Token Sales: ICOs, ITOs, IEOs, STOs - Token-Economy-Book/EnglishOriginal GitHub Wiki

In a token sale, smart contracts are used to issue cryptographic tokens in exchange for existing tokens entirely P2P. As opposed to native blockchain tokens that are minted upon successful mining of a block (Proof-of-Work), for individual contributions to the network to keep it safe, token sales introduced a static mechanism for issuing tokens against a direct financial fee, often even before the project is operational.

Token sales allow the issuance of cryptographic tokens in exchange for existing tokens, entirely P2P. They became popular with the advent of the Ethereum network. Anyone can issue and sell tokens with a smart contract. These first token sales were referred to as Initial Coin Offerings (ICOs), but as the term “token” became more mainstream, token offerings or ITOs (Initial Token Offerings), and in the specific cases of securities, STOs (Security Token Offering), became the term of the hour. The main idea of those token sales was to fund new projects by pre-selling tokens to supporters. These tokens would typically be exchanged for BTC and ETH, as both tokens offer high market liquidity and are easier to exchange for fiat currencies. Unlike highly regulated Initial Public Offerings (IPOs), many of the early ICOs were conducted without lawyers, financial intermediaries, or regulatory approval, and therefore seemed more similar to crowdfunding. Early supporters were often crypto enthusiasts rather than professional investors. Over time, professional investors became interested in these token sales for the high returns on investments that were possible in the bull markets of 2015 to 2017.

Before launching a token sale, developers would present a so-called white paper describing the technical specifications of a project. However, as opposed to the Bitcoin white paper, which described a technological solution, many white papers of recent token sales would often resemble business plans and often lack technical or economic specification. Early token sales were often unclear about the type and role of the token, which often made it hard for an investor or contributor to identify whether they resembled crowdfunding or crowd-investing vehicles. As opposed to crowdfunding, where the investment is considered to be a donation, or a pre-buy of a product, early token sales gave supporters the possibility of a return on their investment. Early token sales often seemed to be a mix between a donation, investment, or risk capital. As regulators became more aware of token sales, the definitions also became more stringent. Offering a possible return on an investment, especially if the token could resemble a security, would be an indicator that the token might fall under the regulatory authority of securities commissions (security tokens). Network tokens that allow for use of service within a network mostly do not. Legislators worldwide are still catching up to understand the different types of tokens, and derive necessary regulations.

It is important to point out that the Bitcoin blockchain never had a token sale, and that Bitcoin tokens are continuously minted each time a block of transactions is created (read more: Part 1 - Bitcoin, Blockchain, & other DLTs, Part 4 - Purpose-Driven Tokens). As opposed to native blockchain tokens that are issued upon Proof-of-Work, and incentivize individual contributions to the network to keep it safe, token sales introduced a static mechanism for issuing tokens against a direct financial fee, before the project becomes operational. Tokens would be created only once, before the launch of the project, and issued to investors. In such a setup, a certain portion of the token supply, or the entire token supply, is released before the launch of a project, in many cases even before any code is written.

P2P Token Sales

History of Token Sales

The first token sale was conducted in 2013, when the “Mastercoin” project issued newly minted Mastercoin tokens against the payment of Bitcoin tokens. The sale happened entirely P2P, raising around 500,000 USD worth of BTC for the Mastercoin project. The success of this fundraising campaign inspired other projects that followed to use the Bitcoin blockchain for P2P crowdfunding purposes. In 2014, the Ethereum project conducted a token sale that lasted forty-two days and raised around 18 million USD worth of BTC, breaking all crowdfunding records at the time. This initial crowdfunding money was used to develop the Ethereum white paper into an operational blockchain network. Once operational, the Ethereum network allowed the creation of a decentralized application for any type of P2P value exchange, using a smart contract with just a few lines of code. This smart contract functionality later became popular among other developers and entrepreneurs looking to fundraise money for their projects. Ethereum smart contracts simplified the process of issuing and trading newly issued tokens for other tokens, thereby sparking a series of record-breaking token sales conducted in 2016 and 2017.

“TheDAO” was an example of one of the earliest token sales conducted on the Ethereum blockchain. Resulting in the biggest token sale at its time, TheDAO collected an equivalent of 150 million USD in Ether within a four-week time period. Everybody willing to invest was guaranteed a proportional share of the future revenues of that decentralized investment fund. However, TheDAO experiment ended prematurely with a spectacular and highly controversial draining of funds, and a subsequent hard fork of the Ethereum network (read more: Part 2 - Institutional Economics of DAOs). The scope of the fundraising success, paired with the dramatic events and controversial hard fork, brought a lot of attention to this new type of fundraising vehicle in international mainstream media and inspired many other projects to raise funds with a token sale. In the ICO boom of 2016 to 2017, more than 800 token sales were conducted, raising a total of about 20 billion in USD. Many of them were oversubscribed, which means that it’s likely much more money could have been raised.

