What Is an Initial Coin Offering (ICO) & How Does It Work?

Within the cryptocurrency world, new platforms, products, and services are often called crypto projects. At one point, startup crypto projects raised a lot of money through initial coin offerings (ICOs) by selling digital coins or tokens directly to individual and institutional investors.

The first ICO was in 2013 for Mastercoin, and there have been several successful ICOs since. Ethereum, which currently has the second-highest crypto market cap (behind Bitcoin), began as an ICO in 2014. 

ICOs were especially popular during 2017 and early 2018, but many proved to be scams. Investors were sometimes pitched or promised big returns, but left with nothing as creators took their money and disappeared.

The popularity of ICOs waned in part because the U.S. Securities and Exchange Commission (SEC) and other regulators around the world increasingly cracked down on ICOs. Google, Facebook, Twitter, and other major platforms also banned ICOs from advertising.

What is an initial coin offering?

An initial coin offering (ICO) is a type of cryptocurrency project fundraising approach that plays on the stock market’s more widely known initial public offerings (IPOs).

With an IPO, a private company becomes public and institutional and retail investors can purchase shares on stock exchanges like the New York Stock Exchange or Nasdaq. Shareholders are partial owners of public companies and can benefit from the companies’ growth.

An ICO lets investors buy into a new cryptocurrency project by purchasing its cryptocurrency tokens, or coins, when they’re first offered to the investing public. The individual or team behind the ICO can use the funds to build the project and the investors receive coins tied to the project.

Unlike owning a stock, owning a coin doesn’t necessarily come with ownership rights in the project. But it could give investors a cut of the project’s earnings, access to services, or value as the project becomes more popular. In that sense, ICOs may be more akin to angel investing in a startup or crowdsourcing a new company than purchasing shares in an IPO.

Another difference between IPOs and early ICOs was regulation. ICOs were largely unregulated when they first became popular. In contrast, the SEC requires many security offerings, including IPOs, to comply with specific registration and disclosure requirements. Investing in an IPO still involves risk, and the investors could lose all their money. But the IPO process can give investors the information they need to make an informed decision and offer some assurance that the opportunity isn’t a scam. In many cases, companies also have a track record and tangible products or services before they do an IPO.

As ICOs became more popular, the SEC made it clear that they also considered many ICOs to be securities offerings that should comply with the same requirements. It also took legal action against individuals and companies who created unregistered or fraudulent ICOs.

The regulators’ focus led some crypto project founders to change the structures of their ICOs so they wouldn’t need to register with the SEC. Or, to give up on the ICO process altogether and look for alternative ways to raise money.

While ICOs aren’t as popular as they once were, founders still use them for some projects. However, investors may need to be accredited investors—generally high-net-worth individuals or organizations—to participate. Additionally, the SEC has warned that it might not be able to get investors’ money back if they buy into a fraudulent ICO.

How does an initial coin offering work?

ICOs aim to raise capital for a crypto project. Individuals or teams behind these projects can set up and run ICOs in different ways. Many begin with a so-called white paper—such as the Ethereum white paper—that can include details about the project’s history, purpose, goals, proposed timelines, and value. This may also be the primary source of information for potential investors.

Choosing a coin to sell

The founders first have to decide what types of coins they’re going to offer during the private and public ICOS:

• Utility coins.

  Also called utility tokens, user tokens, or app coins, these are used within the project. Investors receive these tokens early on, which could give them access (or discounts) on the project's future products or services.

• Equity coins.

  These coins are backed by an asset, such as a share of the project’s future revenue.
  

Additionally, founders need to choose the ICO’s structure, such as the price per coin, sales cap, and sales period. They may also want to create a clear timeline for when and how different coins will be issued and who can purchase the coins.

Types of initial coin offerings

While IPOs are inherently public events, the same isn’t true of ICOs.

Some projects start with a pre-sale or private ICO. These are invite-only initial rounds of fundraising during which a portion of coins are sold to raise money for the full ICO. These funds can help develop the project and generate buzz. Some coins may also be set aside for post-ICO marketing campaigns.

Public ICOs are offerings that anyone can participate in. However, while the project founders might not limit who can invest, depending on the project and where it’s launching, these may be limited to accredited investors.

For example, Binance created and launched the Binance Coin (BNB) with an ICO in 2017. In total, Binance created 200 million coins, but only sold half through a public ICO. Initially, investors could purchase the coins using Ether or Bitcoin for about 11 cents each—it’s trading for more than $400, as of late January 2022. The remaining coins were allocated to founders and angel investors.

Marketing the ICO

Crypto projects are often marketed directly to consumers before and after the ICO through multiple channels:

• Social media.

  Fans may discuss the project on popular social media sites, channels, and groups. Some projects may pay influencers to advertise the ICO or project.

• Bounties.

  The project could try to attract attention by offering rewards (in the project’s coin) to those who perform certain activities, such as writing or creating a video about the project or finding bugs in its code.

• Airdrops.

  Some projects give away coins through an airdrop. Someone may need to complete certain tasks, such as following the project’s social media channels, then share their public crypto wallet address to get the coins.
  

Ideally, the project will reach its funding goal and, after the ICO, gain enough recognition that crypto exchanges and platforms list its coin.

Investing in an ICO: Potential advantages and risks

For investors, an ICO can present an opportunity to get a foothold in a brand-new crypto project. But there are upsides and downsides to consider.

Potential advantages to investing in an ICO

ICOs present a couple of advantages that could make them attractive to investors:

1. Potential for big returns.

   By getting in early, investors may get a great return on their investment if the project succeeds.

2. Future savings.

   If investors received utility coins, they could use the project’s services or purchase the products at a steep discount.
   

Potential risks associated with investing in an ICO

ICOs tend to present certain risks.

1. Potential to lose money.

   Investing in an ICO can be extremely risky. Even if the projects’ founders have the best intentions, they might not be able to create a successful or popular new project.

2. Scams.

   Many ICOs are scams, and some investors are left with nothing after creators take their money.‍

3. Certain investors may not qualify.

   US-based investors may need to qualify as accredited investors to participate in an ICO.

The bottom line

ICOs allow crypto project founders and teams to raise money for their project by selling coins to the public. In exchange, investors receive coins that could greatly increase in value if the project succeeds.

While ICOs have raised billions of dollars, they’ve largely fallen out of favor due to the prevalence of scams, increased regulation, and limitations on advertisements. Today, some crypto projects are turning to alternative types of fundraising, such as initial exchange offerings (IEOs) or security token offerings (STOs).