IPOs, ICOs, and STOs – What’s the Difference?

Funding Innovation

The advent of blockchain technology has reshaped the methods through which capital raises are conducted by offering major corporations and early-stage startups new ways to access funding. This has significant implications for organizations looking to fund future innovations, as well as for investors interested in taking part. While traditional Initial Public Offerings (IPOs) continue to provide a satisfactory solution for many corporations seeking capital, some investors are seeking new investment opportunities. These new blockchain-enabled fundraising methods – namely Initial Coin Offerings (ICOs) and Security Token Offerings (STOs) – are broadening the scope of financing and investment for businesses, particularly startups in the crypto and blockchain sector.

The Traditional IPO Process

An IPO is a means of raising capital whereby a private company seeking funding offers equity shares of its organization to retail investors through the issuance of stocks. These stocks are sold on a public exchange or brokerage and are generally freely tradable in the open market. This is done in accordance with the financial regulations of the U.S. Securities and Exchange Commission (SEC) and the markets where securities are issued and sold. In general, these regulations require detailed registration statements and disclosures and contain restrictions on marketing materials.

Due to the rigorous prerequisites needed to take a company public, IPOs are usually undertaken by more mature, financially stable companies rather than early-stage startups. This is in part because the costs of fulfilling those prerequisites can be quite high (e.g., more than $1 million USD) and because many mainstream investors have less interest or appetite for risk when it comes to investing in younger, less proven organizations. Additionally, companies that intend to issue an Initial Public Offering typically undergo a preliminary IPO readiness assessment to determine the company’s IPO share value, and this exhaustive process often takes 12 - 18 months to complete. This can be too long of an investment waiting period for young companies that need capital quickly.

Crypto ICOs: The Rise of Tokenized Crowdfunding 

Initial Coin Offerings are a form of blockchain-enabled crowdfunding in which an organization sells crypto coins or tokens as a means of raising funds. These crypto assets are sometimes promoted as having future utility on the platform or blockchain to which they are tied. ICO token sales can be open to anyone, or made available to select investors only. In many instances, an issuing project will begin an Initial Coin Offering with a private sale for select investors before opening it up to the public. However, certain crypto projects may forgo a private sale altogether and take their blockchain ICO straight to the public.

Investing in an Initial Coin Offering can be very risky because it generally does not grant purchasers any ownership rights, and does not have the same legal protections as traditional stocks and other regulated securities. Initial Coin Offerings have attracted regulatory scrutiny, most notably from the SEC, where in some instances the SEC has concluded that sales made via an ICO constituted an unregistered securities offering. Initial Coin Offerings initially took the crypto community by storm in 2017–2018, raising billions of dollars for an array of projects mainly through the use of ERC-20 tokens. This period of crypto ICO proliferation helped launch a new generation of projects that significantly shaped both Ethereum and the wider blockchain ecosystem. However, with more than 2,000 unique ICOs raising more than $10 billion cumulatively in 2017 and 2018, this ICO gold rush also gave rise to a number of exit scams and questionable business practices that resulted in negative attention to the industry and increased scrutiny from the SEC and other regulators. 

Initial Coin Offerings are significantly less prohibitive for companies to execute than are IPOs, and they lower the barriers to entry for investors. However, the lack of ICO regulations makes them relatively risky and opaque. As a result, some projects that want to launch a blockchain ICO might also consider taking part in an Initial Exchange Offering (IEO). With an IEO, the issuer transfers its newly minted tokens or coins to a crypto exchange, which manages the crypto sale and distributions on behalf of the issuer. Because crypto exchanges require some level of due diligence for the crypto issuer before agreeing to partner on an Initial Exchange Offering, the IEO method might lend a certain degree of legitimacy to the operation and can allow the fundraiser to leverage the exchange’s existing user base.

STOs: Combining the Best of IPOs and ICOs

Businesses and individual investors alike are increasingly seeing the value in Security Token Offerings, or STOs, which combine the key benefits of IPOs and ICOs. From a procedural standpoint, Security Token Offerings are very similar to Initial Coin Offerings — except that security tokens are subject to the regulatory oversights of an IPO, which can grant STOs and the token issuers involved a potentially higher level of credibility. To conduct a Security Token Offering, organizations must engage with a number of legal and compliance protocols, and the investors who buy these tokens may be subject to certain regulatory restrictions. On the flipside, investors who participate in an STO have certain protections and rights due to the regulatory policies under which the STO operates. This minimizes their risk of being swindled by low-quality projects and frauds, which were a common occurrence during the 2017–2018 Ethereum ICO boom.

Additionally, the security tokens sold through an STO have several unique capabilities that give them potential advantages over corporate stocks and other traditional securities. Because security tokens are transacted through a blockchain, their ownership information is automatically verified and stored in an immutable yet publicly viewable format. This reduces the cost of raising capital from the issuer’s perspective. It also streamlines the Security Token Offering process for investors who would otherwise need to manage multiple types of documentation and execute their investments through a financial intermediary. And, because security tokens can be programmed with unique characteristics and ownership rights, using these tokens unlocks a wide array of potential options including automating traditional procedures, combining multiple equity/stakeholder rights, and enabling new modes of cross-functional asset interoperability.

While this unprecedented level of programmability means that many security tokens currently exist within a relatively unexplored territory from a regulatory standpoint, there is hope that new policies and legislation will clarify and expand the current legal framework governing these new asset classes. As a result, STOs are gradually gaining favor as an efficient means of raising capital, since they balance the benefits of blockchain-enabled crowdfunding with a reassuring level of regulatory oversight.

The Future of Fundraising 

While the legacy model for fundraising is for a corporation to offer an Initial Public Offering to raise capital and increase liquidity, crypto and blockchain startups have experimented with faster, more cost-effective ways to fund growth and development. ICOs have proven a remarkable mechanism for funding startups and projects in the blockchain space, but more traditionally minded organizations and investors might remain skeptical of the experimental and unregulated elements associated with ICOs. Many experts contend that the hybridized model of STOs has the potential to allow token-based companies to raise capital in a more regulated environment while integrating more of the  protections provided by the existing financial services establishment, and offers convenience to fundraisers and investors alike.