Initial coin offerings explained

An initial coin offering (ICO) raises money by selling digital tokens, usually through a blockchain. Buyers pay with traditional currency or cryptocurrency. Depending on the offering’s terms, tokens may provide access to a planned service, governance rights, or financial rights.

An ICO can fund a project before its product is finished, but buying a token does not automatically give you company ownership, a right to repayment, or a way to resell it. The project can fail, the token can lose value, and token rights vary by offering.

How an ICO works

A project explains its plans and token in documents such as a white paper, which describes the project, or a roadmap. It then offers tokens in exchange for contributions. The project often uses blockchain software to issue or distribute the tokens. That software may include a smart contract, code that automatically carries out specific actions, such as transferring tokens after payment.

The project typically says it will use the money raised to develop a product, platform, or network. Buyers receive tokens that may become usable in that project. They can trade the tokens later only if a market exists and buyers are willing to trade. An ICO guarantees neither.

What a token gives buyers

Token rights depend on the offering’s terms. A token might let its holder use a service. Other possible rights include voting on certain project decisions and receiving a share of profits. Some tokens combine these features; others offer no clear rights beyond the ability to hold or transfer the token.

A study of 253 ICOs launched from 2014 through August 2017 found that 68% offered service access, 24.9% offered governance rights, and 26.1% offered profit rights. Those categories overlapped, and the figures describe that historical sample, not all ICOs.

An ICO also differs from an initial public offering, or IPO, of company shares. Shares generally represent ownership in a company, while a token may provide only a specific use or right. The token’s label alone does not establish its legal status or what a buyer receives.

Why projects use ICOs

An ICO can let a project raise money from many potential buyers, even before it has a working product. The project may also distribute tokens for people to use if its network or service succeeds. Researchers describe ICOs as another way for entrepreneurs to raise money, with some features of crowdfunding, venture capital, and public offerings.

Because buyers often support a plan before the product exists, a project’s fundraising success alone says little about whether it will deliver useful software or create lasting demand for its token.

Risks buyers face

You could pay for a project that never delivers. Even a working product may fail to attract users, leaving its token with little use or demand. A token’s price can also swing sharply, and there may not be enough buyers for you to sell at the price you want.

Other risks include false or misleading claims and software flaws. Hacking and lost wallet keys pose further risks. A white paper describes a project’s plans, but no one should assume an independent party has checked those claims or that the document meets the rules for a regulated prospectus. If a project or exchange fails, or someone steals tokens, recovering your money can be difficult.

The U.S. Commodity Futures Trading Commission has cited estimates of ICO fraud ranging from 5% to more than 80%. That wide range reflects different studies and measures, not one settled estimate of the fraud rate. The CFTC has also cited a report finding that nearly half of the projects or companies in its sample had failed or shut down one year after an ICO. That historical finding does not establish a current failure rate.

What ICO studies found

ICO studies report different results because they measure different things. Meeting a fundraising target, listing a token for trading, staying in business, and earning buyers a positive return are separate outcomes.

These findings cover offerings launched mainly between 2014 and 2018. They do not establish today’s typical ICO outcome, fraud rate, or return. A high rate of fundraising success can coexist with project failures or poor token returns because each statistic answers a different question.

How U.S. securities rules apply

In the United States, whether a token offering involves a security depends on the facts. Those include how the token is offered and sold, as well as how it is resold. Calling it a “utility token” does not settle the question. If the offering involves securities, federal securities laws may require registration or an available exemption.

The U.S. Securities and Exchange Commission’s investor bulletin on ICOs dates from 2017, and its framework for analyzing digital assets as investment contracts dates from 2019. Those documents explain the agency’s approach in those publications, but they do not by themselves describe the complete current legal position. Rules also differ by jurisdiction, so a token’s status in one country does not establish its status elsewhere.

Questions to ask before buying an ICO token

Before you send money, make sure you can find clear answers about the token’s rights, the project’s progress, and the risks:

• Who is issuing the token, and can you independently verify the people and claims involved?
• What does the token let its holder do or receive?
• Is the product already working, or are buyers funding development?
• How will the project use the proceeds, and what happens if it stops?
• Is there evidence that buyers can resell the token, and what supports claims about future value?
• What legal protections apply where you live?
• Are promoters promising guaranteed returns or pressuring you to buy quickly?

If the project cannot explain what the token entitles you to, it is hard to judge what you are buying. Promises of guaranteed returns are also a warning sign, especially when the project avoids explaining how those returns would be produced.