Why Most ICOs Will Fail – A Cold Hard Truth

A comprehensive outlook that delves a little deeper into the definitions of these concepts while also answering the fundamental questions especially from individuals asking themselves what tokens and ICOs are all about.

The cryptocurrency world has gained an almost mainstream following over the last five years. It seems that everyone has somewhat of an ‘idea’ about blockchains and Bitcoin, or at least think they do. However, one specific phrase that has gained more attention lately is Initial Coin Offering or simply, ICO. The millions of dollars that ICOs have raised for a good number of startups has gotten people using strong words to describe these events, and these have ranged from everything between ‘revolutionary genius’ to ‘Ponzi schemes.’

Here is a comprehensive outlook that delves a little deeper into the definitions of these concepts while also answering the fundamental questions especially from individuals asking themselves what tokens and ICOs are all about. Well, tokens act as currencies, just like coins do, in an arcade game, and ICOs are the premier means of distributing these tokens. While all of this sounds relatively simple, most people underestimate the science behind it. Primarily, these tokens power their various networks and offer access to individuals that seek to enjoy the benefits that the said networks provide.

With the glitz surrounding the industry, the question here is why do most people harbor the feeling, and rightly so, that most ICO’s are going to flop? Is it because the events that have surrounded the ever-growing ICO environment since the year 2016 have been nothing short of mindboggling by any and all standards?

With almost a trillion dollars raised in two years (yes, you read that right. A trillion dollars!), the world and regulatory authorities are at a loss on what move to adopt next. The scrambles at SEC are a good example. Just like the dawn of, say, the online business era, the common man is just now learning the utility, power, and feasibility of the blockchain.

To try and rightfully put all this into context, here are insights promised at the beginning.

How ICOs work:

All ICOs begin with a blockchain-related idea. Once this idea is well received by the community in which it is initially fronted to, then the real work begins. To a certain extent, Initial Coin Offerings are a form of crowd-funding. A good number of projects have successfully used this model to raise funds for expansion. ICOs are one of the most efficient ways for individuals and companies to invest in and fund their projects.

The intricate workings of ICOs

Firstly, developers have to announce their intention and goal of coming up with a project. The hype that this announcement generates determines how successful the ICO will be. This shows that cryptocurrencies are a lot similar to everything else in this regard; first impressions matter greatly.

After creating the hype, the developers then proceed to craft a white-paper, which is nothing more than a document that highlight project features to increase excitement in potential investors. White papers live up to their simple name; nothing flashy or flamboyant and written academically. Once the white paper is out, developers then run it through the prominent members of the blockchain community. This is done so that the community members get to give their backing to the white-paper for credibility purposes.

Soon after, the developers then go ahead and issue a limited number of tokens. This limited number of tokens can have a static price on them, which might increase (hopefully) or decrease (unfortunately), depending on how the sale proceeds. Now, should someone be interested in buying tokens, all they have to do is send a particular amount (in either fiat or crypto, depending on the preference of the team) to the crowd-sale address. And, once the contract confirms that your transaction is done, you will, in turn, receive the equivalent number of tokens.

Usually, ICOs last between a week and a month, sometimes slightly more. Ideally, the time often depends on the time it takes for the ICO to attain the hardcap.

How are the tokens priced?

In some ICOs, tokens have a pre-designated price that will remain static. Most times, this also means that the token supply will also remain static. Sometimes you can have a limited amount of tokens, but with a dynamic funding goal. This means the manner in which the tokens are distributed is heavily dependent on the funds received, which further translates to a higher token price for a larger pool of funds collected.

Other ICO may choose to have dynamic token supply, but with fixed token prices, or limited ICO timeline. Here, every token is priced the same but for every token bought, a new one is subsequently created. This goes on up until the required funds are raised, or until the allocated time lapses and the sale is closed. Achieving the objectives of the ICO during the specified time, means marketing campaigns become a great tool.

Alternatively, developers may choose a suitable time and date to for their ICO. Where this is the preferred route, it may be essential to:

  • Avoid spring breaks and important holidays because campaigns need to reach as many investors as possible. During breaks and holidays, most people are never optimally reachable.
  • Study investors and their working patterns to capitalize on the days of the week that they are likely to participate in ICOs and commit to the sales.
  • Time the targeted investors aptly by working with the time zones.

This seamless procedure describes how ICOs work, which begs the question, why would most ICOs fail with such an oiled mechanism? The most probable reason is that most developers and entrepreneurs fail to pay any attention to the three major pillars that define an ICO, and these are:

  • The principals of cryptocurrency economics.
  • Token utility.
  • Token security.

