I-C-O. These three letters recently changed the crowdfunding market for ever. In 2016, Initial Coin Offerings (ICOs) raised $96 million globally. Last year, this amount surged to $4 billion. The mood was jubilant, but, with such impressive growth rates expectations became higher and higher. So, where does the ICO market go from here?
The crypto sphere is a brand-new world with its own vocabulary. We often hear terms like “private round,” “testnet,” “softcap,” “fork,” etc. For crypto early-believers these terms are already well-known. Wall Street traders have generally been able to learn quickly — given similarities to existing financial vocabulary. However, for the average retail investor, it has been more of a challenge.
In order to cater to a broader audience, we will explain the ICO process in simpler terms.
Welcome to CryptoLand
Let us imagine that someone has a plan to open a Theme Park called CryptoLand next to Disneyland Paris. Other than the fantastic attractions, what makes CryptoLand unique? The only means of payment accepted inside the park will be Crypto-Dollar tokens.
These Crypto-Dollars act as “utility tokens.” In other words, currency is issued by a company that can later be used to purchase a good or service offered by that same company.
The founders of CryptoLand will need to raise money to build their theme park. Suppose that, based on their calculations, they need $10 million. How can they raise such a large amount of money? They can start issuing Crypto-Dollars today and publicly selling them. Instead of giving up equity, they can pre-sell the tickets they would have sold at the opening of the theme park. As a result, they can keep full control of their company while financing the construction of the park.
Were it not for this “pre-sale,” these Crypto-Dollars would have been sold either at the entrance of the park or online. Once inside the park, the tokens would be the only means by which visitors could pay. Subsequently, any Crypto-Dollars sold would correspond to the park’s future revenues.
The strategy employed by CryptoLand is exactly what happens in a typical “Initial Coin Offering.” Essentially, an ICO is a method of fundraising using cryptocurrency. A quantity of cryptocurrency is sold in the form of tokens to investors in exchange for legal tender. The tokens sold are representt future functional units of currency if or when the ICO’s funding goal is met and the project launches.
Returning to the CryptoLand example, the next question is how to raise $10 million via this ICO. CryptoLand would not succeed if they only targeted visitors of the park such as families. Normal families (“Users”) will only buy some Crypto-Dollars (“Tokens”) just before going to the park to enjoy a day with their kids. In order to raise $10 million, CryptoLand needs to approach investors (“Traders.”)
As we argued in a previous article Ripple: New Token Functionality Gives XRP a Floor: “These [Traders] are buyers that are holding the currency for the sole purpose of making a profit out of their “investment.” This category of actors is not concerned with the token utility. Rather, they are driven purely by price and hopes of future profit.”
In order to attract such investors and succeed in their ICO, CryptoLand will have to pitch two things: 1) their business plan (“White paper”), 2) the return that investors will be able to get out of their tokens.
ICOs usually take place in several rounds, limited in time and supply, with different discounts, depending on the round. The earliest offering is normally the cheapest. Once all the rounds are over and all Crypto-Dollars are sold, these tokens will be quoted in one or several exchanges and the price will vary based on supply and demand.
Let us imagine that a few months later, the ICO is a success and CryptoLand has raised $10 million thus reaching their goal (“Hardcap”). They founders have kept their promise and built a fantastic Theme Park near Disneyland Paris. So far, everything has gone as planned and the park is about to open its doors for the first time.
Until now, Crypto-Dollars have fluctuated on an exchange as investors have speculated on the price based on their personal analysis.
As soon as CryptoLand opens, a new player will arrive in the market: the families (“Users”) who want to go visit the park. Since all Crypto-Dollars (“Tokens”) have been pre-sold during the funding (“ICO”), those visitors have no choice but to buy them on the exchange where they are already trading. This is great news for investors (“Traders”) because it brings new demand to the market. If the demand is large enough the price of a token will go up.
1) Founders issue Crypto-Dollars (“Tokens”), which have been identified as their future revenues.
2) Investors (“Traders”) buy these Crypto-Dollars (“Tokens”) during a succession of sales rounds (“ICO”)
3) Founders keep their promise, build CryptoLand (“Project”) and, families (“Users), come to the market to buy Crypto-Dollars (“Tokens”) to use on their upcoming visit
Why Supply Matters
During the ICO process, we identified CryptoLand as the only supplier and investors as the main source of token demand. As we said above, this initial token supply released by CryptoLand corresponded to the future revenue of the company. Therefore, the Crypto-Dollars sold during the ICO were the same ones that would have been sold to visitors at the entrance of the theme park.
The amount of tokens sold is crucial. Let’s consider, for example, that each visitor is expected to spend an average of $100 inside the park. Here are two possible options:
1) CryptoLand sells $1 million in Crypto-Dollars. This translates to ten thousand visitors buying the Crypto-Dollars they need. The token price will increase based on the ancestral law of supply and demand. Should CryptoLand grow in popularity, investing in the ICO would have been a smart move. For perspective, Disneyland Paris hosts 41,000 visitors a day.
2) CryptoLand sells $10 million in Crypto-Dollars. This represents one hundred thousand visitors buying Crypto-Dollars they need. If the ICO were able to sell so many tokens the message is that investors are very bullish on the idea. After all, this would imply that one day, Cryptoland would be capable of attracting 2.4x as many visitors as DisneyLand Paris.
Conclusion: Small ICOs are Hidden Gems
Taking Etherum as a benchmark, the ICO market has lost more than 67% since January 1st, 2018. Individual tokens have lost even more.
Nevertheless, there are fantastic projects out there about to be launched. The pricing of these ICOs is often attractive given that the market has crashed.
Some projects, due to lackluster marketing, have missed their ICOs targets and raised much less than expected. The low supply of these tokens in the market make them particularly interesting investments for an opportunistic trader.
In conclusion, don’t underestimate the value small ICO projects could bring you. They may turn out to be much more profitable than the those with larger issuance. Instead of getting caught up in “hot” ICOs we prefer to look for the smaller, hidden gems.
— Jonathon Solomon, Enigma Team, Tel Aviv