Most of the earlier token sales had experienced engineers fundraising for research and development of alternative blockchain protocols. As token sales became known to a wider public, they also became a fundraising vehicle for any type of project, many of which are not even related to blockchains or the Web3. Many of these newer token sales launched without any serious business plan, merely marketing a simple idea without any proof of expertise or development. Often, the role and function of the token was unclear, giving the impression that a token was merely issued for fundraising purposes on a simple marketing promise. Especially in the bull market of 2016 and 2017, white papers would throw around marketing buzzwords, lacking technical and economic specifications of how a goal should be achieved, and what the exact function of the token would be. At best, they would lay out project specifics like a timeline for the project, budget, specified token distribution, token supply, and a promise to deliver a piece of software at a future date.

After a two-year rally and token-sale boom, the market sentiment started to change in 2018. Most tokens ended up having a much lower valuation than the total money raised, often just a few weeks or months after successful fundraising. At some point, many tokens only had value if investors could get in early and buy at a discount, just to sell right after the public token sale ended and at a higher price, hoping that someone else would buy their tokens for more than they paid, which often was the case. In finance and economics, this phenomenon is referred to as “greater fool theory.” So-called pump-and-dump tactics proliferated, where coordinated groups manipulated prices on mostly illiquid tokens. Applying coordinated buying action, artificial demand for the token drives prices up quickly, to make it appear as the new rising star to outsiders. As they were trying to profit from this sudden price hike, the insiders of the group would quickly sell their tokens before prices fell. While such schemes are illegal in most jurisdictions, persecution was difficult as identities were easier to obfuscate, at least back then.

Only a third of tokens released in 2017 were listed on any exchange. Unless a token gets listed on an exchange, it will hardly have any market value, as the investment in the token will be hard to liquidate. Listing tokens on an exchange thus became a bottleneck for many projects conducting token sales, since exchanges had a hard time keeping up with running due diligence on applications of potential new tokens that wanted to be listed. As a result, the listing fees became competitively high. Since exchanges don’t tend to disclose their fees, one can only rely on the information given out by individuals, which disclosed that listing fees range from 6000 EUR to 2.5 million EUR.

The overwhelming number of token sales combined with the rise of failed projects and intentional scams made individual investors more critical. The level of scrutiny rose with time, especially as institutional investors entered the crypto-market. Token sales subsequently shifted from public token sales to a pre-sale of tokens that was limited to a small number of wealthy investors before the launch of a public sale. Over time, the increase of private pre-sales outgrew the public token sale process.

As investors became more critical and regulators started to be more vigilant, token prices declined. According to some statistics, more than 70 percent of projects turned out to be intentional or unintentional scams that could not or would not allocate their received funds as promised. A total of 7 percent failed or got abandoned before trading. Only 15 percent of the projects were publicly listed at all. In 2017, out of over seven hundred token sales, over 15 percent of them failed at funding, 40 percent got funding but then failed, and another 14 percent got funding but slowly faded into obscurity. In spite of successful fundraising, many projects are not generating any economic results, with negative ROIs for the token investors. While by the end of 2017 many tokens were overpriced, the market seems to have flushed out many non-viable projects.

Regardless of current market sentiments, token sales have become a popular fundraising and investment vehicle. It is estimated that in 2016, token sales raised over 600 million USD. Numbers from 2017 are estimated around 7 billion USD. For 2018, estimates range from 13 billion to 25 billion, with some spectacular token sales raising over a billion alone, like Telegram (1.7 billion USD)[^1] or EOS (4.1 billion USD),[^2] mostly based on a simple promise and often no product at all.[^3] Comparing this data with traditional forms of fundraising, we can see that global crowdfunding volume in 2015 was around 34 billion USD and is projected to grow to 100 billion USD by 2025. Global VC funding is also on the rise, with currently over 250 billion per year.

As the markets consolidated and regulators caught up, token sales started differentiating between the types of tokens they issued. Security token offerings (STOs) are token offerings that issue tokens that are classified as securities. Security tokens are an exciting new token class that offer embedded business logic that is compliant with regulatory requirements such as Know Your Customer (KYC) and Anti-Money Laundering (AML). The ability to easily fractionalize the ownership of a security token allows for new levels of fractional security investments, which will allow novel and more personalized asset types and derivatives. Any retail investors could hold a portfolio of quality investments, which until now have only been accessible to private equity firms. Regulatory bodies of many countries have already made statements or passed regulations, and many more countries are following. Furthermore, a range of service providers specialized in security tokens is emerging, from lawyers to investment advisers, insurers, and custodians. Explicit regulation of security tokens can provide more certainty not only for investors (investor protection) but also for entrepreneurs, who for a long time had to deal with frozen bank accounts and fear of litigation, due to the uncertainty of whether or not their project or token violated some kind of regulation (read more: Part 4 - Asset Tokens & Fractional Ownership).