One of the biggest pros of ICOs is that anyone can raise money for a concept they believe in, and it need not necessarily be a finished product. So, how do these pillars mentioned here above play in the who scheme of failure?

Principles of Crypto Economy

As the name suggests, crypto-economics revolves around cryptography and economics that defines it. The cryptography bit makes the P2P communication in the blockchain networks secure, and the economics bit incentivizes contributions to the network development over time.

Crypto-economic approaches create decentralized P2P networks capable of thriving over time, regardless of the numerous adversaries attempting to disrupt them from left right and center.

It is interesting how a developer can forget the crypto economics that comes into play in their ICOs. Most of them pay attention to the cryptography part and forget about the economics bit. Because of this, investors in the recent past have found it a challenge to identify a token that boasts of a stable and thoroughly mapped out the economic skeleton. When a token has a flaw in its economic model, it will ultimately suffer inflation that will directly affect its value.

Everyone who gave ICOs a shot at the very beginning when they were still a new concept managed to get the most out of them because the exercises charged low for entry and gave handsomely high profits. When the masses saw this, they decided to jump into the deep end with both feet because of the Fear of Missing Out (FOMO). The industry then saw investors dedicating millions to mere concepts that did not even have an alpha version.

Developers, being the ‘innovators’ we know them to be, saw this and their focus changed, unfortunately. Instead of making currencies that contributed richly to the ecosystem, they started tailoring their product specifics for their whitepaper, just so that they can go for the big win in ICO. Because of this erratic speculation, the ‘Greater Fool Theory’ unfolded.

Greater Fool Theory and its Place in the Unusual Flux of Cryptocurrencies?

The greater fool theory is an Economics supposition, which states that the price of an object does not increase because of its intrinsic value, but rather because of the irrational beliefs attached to the said object.

Looking at it from an ICO’s point of view, numerous cryptocurrencies come up each day, but sadly, not many bring in nothing new to the ecosystem.

The only reason the value of currencies increase is because there are so many ignorant investors who think ICOs are a get rich quick schemes, or they feel that the coins have been hyped up too much. When this happens, the value of the tokens gets inflated.

Does this seem familiar? Chances are you feel it does. The reason you might feel so is that this is not the first time it is happening. A similar situation took place in the late 90s when the dot.com bubble presented a wave that swept a good number of people from all over.

What is the Dot Com Bubble?

(Fun fact: this was named like so, because of the .com. domain used by companies doing online business).

As the adage goes, people that are not consciously aware of history are bound to repeat it. So why not take a quick look at what happened in the past to identify what to look out for?

In year 1997, the internet became big and tech companies sprouted from all corners. The tech start-ups then promised a lot, and so investors pumped millions into them with the hopes that they would soon move from ‘start-up’ status to money minting entities.

Again, because of FOMO, investors doubled, tripled and quadrupled in numbers as well as the investments they were churning out. While investing and reinvesting, they forgot to consider whether these companies that interested them had the potential to succeed in business. Their FOMO made budding tech start-ups rich in the IPOs.

Later, it became apparent that these bubble companies were – for the most part – created to make money off investors, instead of making money for them. The worst thing that could ever happen to an investor occurred. Most of these companies failed, even after receiving millions from well-meaning investors. A good number of the companies were scams.

Things were not looking so good by the time all the bubble was morphing. In 1999, the dot-com bubble, begun showing signs of bursting. The following year, companies that were considered to be the famous ‘dot-coms’ became the infamous ‘dot-bombs.’

The enormous losses, the crash of the stock market at that time, and the financial damage that came with 9/11 terrorist attacks led to joblessness in the tech world. This went on to unfold up until the year 2002 when the bubble burst. Companies that were doing well ended up halting operations and others just flat out collapsed.

What most investors ignored, was the traditional investment metrics, and instinctively subscribed to a business model that favored building market share quickly, disregarding the fact that the same companies had to offer their services for free or at a discount.

The Stunning Similarities Between the ICO and Dot.Com Bubbles

The parallels between these unique yet very similar bubbles are a tad bit frightening.

Firstly, ICOs have attracted a considerable number of investors from all over the world, just like the dot-com bubble did. These guys have major FOMO and want to catch every bit of the gold rush. Secondly, all the investments that were made in the dot.com era, as well as those that are currently being made in the ICO, are done purely from speculation.

It is highly likely that most of the companies looking for investment in ICOs, barely have anything prepared. Upon probing, you will realize that they do not have an alpha version of their result. All you will hear is speculation and the ‘potential’ of the project.

