Financial Advisor Guide to Initial Coin Offerings (ICOs)

Initial coin offerings (ICOs), the crypto version of an initial public offering (IPO), are a way for startups to raise capital through an alternative to traditional financing methods. As a financial advisor, understanding ICOs can help you guide clients in this area of the crypto space. ICOs can present prospects for high returns, but they also come with significant risks that must be carefully considered.

Below, we examine the fundamentals of ICOs, including how they work and their place in today's regulatory environment. In addition, we'll discuss the importance of thorough due diligence when assessing these investments. By the end of this article, you'll be well-equipped to help your clients make well-informed decisions, taking into account both the potential rewards and the inherent risks associated with ICOs.

ICOs as an Investment Opportunity

For clients interested in cryptocurrencies, ICOs may be an attractive early investment opportunity in this technology. However, investment advisors have an obligation to ensure that clients fully grasp the risks involved and that their ICO investments align with their broader financial goals and risk tolerance. You can then set client expectations and uphold your ethical duties, especially in such areas as cryptocurrency.

With the appropriate due diligence and a measured approach, advisors can navigate the fast-moving ICO landscape on behalf of their clients to give them prudent advice. This remains a “buyer beware” market still needing development and regulatory clarity. In the interim, advisors must vigilantly assess each offering and emphasize transparency with clients above all else.

How Initial Coin Offerings (ICOs) Work

Conducting an ICO usually involves the issuer releasing a white paper detailing the project, goals, timeline, and use of funds. The white paper serves as an informal prospectus to attract potential investors.

Once the white paper circulates, the issuer sets a date for a token sale to exchange newly created crypto tokens for established cryptocurrencies such as bitcoin or ether. The tokens are stored in digital wallets and are typically based on blockchain technology.

These newly minted digital tokens have two main varieties:

• Utility tokens: These provide their holders with future access to a product or service on the platform being developed. Essentially, they grant usage rights or the prospect of such rights.
• Security tokens: These entitle holders to an investment return, profit share, dividends, or other financial interest tied to an underlying asset. These are usually subject to securities regulations.

To date, the vast majority of ICOs are for utility tokens. Unlike company shares, these ICO tokens generally do not confer equity ownership in the issuing entity. Instead, they represent a digital asset specific to the project or platform.

For this reason, the value of utility tokens depends on the successful development and adoption of the project’s platform or service. If the project fails to materialize or gain traction, the tokens can quickly lose all value.

Key Differences Between ICOs and IPOs

While frequently compared with IPOs of company shares to the public, ICOs differ considerably concerning their regulation, structure, inherent risks, and investor rights. Here are some key differences:

• Regulation: IPOs must adhere to strict rules under the Securities Act of 1933, which requires company disclosures, financial statements, liability for misstatements, and registration with the U.S. Securities and Exchange Commission (SEC). Meanwhile, ICOs often operate in a regulatory gray area. Many jurisdictions have not yet established comprehensive regulations specifically for ICOs, leading to a wide variance in how they are treated. This lack of standardized regulation can result in higher risks for investors due to potential fraud and lack of transparency.
• Underwriting: For IPOs, underwriters like investment banks conduct thorough due diligence, receive fees, and act as gatekeepers to the public markets while marketing new shares to early investors. ICOs have no intermediaries screening or validating their offerings. Instead, the investing public must do their own research and build trust in the issuer, which directly markets the tokens.
• Rights and privileges: Stocks bought in IPOs represent equity ownership in a company’s assets and entitle shareholders to residual profits, voting rights, and the potential for dividends. ICOs rarely confer such rights, as they are typically utility-based tokens granting platform access and usage rights—or nothing at all.

These differences mean that IPO investors have more transparency, oversight, and legal protections than those in the ICO market, which is saying quite a lot given how often investors wish they had more to go on with IPOs. Advisors need to underscore these contrasts so that clients appreciate the heightened risks.

Risks and Challenges of ICOs

Given the lack of mandatory disclosures, regulations, and standardization, ICOs present a high risk of fraud, misrepresentation, and cybersecurity breaches. Advisors should warn clients of potential red flags like statements guaranteeing high returns, fake founder credentials, plagiarized white papers, or pressure to invest quickly.

Risk of Fraud

While many ICOs are legitimate, the largely unregulated arena has been the target of many instances of fraud. Here are some of the most notorious examples:

• OneCoin: OneCoin was promoted as a new cryptocurrency that would yield high returns. However, it was eventually revealed to be a Ponzi scheme. Its founders have since been convicted of defrauding investors of billions of dollars. Red flags included overpromising future returns and the company’s technology. Worse, the founders had dubious credentials.
• BitConnect: BitConnect promised high returns to investors but was eventually exposed as a Ponzi scheme. When it collapsed in 2018, it led to massive losses for investors worldwide. Red flags included overpromising on high returns, a white paper that was murky at best, and a referral program that used a structure known from Ponzi schemes.
• Centra Tech: The Centra Tech ICO was backed by several celebrities and raised $25 million in its offering. The founders later pleaded guilty to fraud and other charges, having made false claims about their technology and business relationships with major credit card companies. Red flags included overpromising future returns, overpromising on the company’s technology, unconfirmed relationships with major non-crypto firms, and the dubious credentials of executives (who didn’t exist).
• Pincoin and iFan: These two ICOs, run by the same Vietnam-based company, Modern Tech, defrauded over 30,000 investors out of a combined total of $660 million. The scheme promised high returns, but investors were paid with tokens from a new ICO rather than cash. Red flags included overpromising on high returns (up to 48% monthly at one point), a pyramid scheme arrangement (returns paid in further tokens), and an opaque business structure.
• PlexCoin: The PlexCoin ICO promised a 13-fold profit in less than a month but instead defrauded investors of millions. Red flags included overpromising future returns (1,354% profit in less than 29 days) and dubious backgrounds for the executives.

