Reports show initial coin offerings — the IPOs of the cryptocurrency world — have more than doubled in volume during the past year, raising $12 billion so far in 2018.
The Better Business Bureau Institute and the Financial Industry Regulatory Agency (FINRA) recently authored a blog post describing how ICOs work and spelling out the risks and benefits.
John Masterson, marketing director at the BBB Serving Western Michigan, has long been fascinated by — but also fairly skeptical of — cryptocurrencies.
Masterson said while plenty of West Michigan investors use Bitcoin or any of the other 1,565 digital currencies on the market as of April, his organization has not yet had any clients that have floated an ICO.
However, he believes the lack of government regulation for ICOs and the “thrill of reward” for investors may entice local startups to get on the bandwagon in time.
“There’s no reason someone here in West Michigan couldn’t start their own digital currency and start an ICO,” he said. “It takes some programming ability, but anyone could build that hype, do some programming and take investments.”
Masterson cautioned investors to “do their homework and know the risks.”
Here is some background information on ICOs from the BBB and FINRA.
How ICOs work
An ICO involves the creation and distribution of digital tokens by a company — often a startup — to raise capital.
Companies typically promote the offering via their websites and online blockchain and digital currency forums. Instead of issuing a prospectus to potential investors, they publish a white paper.
The company announces the funds it wants to raise and the number of tokens available for purchase. The fundraising — conducted online — continues until that amount is reached. Purchasers can pay for their tokens with cryptocurrencies or fiat currencies such as the U.S. dollar.
Return on investment
ICO investors receive tokens that can eventually be used on the product or platform being created by the company — or to receive goods, services or rewards from the company.
Investors also can wait for the tokens to become valuable enough to trade on secondary markets.
According to the BBB and FINRA, unlike stocks, most ICOs to date have conferred no ownership rights in the company, and unlike bonds, investors do not usually lend money to the issuer as part of the ICO.
However, the Securities and Exchange Commission (SEC) said depending on the circumstances of each ICO, the tokens offered and sold to investors might be considered securities.
If so, the offer and sale of these tokens would be subject to federal securities laws. This means the ICO must be registered with the SEC or meet an exemption from registration.
Offerings that are performed under an exemption from registration typically require investors to meet income or net worth thresholds — for example, only accredited investors with a net worth of $1 million or more can invest in the ICO.
Masterson said the “virtual tokens” aspect of ICOs is part of what makes them so different and unnerving — it’s like starting “new currencies.”
“I could talk about this all day, but I’m not bold enough to invest,” he said. “A couple different times, I thought Bitcoin would fail, and we’d never hear of it again. But it’s just continued to grow and spin off.
“A lot of people hope (ICOs) skyrocket.”
Risks of investing in ICOs
Prospective investors should be aware many ICO ventures fail, just as startups do. Some reports estimate more than 50 percent of the ICOs conducted in 2017 failed. That’s in part because many ICOs are based on an idea without a tangible product or sales history.
And, some ICOs are scams in disguise. The Wall Street Journal recently released a review of documents related to 1,450 digital coin offerings and found 1 in 5 of the offerings had red flags of fraud, such as “plagiarized investor documents, promises of guaranteed returns and missing or fake executive teams.”
Two common ICO scams to watch out for:
Exit scams: Scammers posing as legitimate startups persuade investors to pay large sums of money or cryptocurrencies to buy into an ICO, never build a company, then walk away with the investors’ assets.
Pump-and-dump scams: Groups of people coordinate to purchase a token issued during an ICO and urge other investors to participate in the ICO. The scammers then sell their tokens at a profit, stop promoting the ICO and the value of the tokens plummets.
How to spot a scam
Investors should be careful to scrutinize ICOs before committing capital. Red flags include a poor online presence, a white paper lacking in technical details, celebrity endorsements, guarantees of big profits or unrealistic expectations about the type of platform or service the company is proposing to build.
The SEC set up a website, HoweyCoins.com, that mimics a bogus ICO to educate investors on warning signs of a scam.
Those who decide to invest despite the risks should only commit what they can afford to lose and be aware of the risk of losing some or all of their investment.
“It’s unregulated, and it’s like betting on startups where you have no idea if it will succeed,” Masterson said.