The most prominent reason why Golem and Ethereum ICO have worked so well is that they both had a dedicated and hardworking team of passionate developers, who wanted to make their ICO successful. Thinking about this superficial approach to ICOs can get scary because it is cumbersome to ascertain whether it’s an ICO bubble or not, and even if it is, there is nothing concrete hinting at when it will pop if it eventually does.

One thing remains; unless the developers start paying attention to detail when launching ICOs and put a stop to the quests to get rich quickly, the real value will remain elusive. Keep in mind that crypto-economics is the lifeblood on which cryptocurrencies and tokens survive.

Token Utility:

The year 2017 was the moment of the token. Utility tokens also called user tokens or app coins, are not designed as investments. They represent future access to a company’s product or service. If they are well structured, they will be exempt from federal laws that govern securities.

Whether with a group of your friends at the bar, attending a trade show in town, reading the news, or just in your preferred coffee shop, you do not have to venture far to hear someone talking about tokens.

If you are a developer and you wake up one day and decide that you want to create a token, you must provide a utility in your ecosystem. You should purpose for the token to be integral to the business model that it is being built for.

Think of utility tokens as the fuel that drives the entire system. Without a utility for your token, you cannot do an ICO. If a start-up creates utility tokens, it can sell digital coupons for the service it is developing. This works just the way electronics dealers operate. You can call your local electronic shop and put in an order for a video game that has not been released yet.

A token can either be a utility token or a security token; it can’t be both. Additionally, security tokens require licensing, which is costly and administratively demanding for many startups. It is for this reason that most ICOs prefer to go for utility tokens. Since their total supply is fixed, utility tokens appreciate in value over time, but only if the demand for products or services increases.

If you do decide to use tokens for your business, then will you need to understand their role so that you can efficiently maximize their utility. Understanding that tokens can be multi-purpose tools can shed a lot of light on how to go about it all and bring in ‘oomph’ to your business.

There are three tenets to token utility, which are role, features, and purpose.

Before discussing the three tenets further, here is a quick look at each of the roles that a token can take up. Doing so will help provide more insight on token utility.

Roles of a token

  • A token gives you rights

When a holder takes possession of a particular token, they get a certain amount of rights within the ecosystem, from voting rights to making executive decisions like deciding which projects get funding and which ones do not.

What rights does a utility token have?

  • Access to the system.
  • Program, develop or create features for the distributed ledger.
  • Use the services of a system and its outputs at no charge at all.
  • Contribute labor and effort to the system.
  • Vote in a meaningful way and possibility engage in an exchange of opinions among token holders.
  • Sell the system products.
  • A token enables value exchange

Tokens create an internal economic system within the project. They help the sellers and buyers trade value within the ecosystem. This, in turn, allows people to gain rewards once particular tasks have been completed. This maintenance of both individual and internal economies is one of the most important roles that tokens possess.

  • A token as a toll

A token can act as a toll gateway that enables you to use specific functionalities of a particular system. Take Golem, for instance; you will need to have golem tokens (GNT) to gain access to the benefits of the Golem supercomputer.

  • A token as a function

The token can be used as a function that enables its holders to enrich the user experience inside the confines of the particular environment. For example, the case of Brave, a web browser, holders of BAT, the native token used in Brave will get the rights to enrich customer experience by using their tokens to add suitable and relatable advertisements (or other attention based services on the Brave platform).

  • A token as currency

A token can store value. Use as such; it can power transactions both inside and outside the given ecosystem.

  • A token as earnings

Tokens aid in an equitable distribution of financial benefits or profits among investors in a particular project.

So, how do all these rights help in token utility?

You need to list all the above and tick off more than one of these properties if you want to maximize the amount of utility that your token can provide. The more features you tick off your list, the more service and value your token brings into your ecosystem.

If somehow, the role of your tokens cannot be explained or categorized as the rights listed above, or if they do not tick off more than one of the functions, then your token does not have any utility, and you can do without it.

Now, before moving on to the next section, it is impossible to conclude a discussion token utility without mentioning token velocity.

What is token velocity?

It is important to determine if people are going to hold on to the tokens for long-term gain or if they will sell them off immediately?

Every day, scam ICOs are coming in, and it does not help that developers are not doing projects that are valuable enough. As a result, investors end up with tokens, which perform no other utility apart from being a means of liquidation. This is precisely why Bitcoin and Ethereum keep soaring above other cryptocurrencies. People have realized their potential as proper long-term stores of values, and they are low-velocity coins.

Here is how to quantify token velocity (TV):

TV = Total Trading Volume / Average Network Value.

This means, the more the trading volume or, the more that coin is traded, the more the velocity. Consequently, the less the network value, the more the velocity.

