The digital currency ecosystem has had a crazy year. The Bitcoin market capitalization has grown from $11 billion on June 5, 2016 to almost $47 billion USD on June 5, 2017.
Negative news during that time included a 120,000 BTC heistfrom Bitfinex, worth $65m then and $350m now. The Winklevoss twins sought to create an exchange traded fund dealing in Bitcoin, but they were denied. Positive events were much broader, including Japan recognizing the coin as a legal payment method, Russia reversing their prior stand against Bitcoin, and Australia adjusting its policies to remove a double taxation problem for those accepting digital currencies.
Now a new phenomenon is sweeping the market, the Initial Coin Offering.
As of May of this year, over $380M has been invested into ICOs. Many of these companies are raising millions of dollars with nothing more than a white paper and a cryptocoin dependent on a small network of nodes running their blockchain. A year ago Bitcoin was 80% of the entire market capitalization of cryptocurrencies, and now it’s less than 50%, despite its meteoric rise in price.
Something is clearly happening here, so I spoke with Michael Terpin, a pioneering investor in the space, James Prestwich of Storj, a company that has offered ICOs on two different blockchain platforms, the co-founder of Ethereum, Anthony Di Iorio, and Ted Livingston, the CEO of KIK, the first $1 billion company to announce an ICO.
But first, what is an Initial Coin Offering? This phrase, like cloud and blockchain before it, is becoming overloaded as the market seeks to explain new concepts.
The idea around an ICO is that you create a digital coin or token and then you offer this coin or token for sale in an initial offering. An ICO is in some ways similar to an initial public offering. Both are done to raise funds, but, instead of stock, your ICO purchase gets you a new type of coin or token, an asset rather than a security.
The token can represent some sort of value or be of value itself. An ICO might involve attributing equity to a token so that ownership gives you voting privileges and access to dividends, which is what the now infamous fund raising effort of The DAOdid. Their use case for a token is the most similar to that of an IPO, however, the majority of use cases are for something different. The typical use case of a token issued in an ICO is the creation of an asset that gives you access to the features of a particular project. Instead of having cash or Bitcoin as the way to pay for goods and services from the ICO offerer, you use their token. You can think of these tokens as being similar to a store specific loyalty point, something you purchase with a general purpose digital currency and use at a specific location.
Ok great, now you have digital store specific loyalty point, why are these loyalty points so special? The reasons are tradability and use in decentralized applications.
Because these tokenized loyalty points are put onto a public blockchain, the points are not limited to being traded in exchange for services within the platform, but instead can be traded anywhere. If there is enough activity within a given ICO’s environment, their tokens will become globally traded on the various exchanges that handle cryptocurrencies. Successful ICOs are the product of careful thought on economics and game theory, and as a feature they intend that their tokens will increase in value as the volume of the activity on their platform rises.
As such, these loyalty points now have a variable value, based off of market perception and growing use of the platform. This creates a very interesting incentive mechanism because now the users of the platform who are receiving the tokens have incentives to bring other users to the platform in order to increase the value of their tokens.
I spoke with Anthony Di Iorio, co-founder of Ethereum, the most successful ICO to date with over a $35 billion market cap, on the benefits of combining a token with a crowdsale. “Part of the goal of the [Ethereum] crowdsale was to create a community of ambassadors for the Ethereum project. We managed to grow our base of ambassadors by attending meetups around the world, targeting groups and leaders in certain communities. Once they got on board, these communities would become advocates for our project. In addition to being able to conjure up a massive community behind the project, about 9,000 people participated in the crowdsale, we were able to sell across the world.”
Combining a token with an initial offering through a crowdsale allows you to build an international network of early adopters and investors who will actively work to educate and spread awareness of your project. Unlike a traditional crowdsale on a system like Kickstarter, where the users who invest typically only have an incentive to invite others to enjoy the product with friends and family, the users who participate in a token crowdsale have the additional incentive of a gain on the value of their asset.
So what about the use case for decentralized applications? This is not as easily applied for typical companies. This assumes that you want to create an application that, instead of being centrally hosted by a company, is hosted in a decentralized manner. The main value of this is that, since there is a reduction in intermediaries, users have more control of the application and it can be faster and cheaper to use the application for certain use cases. A perfect example of a decentralized application is Bitcoin.
Bitcoin represents a decentralized monetary system, whereby users have direct control of their money and can send money to one another in a peer to peer fashion. No one company owns Bitcoin or verifies the legitimacy of transactions, instead, this is done in a decentralized way by stakeholders called miners, and to a lesser extent, user nodes. Everyone is incentivized to maintain the system through transaction fees directly from the users and the creation of new tokens, which in this case is the mining of Bitcoin. This mix of incentives and decentralization make it such that, for the first time, users no longer need to rely on a third party to issue, hold or transact with funds digitally.
But there are additional layers of complexity that a token can add to a decentralized application. I spoke with James Prestwich, co-founder of Storj, a pioneering decentralized storage platform, to learn more.
“Storj is a distributed network where machines can autonomously sell their storage space and bandwidth. Any computer can join the network and they pay each other with Storj. Storj Labs is a company built on top of this infrastructure. No one wants to learn how to use a distributed network and cryptocurrencies to push & pull data, so Storj labs inc builds the tools to make it easy.
