By the BBB Institute and FINRA staff

This article is the third in a series on the emerging world of digital assets. Additional articles explore blockchain technology, cryptocurrency storage, the virtual currency regulatory landscape, and tips to avoid fraud and scams in this area.

As digital assets like cryptocurrencies gain popularity, the terms "initial coin offering" and "digital tokens" have become common phrases in technology and investment circles. Some reports estimate that start-ups raised over $5 billion through ICOs in 2017, indicating that many entrepreneurs and investors view this capital raising method as a viable way to raise funds for their business ventures. In 2018 so far, reports estimate that ICOs have doubled in volume from last year, raising more than $12 billion.

It is important for both new and experienced investors who are interested in digital assets to learn more about ICOs so they can make wise investment decisions and avoid the lure of scammers -- who seek to profit on the hype surrounding the emerging world of digital assets.

digital dollar sign surrounded by binary code

Image source: Getty Images.

What is an ICO?

An Initial Coin Offering, also known as an ICO, involves the creation and distribution of digital tokens by a company to raise capital. Here's how an ICO works. A company with a new idea woos investors by promoting the release of its own digital token. Companies that issue ICOs typically promote the offering through their own websites and through various online blockchain and virtual currency forums. Potential purchasers in an ICO might not receive a prospectus; instead, companies often publish a white paper describing the ICO.

In general, the company announces a specified amount of funds that it wants to raise, as well as the number of tokens available for purchase. The fundraising continues until that amount is reached. ICOs are conducted online, and purchasers can pay for their tokens with cryptocurrencies, like bitcoin or ether, or fiat currency, like the U.S. dollar.

Most companies that have used an ICO to raise money have been start-ups that use blockchain technology as part of their business to provide a particular service or product. These companies raise funds to establish a new blockchain-based business and in return issue their own digital tokens to investors. ICO tokens are disseminated to buyers via their blockchain network. Check out this video from the North American Securities Administrators Association (NASAA) for an animated ICO primer.

Token takeaways

When you invest in an ICO, you receive tokens that you can eventually use on the product or platform being created by the company (and for which they raised money in the ICO). Investors might use these tokens to receive goods or services offered by the company or to participate in a rewards program on the new platform being built.

Investors also might hope that the tokens become valuable and seek to trade the tokens issued through the ICO on secondary markets, if available, hoping for a profit.

Unlike stocks, most ICOs to date have conferred no ownership rights in the company and, unlike bonds, ICOs typically do not involve investors lending money to the issuer. However, the Securities and Exchange Commission (SEC) has stated that depending on the circumstances of each ICO, the virtual coins or tokens offered and sold to investors may be securities. If so, the offer and sale of these tokens are subject to the federal securities laws. This means the ICO (the offer and sale of the tokens) must be registered with the SEC or meet an exemption from registration. Offerings that are performed under an exemption from registration typically require investors to meet certain income or net worth thresholds to be eligible to invest. For example, exempted offerings often are limited to accredited investors, those with a net worth in excess of $1 million or that maintain certain levels of income.

A token by any other name

ICO tokens are often called by different names, such as utility tokens or security tokens. The SEC has noted that using such names or structuring tokens to have some utility does not prevent the tokens from being a security. If you're considering an ICO investment, consider the following tips:

  • Verify whether a company has registered an ICO (or any offering of securities) with the SEC by searching the SEC's Edgar system.
  • If the ICO is not registered, it is likely only available to accredited investors, and most retail investors do not meet this standard.
  • If the ICO is described as a crowdfunding investment opportunity, be aware, as the SEC notes, that the offering might not be operating in compliance with the requirements of Regulation Crowdfunding or with the federal securities laws generally.

Invest cautiously

ICOs involve new technologies and products that are highly technical and complex, and you can lose some or all of the money you invest in an ICO. Investing in an ICO might seem like an exciting way to be a part of the buzzing (and volatile) markets for digital assets. But remember to use caution when you consider these investments. New technologies and markets that gain media attention can be used by fraudsters as an opportunity to take advantage of investors.

While there are some high-profile ICO success stories, investors thinking about risking their money should be aware that many ICO ventures fail, as do start-up companies in many other sectors. Some reports estimate that over 50% of the ICOs conducted in 2017 failed. Why the low success rate? In part because many, if not most, ICOs are based on an idea without a tangible product or sales history. And, unfortunately, some ICOs are scams in disguise. The Wall Street Journal recently released findings based on a review of documents related to 1,450 digital coin offerings. The review showed that about 1 in 5 of the offerings had red flags of fraud, such as "plagiarized investor documents, promises of guaranteed returns and missing or fake executive teams."

Two common ICO scams to watch out for are:

  • Exit scams: Scammers who pose as legitimate start-ups persuade investors to pay large sums of money or cryptocurrencies to buy into an ICO. These scammers have no intention of building a company. They then walk away from investors with the assets they acquired.
  • Pump-and-dump scams: Groups of individuals coordinate to purchase a particular token issued during an ICO and urge other investors to participate in the ICO. The individuals then sell their tokens for a profit and stop promoting the ICO, leaving investors with tokens that have a low value.

Investors should be careful to scrutinize ICOs before committing their capital. Be wary of an ICO that has a poor online presence, a white paper lacking in technical details, celebrity endorsements, guarantees of big profits, or unrealistic expectations about the type of platform or service the company is proposing to build. These attributes are red flags of a potential scam.

The SEC and other regulators have halted fraudulent ICOs and taken action against individuals and companies that are engaging in alleged fraudulent activities. The SEC also set up a website, HoweyCoins.com, that mimics a bogus ICO to educate investors about what to look out for to avoid getting taken in by a scam. The site provides investor education tools and tips, and it highlights the classic warning signs of fraud.

Do your homework

Most investors are not experts on cryptocurrencies or offerings of digital tokens, so it is important to look carefully at the company and individuals offering and promoting an ICO. If you choose to invest, only invest what you can afford to lose, and be aware that you may lose some or all of your investment.

As the SEC has stated, while blockchain technology and ICOs can add efficiency to the capital raising process, companies and promoters must ensure that they are making these offerings legally, in compliance with all applicable laws and regulations. Educate yourself and ask questions before entering into any new investment opportunity, especially if you're entering the world of digital asset investing. You will thank yourself in the end.

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