Now if you examine token velocity from the perspective of Bitcoin, then you will know exactly why its premier cryptocurrency has little velocity. No other crypto has as much network value as the Bitcoin, and no one wants to trade the Bitcoin off because everyone knows that there is value in holding it.

What should you do as a developer to ensure you have less token velocity?

Developers need to work and re-examine their tokens. They need to understand when and whether a token is being fully utilized. It is only then that they will be able to create something that contributes significantly to the ecosystem efficiently.

Token Security:

Unlike utility tokens, security tokens constitute an investment contract. Just like stocks, they represent a share in a company that has completed a token sale and allow the owner to have some ownership of the company. Those who invest in such tokens do so to earn company profits in the form of dividends, revenue shares and price appreciation (which happens often).

Individuals that contribute Bitcoin or Ether in exchange for tokens are said to have tokens that are structured as a donation. The tokens will be considered to have been charitably donated to a cause, foundation or non-profit entity.

However, in future, it is unlikely that this structure is going to be a best-practice solution because this does not provide any legal protection for the investor. Tokenized securities, also known as equity tokens, now fall under the regulatory scope of global regulators since they have been deemed securities under securities laws.

An example of such tokens are the tZero tokens, which are the native crypto coins for the portfolio company, Overstock Inc. that develops a regulated token trading platform. Holders of these tokens shall get quarterly dividends resulting from the profits of the company. Thus, tZero tokens will be issued according to SEC’s rules and regulations. These equity tokens are considered as securities.

It is important to note that not all security tokens are equity tokens. The latter is even complex.

Although the Howey Test is the right tool for identifying a security token, the legalities are quite ambiguous and do not give a clear guideline to classify these tokens as security tokens.

As much as security tokens would seem very attractive because of their provision for ownership, one should be extremely cautious before investing in these tokens. It would undoubtedly prove prudent to take legal advice from a person with expertise in federal securities law before making any move.

But one significant advantage of these securities and one that cannot be overlooked is the fact that secondary trading will be simplified through licensed security token trading platforms. This makes it twice as easy for the investors to liquidate the security tokens; a move that further creates transparency between both parties. It is also important to appreciate the fact that these tokens are akin to actual shares of the company; so if the company ends up doing well and it expands, then the prospect will seem quite promising.

Immediately after, and even during your ICO, you will automatically have a big target on your back. If you do not pay attention to your security, hackers will attack and rob you. In fact, more than 30,000 people have already fallen prey to Ethereum-related cybercrime, in the process losing about $1.6 billion.

There is a 1 in 10 chance that you will end up a victim of the theft. As staggering as that may be, these crimes do happen, and there fall into three categories:

  • Faulty code.
  • Phishing schemes.
  • Mismanagement of keys.

Faulty Code

The most infamous example of the faulty code is the Decentralized Autonomous Organization (DAO) attack. This was a decentralized venture capital fund which was going to revolutionize Ethereum forever and fund all future decentralized applications dApps made in the eco-system.

Its operation was quite simple and straightforward. If you wanted to have any say in the kind of dApps that would get funded, then you would have to buy DAO tokens for a certain amount of Ether. The DAO tokens were to serve as indicators that you are now officially part of the DAO system and gave you voting rights.

Just in case as time passed, you and a group of other people found that you were not happy with the DAO, then you would be allowed to split from it by using the ‘Split Function.’ By using this function, you would get back all the Ether you had invested and, if you so desired, you could even create your own ‘Child DAO.’ In fact, you and a couple of other dissatisfied DAO token holders could very easily create your own ‘Child DAO’ and start accepting proposals.

One condition, however, was that upon successful splitting off from the DAO, you would have to hold on to your Ether for 28 days before you could spend them – and this was the loophole. People saw this in hindsight and went to the extent of bringing it up, but the DAO creators assured them all that this was not going to be a big issue. They couldn’t have been more wrong.

On June 17, 2016, The DAO Attack took place. Someone cleverly exploited this very loophole in the DAO and siphoned away a cool one-third of DAO’s funds. That was around US$ 50 million. The gap that the hacker(s) discovered was pretty straightforward, in hindsight.

If you so wished to exit the DAO, you went ahead and did so by sending in a request. Then the infamous splitting function would follow the following two steps:

  • Reimburse the user back his or her Ether in exchange for the DAO tokens that were purchased.
  • Register the transaction in the ledger and update the internal token balance.

They hacker made a recursive function in the request, so that instead of the usual process:

  • The system took the DAO tokens from the user wanting to split and gave them the Ether they initially had invested, back.
  • However, before they could finish registering the said transaction, the recursive function made the code go back and transfer even more Ether for the same DAO tokens.