These cases highlight the need for due diligence and caution when investing in ICOs. The cryptocurrency space, especially over several years in the late 2010s, saw a proliferation of such schemes, taking advantage of the hype, lack of regulation surrounding digital currencies and blockchain technology, and investors wanting to get in on the returns seen in legitimate ICOs.

Heightened Volatility

But even legit ICOs have high failure rates. Their speculative nature means that ICO investments tend to be extremely volatile. The principal invested can decline significantly or go to zero after a startup failure. Moreover, studies have found that most ICOs lose most or all their value over time, a problem amplified by persistent delays, project abandonment, or lack of liquidity.

Limited Data for Evaluation

Another challenge is the limited historical data and lack of established valuation models for ICOs, making it difficult to assess their fair value or potential return rigorously. Traditional financial metrics and analysis methods used for stocks and bonds are often not applicable to ICOs.

Liquidity Concerns

Liquidity risk is another concern. Unlike publicly traded shares listed on major stock exchanges, many ICO tokens are traded on less regulated and less liquid cryptocurrency exchanges. This can make it difficult for investors to sell their tokens at a fair price (or at all), especially during market downturns.

Evolution of the ICO Market

In the 2010s, ICOs emerged as a method for blockchain-based startups to raise capital outside the traditional venture capital model. They were enabled by the increasing popularity and acceptance of cryptocurrencies, especially bitcoin and ether. The first notable ICO was for Mastercoin (now Omni) in 2013, which raised $5 million, an impressive figure at the time that demonstrated the potential of this new fundraising mechanism.

Rapid Growth

Over the next few years, the ICO market grew rapidly, culminating in a 2017–2018 peak, when billions of dollars were raised by various projects, including notably shady ones. The appeal was simple: It was a way for anyone with an internet connection to invest in projects that seemed to grow in value rapidly. For instance, Dragon Coin, a payments system targeting the Southeast Asia online casino market, raised $320 million in one month, from February to March 2018.

Early Successes

While many fail, several cases highlight the potential success ICOs can have. Perhaps the best known is Ethereum, which had its ICO in 2014 and raised over $18 million. It has since grown into the second-largest cryptocurrency by market capitalization. Ethereum’s success lies not just in its fundraising but in how it contributes to the cryptocurrency ecosystem more broadly. The platform’s introduction of easily programmable smart contracts changed the industry, laying the groundwork for decentralized applications (dApps) and many other blockchain projects.

Another prominent example is EOS, which raised a record $4 billion in its 2018 ICO ending in 2018, though its market cap has since decreased to about $915 million, as of May 2024. These successes underscored the massive fundraising potential of ICOs and how these funds can be channeled to create platforms that aimed to improve the crypto space. Unfortunately, they also whetted the appetites, too, of con artists and frauds seeing the gains to be had.

Regulatory Scrutiny

More recent trends in the ICO market indicate a shift toward more regulatory compliance and investor protection. The explosive growth and subsequent scams and failed projects caught the attention of regulators worldwide. This has led to increased scrutiny and the implementation of more stringent rules around ICOs.

Shifting Trends

Due to increased regulatory scrutiny, the number of ICOs has declined, with a noticeable shift toward security token offerings and initial exchange offerings, which are said to be better regulated and more secure alternatives. These trends could reflect a market that is gradually aligning with traditional financial and regulatory standards while maintaining the best aspects of the crypto space.

What Financial Advisors Should Review

ICOs require advisors to conduct extensive due diligence. Here are some of the most crucial elements in an ICO to evaluate:

• Founder credentials and track record (if it's fuzzy at all, avoid)
• Proposed product or service viability and competition
• Token utility and use cases
• Code audits and cybersecurity
• Token valuation and sale structure
• Planned uses for the proceeds
• Market conditions and growth projections

Advisors should thoroughly vet white papers, interrogate assumptions, and assess alignment with client goals before endorsing any ICO investment. From a suitability perspective, clients should only use discretionary risk capital for ICOs they can afford to lose. Conservative allocations are prudent.

Legally, advisors must follow all applicable regulations should they recommend ICOs, a largely unregulated space. As the market evolves, advisors must regularly advise clients on trends, risks, and developments to make informed decisions on any ICO prospects. Advisors should monitor the changing regulatory landscape, especially provisions around KYC and anti-money laundering rules that can determine a client’s eligibility to participate in ICOs.

While risky, ICOs offer exposure to emerging technologies and business models that can diversify and contribute to an overall investment portfolio. Well-equipped advisors can guide clients to make informed decisions about this complex, rapidly evolving ecosystem.

The Bottom Line

ICOs are an evolving method of fundraising that has prospects and risks. Financial advisors must understand these developments, as well as the evolving regulatory environment, to guide their clients in this space, balancing these investments with the need for due diligence and risk management.

Your clients rely on your expertise and objectivity to guide them through the intricacies of the investment world. By taking a balanced approach to ICOs, you can help your clients avoid the pitfalls in the crypto space. By staying informed and providing valuable insights, you can differentiate yourself as a trusted advisor and help your clients achieve long-term financial success in the ever-changing investment landscape. Lastly, if you're up to date in this area, clients will trust your word far more should you need to steer them away from certain investments.

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