History of Token Sales

Types of Token Sales

In the early days of token sales, due to lack of explicit regulation, many developers assumed that they had total freedom on how to conduct those token sales. Different approaches were experimented with. The most distinguishing factor of which was the price curve of the token throughout the different stages of the sale: (i) price increase; (ii) price decrease; (iii) fixed price; and (iv) undetermined price. Token sales can be issued at a fixed price throughout the duration of the sale. The exchange rate could also increase over the duration of the sale, so early stage investors get a better price (risk discount) than later stage investors. Other options include Dutch auctions, where the token sale starts at the highest price per token, and decreases with time. Furthermore, a token sale can issue a fixed amount of tokens, or an unlimited amount of tokens. A token sale might be conducted in a way where tokens are distributed as a percentage of total funds raised. The EOS project, for example, sold equal portions of their total token supply per day, and the total money invested per day decided the investors’ allocation of that day’s token portion. EOS was also one of the few projects that withdrew invested funds before the token sale was over, which raised concerns of whether they reinvested previously withdrawn funds to minimize tokens sold to outsiders.

After the end of a token sale, exchanges can start listing the tokens, thus allowing other people to trade them at a market price. To prevent market manipulation, projects might choose to set up freezing or cool-off periods. In some cases, it might be a cool-off period where tokens are frozen, or vested, which means that investors are not allowed to transfer their tokens for a certain amount of time. Cool-off periods are usually applied to big token holders (whales) who bought in at a discount to prevent them dumping their tokens; otherwise, the market price would crash.

Challenges of Token Sales

Many of the early founders of the projects that managed to raise funds through token sales were engineers, not entrepreneurs or asset managers. This lack of managerial scrutiny resulted in a high burn rate of the funds raised in a token sale. Many of the funds were raised in Bitcoin or Ether, which are subject to price fluctuation. Securing the value of these raised funds through adequate portfolio management is the job of an asset manager, not of a blockchain engineer, and many projects failed, or almost went into bankruptcy, just because of that. The Ethereum project, for example, successfully raised 18 million USD. However, as a result of a price drop in BTC in the weeks following their token sale (from 600 USD to 200 USD), the 18 million USD dropped to 6 million. Ethereum Classic development project (ETCDEV) had similar problems when their token price plummeted and left them with no funding. Steemit is another project that had to cut their team due to value loss of tokens.

On the investors’ side, token holders of these newly issued tokens were very often not able to trade their tokens because of lack of liquidity and market depth. Relatively small amounts of tokens traded could lead to considerable price volatilities. Many token holders therefore had no other choice than to hold on to their tokens, sometimes for a very long period of time, as any minor sale could cause prices to fall.

For a more mature and transparent token sales market and to provide investor protection, the market will need more standardized procedures and better accountability. Furthermore, continuous token models and liquid pledging are being proposed as more innovative approaches. “Continuous token models” attempt to generate longer term funding by issuing and selling tokens continuously. Instead of having a one-time, often arbitrarily high funding round, where tokens are minted only once and never again, continuous token sales allow for continuous cash flow, reducing the risk for both entrepreneurs and investors. “Liquid Pledging” was introduced by the “Giveth” project and addresses the transparency problems of traditional fundraising and charity work. It allows both oversight and often even a say in how funds are used, enabled by real-time blockchain data.

Initial Exchange Offerings

As new token sale mechanisms and third-party service providers are entering the market, token exchanges have started to offer their platforms for fundraising purposes. Initial Exchange Offerings (IEO) are intermediary services where token issuers can raise funds by offering their token on a token exchange, instead of offering the tokens directly on their website. The token exchange provides the infrastructure, including the KYC process, and supervises the token sale. Token issuers send the tokens to the exchange, which then sells the tokens to investors in exchange for other tokens or fiat money. Issuers of tokens can reduce the organizational overheads and bureaucracy related to registering for a token sale with regulatory authorities and leverage the existing user base of the token exchange, reducing marketing efforts. Similar to ICOs or IEOs, sale parameters of the token sale can vary (pricing, distribution type, amount of tokens issued). IEOs offer a convenient way to conduct a token sale, while automatically listing the token for future trading on that exchange. This reduces the risk of never getting one’s tokens listed.