This absurdity went on until around $50 million worth of Ether were eventually taken out and stored in a Child DAO. And as you would expect, the entire Ethereum community was in chaos and anarchy. Consequently, the price of Ether dropped from twenty dollars to thirteen dollars overnight.

To this day, this incident remains to be the worst ICO hack ever. The aftermath of the hack was so severe that it split Ethereum into two different currencies: Ethereum and Ethereum Classic.

Phishing Schemes

If you cringed at the DAO Attack, then here is something terrifying for you to try and wrap your head around. It will sure jolt you.

History has it that phishing scams have stolen up to $225 million in Ethereum-related cybercrimes. In simple terms, phishing is the process by which scammers get your sensitive information (like credit card details) by impersonating someone who is trustworthy and who appears to be of notable fame. The scammers usually use email to capture your information, and in some cases, they use social media.

As a developer, you need to be careful about phishing. Imagine giving away your card details, even more importantly, your essential information just before your ICO! Apparently, the investors get scammed more than the developers.

One of the more popular ways of scamming investors today is by creating a fake social media profile which uncannily resembles the real ICO page. With this social profile up, manipulating potential investors to send money to your address is easy.

Mismanagement of Keys

This crime category mainly addresses the faults of developers.

If you are a developer, then there are four very critical questions that you need to ask yourself:

  • Where am I storing my private keys?
  • How am I protecting my wallets?
  • How am I defending my customer’s tokens on my ecosystem?
  • Who am I you sharing my multi-sig wallet keys with?

As a developer, one of the many doubts (and sometimes fears) that you will face from your investors is the probable chance that you might decide to run away with all of their funds. This is quite a valid reservation.

The only possible way that you can allay these fears in this day and age is by using a multi-signature wallet. To understand how a multi-signature (multi-sig) wallet works, you will need to imagine a safe, which requires multiple keys to operate.

The wallet is excellent for two purposes:

  • Creating a more democratic wallet, which can be used by one or more people.
  • Ensuring the security for your wallet and saving you from human error.

How does multi-signature wallet save you from human error?

Talking an example of one of the multi-sig wallet service providers; say that they issue three private keys, one will be held by the company while the user gets to carry another key. The third one is often a backup that the user can keep or give to someone trustworthy for safe keeping.

To do any transaction in such a wallet, you will need at least two out of the three keys to get somewhere. Even if you have a hacker standing right behind you, it will be tough for them to get their hands on two out of the three private keys. And as if that is not enough, should you lose your private key for whatever reason, you will still have that backup key that you had given to your trusted friend.

Now, you might be thinking how a multi-signature wallet creates a more democratic environment. Well then, imagine that you are working for a company that has ten people and you need eight approvals to make a transaction.

Using software like Electrum, you can quickly create a custom multi-sig wallet with up to ten keys, and that is how you allay fears regarding the safety of your investors’ money.  

A wallet is only as secure as the code that makes it. Despite all this, even a multi-sig wallet is prone to a hack attack. On the 19th day of July, a vulnerability in the Parity Multsig wallet was exploited and the hackers involved, made do with $30 million in Ether.

Next time you are about to hold an ICO, please make sure that you are taking care of your security, and that you take your developer to task.

Essentially, failing to ensure security may mean losing your backers’ money and in the process, failing to develop the product promised on your ICO whitepaper because of lack of capital. The combination of the facts mentioned above may see many of the ICOs conducted coming to naught.

Final Words

ICOs are currently the ‘in thing.’ There is no doubt that the number of ICOs held per month is increasing exponentially. With the hype still in the air, it is wise to keep in mind that ICO’s are much more than fundraising. They are about building networks and productive ecosystems. If you see companies raise money with tokens that have no utility, just give them time. They are on a one-way train to ‘Doomsville.’

On the flip side, if you are a developer, there is no easy way of saying it. Most likely you will fail to create an end product but fret not. Does this mean that you should hate ICOs? Well, you absolutely should not.

ICOs are revolutionary, but if you are a developer, then it is your responsibility to yourself, your potential investors, and to the future of crypto-currency to use the ICOs as a means of creating something significant. If you cannot convincingly provide reasons why you are doing your ICO, or if your token is something that will bring actual value, then ICOs aren’t for you. This also applies to developers that aren’t sure if whatever they are doing is revolutionary and that they just want to make a quick buck. Refrain from contributing to this ‘bubble.’ Make something that will add to the environment, not exploit it. Make something meaningful.

One thought on “Why Most ICOs Will Fail – A Cold Hard Truth

  1. Anna Evans Reply

    The article is very informative. You should understand all the nuances to succeed. It is difficult but interesting.

Leave a Reply

Your email address will not be published.