Shawn Wilkinson ran the initial crowd sale in the middle of 2014, selling 500k USD worth of Storj coin in exchange for Bitcoin. Storj executed a second crowdsale ending May 25th, where we raised $30m USD worth of tokens. The coin is used to buy and sell storage space on the network. Micropayments to the users hosting storage space will be a lot easier than with Bitcoin or Ether itself, since the coin is built with the Storj use case in mind. But the reason for the token goes beyond payments. It is necessary for the system to have everyone on the same token to ensure that people are following the protocol rules and behaving fairly. This will be done through network specific smart contracts that will incentivize people to behave fairly and punish users who try to cheat the system.”
The Storj system is a bit complex, as it handles two commodities – spare storage space and unused bandwidth of those providing that storage. Unlike Uber, where there is a central company organizing everything, Storj is completely decentralized and all the funds go directly to the storage holders. Lacking a centralized service ensuring that everyone is behaving correctly, there has to be some means of enforcing the agreed upon behavior. This is where smart contracts enter the picture.
The easiest way to think about a smart contract is allowing for the movement of money, without a third party involved, based solely on data input that is defined when the contract is made. Since Storj coin is built atop Ethereum they have access to a Turing Complete programming language for smart contracts, which is the computer scientist’s way of saying it’s a full featured language.
Storj smart contracts require that funds be held in escrow for users to participate in the system, either as storage providers or renters. If a user tries to cheat the system in some way, the smart contract can drain the funds from the escrow account of the cheater and return it to the user affected by the cheating. By leveraging the Storj coin, the value of these smart contracts become more predictable and correlated to the Storj platform, instead of being subject to the volatility of general digital currency markets such as Bitcoin or Ether.
Storj’s approach to building a company working on top of an infrastructure that is built with a team of Storj Labs developers in addition to the open source community is a very common approach for decentralized applications. This is done to create a more transparent environment for the infrastructure and to create an open platform that encourages other companies to build on top of and contribute to the system.
While Storj & Ethereum participated in crowdsales for the initial offerings of their tokens, they are careful to never use the term ICO, fearing that it is too closely associated with an IPO. Alan Cohn, co-char of Steptoe & Johnson LLP’s Blockchain and Digital Currency practice and head council to the Blockchain Alliance, explains that by calling an ICO a token crowdsale, it helps investors understand that they aren’t purchasing equity or a security, but an entirely new asset class. This is important for protecting investors in addition to protecting the startups themselves so that the SEC does not confuse their tokens with an asset that does not pass the Howey test. That being said, there are many ICO that intentionally act as securities, the most popular of which being Blockchain Capital, which raised $10 million in six hours.
So why are investors so excited about the new technology? I asked Michael Terpin, who invested in the original ICO, Mastercoin, and has advised 30+ ICOs, including top ICOs such as Ethereum, Factom, Augur, Golem and Gnosis, either personally or through his company Transform Group.
Terpin explains that “as a angel investor, you can put 25k into company equity, then the company goes through many more rounds of funding, and perhaps sells for $300m, but your stake has been diluted to almost nothing if there’s a down round anywhere along the way. With tokens, you can do the same kind of analysis of team and technology, but because it’s a trading token and not private equity, you can get out whenever you want. Even though tokens are typically not securities, they act more like gold or public stock from day one in terms of liquidity. This alone, coupled with the current bull market for ICOs, means a lot of investors are saying ‘I’ll take my chances with tokens’. Investors like it. Companies like it. Companies don’t give up any equity, just tokens, which in most cases are their product. Because it’s a product, it’s more akin to wine futures than stock. It’s a product with a resale value.”
Another unique sign that ICOs are becoming mainstream is Kik’s upcoming Kin coin. Kik is a chat platform popular with U.S. teens with over 300 million users. Ted Livingston, Founder & CEO of KIK, explains, “A cryptocurrency creates a new way to economically align a large group of developers to work together to create a new ecosystem of digital services that are compelling for consumers, and fair and lucrative for developers. Doing an ICO is a new and exciting idea, and it took some time to run experiments like the Kik Points pilot program to prove that we could build an economy inside of Kik…[T]his was a new and viable way to monetize a community – instead of showing ads or selling items to our users, we could grow the value of a cryptocurrency with a larger community.”
Instead of relying on an ICO to raise money in order to build a product, Livingston sees this as a way to reduce friction for goods and services that already change hands via Kik, as well as creating the foundation for exciting new projects.
However, a token doesn’t have to be about raising money. My company, Bitwage, leverages the Bitcoin blockchain to help workers receive their wages faster and cheaper when working across international borders. We are looking at ways to leverage a token to create momentum around a new peer to peer recruitment platform we are launching. There will be no initial offering or selling of the token, we’re going to provide a method to earn tokens in a way to incentivize users to refer others and create a community.
If you are thinking of running or investing in an ICO yourself, make sure to check out my next article on the “dos & don’ts” for running your own ICO and how investors should evaluate potential ICOs and tokens to invest in.