What the Hell Is an Initial Coin Offering?

Initial coin offerings are all the rage. Dozens of companies have raised nearly $1.5 billion via the novel fundraising mechanism just this year. Celebrities from Floyd Mayweather to Paris Hilton have jumped on the hype train. But don’t feel bad if you’re still wondering: what the hell is an ICO?

The acronym probably sounds familiar, and that’s on purpose—an ICO does indeed work similarly to an initial public offering. Instead of offering shares in a company, though, a firm is instead offering digital assets called “tokens.”

A token sale is like a crowdfunding campaign, except it uses the technology behind Bitcoin to verify transactions. Oh, and tokens aren’t just stand-ins for stock—they can be set up so that instead of a share of a company, holders get services, like cloud storage space, for example. Below, we run down the increasingly popular practice of launching an ICO and its potential to upset business as we know it.

Let’s start with Bitcoin, the most popular token system. Bitcoin and other digital currencies are based on blockchains—cryptographic ledgers that record every transaction carried out using Bitcoin tokens (see “Why Bitcoin Could Be Much More Than a Currency”). Individual computers all over the world, connected via the Internet, verify each transaction using open-source software. Some of those computers, called miners, compete to solve a computationally intensive cryptographic puzzle and earn opportunities to add “blocks” of verified transactions to the chain. For their work, the miners get tokens—bitcoins—in return.

Blockchains need miners to run, and tokens are the economic incentive to mine. Some tokens are built on top of new versions of Bitcoin’s blockchain that have been modified in some way—examples include Litecoin and ZCash. Ethereum, a popular blockchain for companies launching ICOs, is a newer, separate technology from Bitcoin, whose token is called Ether. It’s even possible to build brand new tokens on top of Ethereum’s blockchain.

But advocates of blockchain technology say the power of tokens goes beyond merely inventing new currencies from thin air. Bitcoin eliminates the need for a trusted central authority to mediate the exchange of value—a credit card company or a central bank, say. In theory, that can be achieved for other things, too. 

Take cloud storage, for example. Several companies are building blockchains to facilitate the peer-to-peer buying and selling of storage space, a model that could challenge conventional providers like Dropbox and Amazon. The tokens in this case are the method of payment for storage. A blockchain verifies the transactions between buyers and sellers and serves as a record of their legitimacy. How exactly this works depends on the project. In Filecoin, which broke records last month by raising more than $250 million via an ICO, miners would earn tokens by providing storage or retrieving stored data for users.

One of the first ICOs to make a big splash happened in May 2016 with the Decentralized Autonomous Organization—aka, the DAO—which was essentially a decentralized venture fund built on Ethereum. Investors could use the DAO’s tokens to cast votes on how to disburse funds, and any profits were supposed to come back to the stakeholders. Unfortunately for everyone involved, a hacker exploited a vulnerability in Ethereum’s design to steal tens of millions of dollars in digital currency (see “$80 Million Hack Shows the Dangers of Programmable Money”).

Some people think ICOs could lead to new, exotic ways of building a company. If a cloud storage outfit like Filecoin were to suddenly skyrocket in popularity, for example, it would enrich anyone who holds or mines the token, rather than a set group of the company’s executives and employees. This would be a “decentralized” enterprise, says Peter Van Valkenburgh, director of research at Coin Center, a nonprofit research and advocacy group focused on policy issues surrounding blockchain technology.

Someone has to build the blockchain, issue the tokens, and maintain some software, though. So to kickstart a new operation, entrepreneurs can pre-allocate tokens for themselves and their developers. And they can use ICOs to sell tokens to people interested in using the new service when it launches, or in speculating as to the future value of the service. If the value of the tokens goes up, everybody wins.

With all the hype around Bitcoin and other cryptocurrencies, demand has been extremely high for some of the tokens hitting the market lately. A small sampling of the projects that have raised millions via ICOs recently includes a Web browser aimed at eliminating intermediaries in digital advertising, a decentralized prediction market, and a blockchain-based marketplace for insurers and insurance brokers.

Still, the future of the token marketplace is highly uncertain, because government regulators are still trying to figure out how to treat it. Complicating things is that some tokens are more like the basis of traditional buyer-seller relationships, like Filecoin, while others, like the DAO tokens, seem more like stocks. In July, the U.S. Securities and Exchange Commission said that DAO tokens were indeed securities, and that any tokens that function like securities will be regulated as such. Last week, the SEC warned investors to watch out for ICO scams. This week, China went so far as to ban ICOs, and other governments could follow suit.

The scene does seem ripe for swindles and vaporware. Many of the companies launching ICOs haven’t produced anything more than a technical whitepaper describing an idea that may not pan out.

But Van Valkenburgh argues that it’s okay if the ICO boom is a bubble. Despite the silliness of the dot-com era, he says, out of it came “funding and excitement and human capital development that ultimately led to the big wave of Internet innovation” we enjoy today.