First Stage Investor

How Initial Exchange Offerings Save Time but Add Risk

How Initial Exchange Offerings Save Time but Add Risk

Initial coin offerings (ICOs) were all the rage in 2017. Some 435 “successful” ICO raises received $5.6 billion in funding, according to Fabric Ventures and TokenData. While some companies developing new tokens opted to raise via the more traditional route of selling shares or equity, ICOs were the far more popular choice.

A third way to raise money has recently emerged: IEOs, or initial exchange offerings. And they’re coming on like gangbusters. In March and April of this year alone, IEOs generated more than $196 million in fundraises, according to CoinSchedule.

Binance dominates the IEO space right now. Binance’s Launchpad has launched five IEOs this year and is moving ahead with plans to do at least one per month. Binance’s only IEO competitor, KuCoin, launched its third IEO two days ago.

So what exactly is an IEO? It’s similar to an ICO but is launched exclusively on a single exchange.

In an ICO, the fundraising company’s development team creates the tokens and distributes them. That makes the fundraising company a counterparty, which basically means it’s exposed to financial risk.

In an IEO, cryptocurrency platforms essentially become the counterparties, enabling crypto projects to launch their offerings directly on the platform. The tokens are sold to investors by the cryptocurrency platform itself. Once the IEO ends, the coins are listed on the cryptocurrency trading platform.

Token issuers typically pay a listing fee to the cryptocurrency platform along with a percentage of the tokens sold during the IEO. The cryptocurrency trading platform also provides marketing, due diligence and other services relating to the newly issued coin.

The Good and the Bad

Are IEOs superior to ICOs?

IEO companies save time and resources. They don’t have to deal with marketing an ICO, partnering with exchanges and paying the expenses of a self-launch. IEO investors get due diligence conducted by the cryptocurrency platform, and buyers benefit from the ability to trade tokens straightaway.

But there are definitely some things investors should watch out for. Jeff Dorman, chief investment officer at Arca, does a great job of enumerating several concerns in a long tweet thread. Here are the issues that got my attention:

  • Exchanges determine the price of the IEO with very little information. You could be buying low. But you could also be buying excessively high.
  • Issuing companies want higher prices. But the exchanges favor lower prices because they don’t want to anger investors. Without much competition, Binance holds the power. Issuing companies must listen to its advice. This could change when competition increases.
  • Exchanges’ due diligence is probably better than average retail investors’ due diligence, but it’s a CYA policy, not a statement of merit regarding the issuer or the investment. Investors need to do their own research.
  • Syndicate desks are trained to exaggerate demand and create a false sense of urgency. It hasn’t happened yet with Binance because demand for its IEOs has been so high. But it’s coming.

King-Size Legal Risk

The U.S. Securities and Exchange Commission (SEC) has made its views on ICOs clear. It thinks the vast majority of them qualify as securities. And if they don’t register with the SEC as securities, they’re not legal in this country.

Once again, the SEC is warning everybody associated with IEOs that if an IEO issuer or any of the IEO buyers are based in the U.S., cryptocurrency trading platforms facilitating token sales for a fee likely meet the legal definition of broker-dealers. As such, they must follow the registration and licensing requirements for broker-dealers.

If they don’t? “They will find themselves in trouble in the U.S.,” says the SEC’s crypto czar Valerie Szczepanik.

Bottom line: Like ICOs, most (if not all) IEOs are illegal in the U.S. For now, the SEC’s Regulation Crowdfunding is one of the few proven, SEC-compliant ways to sell digital assets to non-accredited U.S. investors.

The First Stage Investor team is sensitive to this issue, which means you won’t be seeing any IEO recommendations from us. We don’t like the rules. But the cryptocurrencies on the SEC’s hit list of noncompliant companies represent a king-size risk. It’s not worth it.

Good investing,

Andy Gordon

Co-Founder, First Stage Investor

Top Posts on Early Investing