2) Alignment of Interests, Motivations and Risks
ICOs are the reverse of IPOs as far as investment logic is concerned.
A company which IPOs has demonstrated a solid track record of cash flow and profit. It has probably gone through multiple rounds of funding before the all important ‘exit’.
ICOs are the start of a company’s operations. In many cases, a company doing an ICO has not even built the first version of their product. So when you buy an ICO, you are basically providing initial capital to a company — and usually, given we are talking about blockchain, it is for a product which is yet to demonstrate its usefulness at scale.
Furthermore, most ICOs raise millions at a single time. As an investor, what you are doing is telling the company the following: ‘Here you go, on the basis of this beautiful 5 page whitepaper you have published, I trust you a lot, and believe without any doubt that you will build this platform in the time period you state. The problem you are solving is unclear to me, and there is a lot of regulatory indecisiveness at this point in time, but to hell with that. Here — please take $15 million. Do as you wish. I am rooting for you.’
What do you think happens immediately after an ICO?
Well, the ‘founders’ get to keep a chunk of the money raised. Obviously. This is called ‘founders reward’.
Which comes to the next big issue with ICOs — vesting. Most ICOs have very short periods during which tokens vest i.e. time during which the tokens are ‘earned’ by founders and employees. The time taken for tokens to vest after ICOs is too short compared to the time it takes to build a project on the blockchain and get it to a point of mass adoption.
For example, in a vesting period of 3 years, with every month that passes, the employee earns 1/36 of his allocation of shares. At the end of 18 months, he will have earned half the shares. At the end of 36 months, he will have all the shares to his name.
Some ICOs have a vesting schedule which starts 6 months after the raise, and finishes as early as 2 years after the raise.
Some ICOs don’t have a vesting schedule.
However, there is usually also a lock-in period, which is a period of time during which they are unable to sell their tokens on the open market after they have earned them. In the case of ICOs, lock-in periods are quite short — ranging from 3 months to 18 months. This is too short in my opinion.
There is little uniformity across ICOs. Some ICOs have only vesting periods, some have vesting plus a lock-in (good, depending on how long this is) and some only have a lock-in. So many sure you study each ICO thoroughly before you invest — vesting and lock-in periods give clues about the seriousness of the project!
One option to better marry the interests of investors and the company is that instead of one big, humongous raise at the start, the ICO is followed by subsequent coin offerings, leading to better alignment of interest between the founders and investors. This is what Blocksquare has done. The exact split to be raised at each stage is determined by the company, but it is essentially the same as a seed round (30% of total supply), Series A (30% of token supply), Series B (20% of total supply) and so on. This ensures that founders hold onto their shares longer, since the supply of the token is introduced in a staggered fashion. It also allows future investors to assess that the project is meeting its targets, and only then invest.
Another big problem with ICOs is that the tokens are often available for trading very soon after the ICO. This obviously causes huge price spikes and drops (volatility!) as ICO flippers work their magic. They make a short term buck, but this does nothing to augment faith in the long term value of the project. Going forward, we will probably see many tokens that don’t recover after the first price slump following the ICO. This raises the risk of investing in an ICO, if you are a long term investor.
In conclusion, if you do invest in ICOs and intend to hodl, it is worth studying the vesting schedules and lock-in periods thoroughly, since there are likely to be (massive) drops in price the moment the vesting and lock-in periods are over, as founders and employees cash in on their bounty. Short vesting periods also signal a mentality of founders wanting to make a quick buck, as opposed to being invested in a project for the long haul.
Given the number of ICOs in 2016, 2017 and 2018 one can only imagine the state of the market in 2019, 2020 and 2021, when all these ICOs will be fully vested and out of their lock in periods!
All this sounds pretty scary, doesn’t it?