is under legal obligation to be transparent or even truthful.

Be vigilant about fraudulent ICOs because that responsibility falls entirely upon you as an investor. The Blockgeeks guide has some useful tips for spotting fraud:

  • Make sure that the project developers can clearly and succinctly tell you what it is they’re building.
  • Make sure you know who the developers are and how you can reach them. Know their names, their locations, what their business plans are. Also, make sure you are able to contact them with any questions.
  • A legal framework should exist that sets out the roles of the developers and the contributors. This includes a terms and conditions document for the ICO.
  • Make sure the ICO funds are stored in a multi-signature escrow wallet, and that one of those keys is held by a neutral third party.

Resources for Evaluating an ICO as an Investment

Once you feel comfortable with the authenticity of the ICO, you need to perform due diligence into its potential as an investment.

First, you’ll want to understand what kind of coin or token you are buying.

Second, understand what stage the project is in and who is behind it. Steemit user @tomshwom has an excellent checklist for this kind of research:

  • Look up the developers and important lead roles on LinkedIn, GitHub, Twitter, etc.
  • If you can’t find consistent accounts with names, faces, and past projects, this is a BIG red flag that the ICO may be a scam.
  • Read the white paper!
  • Yes, this takes time. Yes, it can be complicated. Still, this is a great way to understand your investment BEFORE YOU INVEST.
  • Ask questions.
  • Reddit, slack channels, email, whatever; give the devs a poke and ask about the project. r/ethtrader is generally a good jumping-off point.
  • Check out the project code.
  • See if development has been progressing, dig into the code itself if you’re a programmer. Since many projects built on Ethereum are open-source, it’s not unheard of that a company copies parts or even entire projects.. cough Monaco
  • Keep up with some of the great community members that do a lot of this for you!
  • I personally keep up with @crypt0 and his youtube channel, CryptoPortfolio, and the folks over at ICO Alert to have a good idea of what ICOs are coming up and the ideas behind them.

Picolo Research has a free book, The Beginners Guide to Investing in ICOs, that’s another excellent resource for understanding the scope of the due diligence you will want to perform. The book takes you step-by-step through Picolo’s research methodology, and it’s well worth downloading.

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