Initial Exchange Offerings also provide more flexibility for investors, since they are not forced to pay with one particular token, but could potentially pay with any of the tokens they have already deposited on that exchange. IEOs mitigate the risk for investors to enter into a “gas war” and worry about transaction fees.[^4] Investors also avoid going through a separate identification process, if they are already registered on the exchange. Since exchanges have a reputation to lose, they can be expected to audit the issuer, perform technical analysis, and assess the potential of a token, reducing the possibility for scammers to sell their tokens, thereby providing a certain level of investor protection. Exchanges could hereby introduce necessary standardization of the industry. Exchanges, on the other hand, benefit from conducting IEOs as an additional source of revenue. They might attract new users, who sign up for the exchange in order to participate in a particular token, to become long-term users of the exchange. However, as long as token exchanges are not decentralized, IEOs also eradicate the P2P nature of early token sales.

Chapter Summary

Token sales allow the issuance of cryptographic tokens in exchange for existing tokens, entirely P2P. They became popular with the advent of the Ethereum network. Anyone can issue and sell tokens with a smart contract.

These first token sales were referred to as Initial Coin Offerings (ICOs), but as the term “token” became more mainstream, token offerings or ITOs (Initial Token Offerings), and in the specific cases of securities, STOs (Security Token Offering), became the term of the hour.

Token sales introduced a static mechanism for issuing tokens against a direct financial fee, before the project becomes operational. Tokens would be created only once, before the launch of the project, and issued to investors. In such a setup, a certain portion of the token supply, or the entire token supply, is released before the launch of a project, in many cases even before any code is written.

In the early days of token sales, due to lack of explicit regulation, many developers assumed that they had total freedom on how to conduct those token sales. Different approaches were experimented with. The most distinguishing factor of which was the price curve of the token throughout the different stages of the sale: (i) price increase; (ii) price decrease; (iii) fixed price; and (iv) undetermined price.

Token sales can be issued at a fixed price throughout the duration of the sale. The exchange rate could also increase over the duration of the sale, so early stage investors get a better price (risk discount) than later stage investors. Other options include Dutch auctions, where the token sale starts at the highest price per token, and decreases with time. Furthermore, a token sale can issue a fixed amount of tokens, or an unlimited amount of tokens. A token sale might be conducted in a way where tokens are distributed as a percentage of total funds raised.

As new token sale mechanisms and third-party service providers are entering the market, token exchanges have started to offer their platforms for fundraising purposes. Initial Exchange Offerings (IEO) are intermediary services where token issuers can raise funds by offering their token on a token exchange, instead of offering the tokens directly on their website.

In an IEO, the token exchange provides the infrastructure, including the KYC process, and supervises the token sale. Token issuers send the tokens to the exchange, which then sells the tokens to investors in exchange for other tokens or fiat money. Issuers of tokens can reduce the organizational overheads and bureaucracy related to registering for a token sale with regulatory authorities and leverage the existing user base of the token exchange, reducing marketing efforts.

IEOs offer a convenient way to conduct a token sale, while automatically listing the token for future trading on that exchange. This reduces the risk of never getting one’s tokens listed. Initial Exchange Offerings also provide more flexibility for investors, since they are not forced to pay with one particular token, but could potentially pay with any of the tokens they have already deposited on that exchange.

Chapter References & Further Reading

Footnotes

[^1]: Telegram canceled the public sale of its token after raising over 1.7 billion USD in a private pre-sale, which usually allows VCs and larger investors to buy tokens at lower prices. It is unclear whether they raised enough already or whether regulatory issues forced them to abandon a public sale. Reports claim that fewer than 200 investors funded the whole sum.

[^2]: The EOS token sale lasted a whole year (June 2017 to June 2018). Their subsequent mainnet on launch had some issues, and couldn’t go live for at least two weeks, with issues recurring again later.

[^3]: The statistics vary due to a lack of reporting standards, and the fact that a growing portion of tokens are offered in a pre-sale to a select number of often undisclosed investors.

[^4]: In Ethereum, transactions can range from simple „send money“ to complex smart contract interactions. To reflect the difference, transactions consume Gas - a measure of computational steps. Users can‘t change how many computational steps are needed for an action, but they are able to decide how much they are willing to spend for these computational steps. By paying a higher or lower price per computational step, they can help miners make a decision on including the transaction in the next block. In a Gas War, several users are competing for a spot in the next block. Especially during ICOs, being included in the next block or not can make a difference in being successful in an auction. During peak times, users have paid many multiples of average transaction fees, effectively outbidding each other for miners to include their transaction as soon as possible.