Proof-of-Utility for ICOs
The ICO Phenomenon
The rapid rise and fall of cryptocurrency have spurred the interest of the masses in blockchain technologies. Hundreds of thousands of people register on various crypto exchanges daily, the largest of which this year had to close registration for new accounts to update the infrastructure, which had simply stopped coping with the influx of new users.
ICOs are known as a blockchain-based form of project financing. To collect funds for future application development, a project issues tokens (analogs of shares) at a fixed price. The company’s main account is a crypto wallet, and deposits are accepted exclusively in cryptocurrency. In this way, they provide their project with the initial capital necessary for development after the ICO.
The more people want to invest in a project, the faster its token price rises. Inside the blockchain system, a token can be almost anything. It all depends on the value the developer attributes to it. Often, tokens are somewhere between stocks, local currency, and a unit of account.
ICO Investment Risks
Any ICO investment involves risk. Experts have put forward the opinion that the overwhelming majority of companies entering the ICO market do not meet the expectations of the crypto community. Unlike selling shares, when investors simply get a certain share of the company value, the rights of tokens holders are very different. In most cases, the buyer receives the right to a part of the company’s profits or to a certain share of its coins.
Investing in an ICO and buying tokens is a very crucial step. An investor must evaluate the project, research its white paper and ICO jurisdiction, and study the type of token and the possibility of exchanging it for promising services. At the same time, anyone who has decided to acquire project tokens should, first of all, be confident in the product technology and the demand for the product in the future.
Classification of token type and assessment of its value is more fundamental than anything else with regard to an ICO startup. If an investor is sure that the project is reliable and its idea has a certain value, he or she can proceed to the assessment of the tokens themselves. The key questions for an investor are how much the token will cost after the ICO, which opportunities this token offers, and how it will be used in the project ecosystem.
So, what is the essential criterion when assessing a project and weighing the pros and cons of its token value? How should one seek proof of the token’s utility and receive assurances of investment credibility? You can find the answers to these and other questions below.
Security Tokens and Utility Tokens
We can safely state that there are two major types of ICO tokens: security tokens and utility tokens.
Security tokens are management stocks of a company. As a holder of this type of asset, you can influence the development of the project and even vote for termination of the system with a return of deposit. A security token is a bond or a share. This digital asset is acquired for the purpose of making a profit in the future. Security tokens sometimes allow you to receive certain dividends and even vote on decisions that affect the work of the project. Security tokens facilitate return on investment, and can also be sold.
Utility tokens are tokens that allow the owner to purchase services and service units. A utility token is a coin that is used as the company’s internal digital currency. It is a means of payment with which users can pay for services and products on the site that issued it, or interact with other users (for example, buy goods and services from them). The number of utility tokens produced by a project is always limited. For this purpose, either the emission restriction or pre-mining — the extraction of tokens before their public placement — is used. This means that the growth of popularity and success of the project leads to an increase in the price of its tokens.
Utility tokens allow the owner to buy certain goods and services within certain applications (the list of goods and services is usually specified in the white paper). Utility tokens can be:
- open (they can be transferred, sold, exchanged on exchanges, etc.)
- closed (they cannot be transferred to third parties)
- limited (they can be transferred to third parties under certain conditions)
For example, users of the social network Steemit can receive tokens for their useful activity (creating and publishing content, writing news articles, etc.), which can then be exchanged on the crypto exchange. Utility tokens can only be sold on an exchange.
What is Proof of Utility?
A token is a special type of digital cryptographic asset, the economic meaning of which is determined by its issuer. When we talk about a utility token, we mean that a token is a product, a discount, or a means of payment. When you create a utility token, you sell your goods and services in advance. It is a digital currency that is used exclusively within a single project and provides access to its services. For example, advertising companies can allow you to buy ads for previously-issued useful tokens.
Proof of Utility is evidence of value, proof that you are creating something useful. So, before going public with your ICO, you have to be sure that your token generates value and cannot be substituted, for instance, with the ERC20 token.
Note: Your project doesn’t need a new token if it does not have a “natural” utility. Don’t try to get involved in an ICO just for fundraising, as this can put you in an unfavorable legal position (as in the case of Tezos). Determine the utility before using the token. It is vital to carefully determine the needs of your system and what the utility token can be used for before plunging into the legal abyss of token sales. Do not invent false needs for yourself; be honest in the same way as when you confirmed the need for your idea.
Fungible and Non-Fungible Utility Tokens
Non-fungible tokens are almost always utility tokens. Non-fungible tokens (NFTs) are unique cryptographic tokens that are not interchangeable (compared to fungible tokens, such as Bitcoins). They are unique, and cannot be replicated or destroyed. They are used wherever virtual goods can be collected and traded as one-off objects: in virtual art, for example, or as individual objects in computer games. A well-known example of a non-fungible is the CryptoKitties token, each of which is unique.
Non-interchangeable utility tokens cannot replace each other. In Ethereum, non-interchangeable tokens adhere to the ERC-721 standard, which emphasizes the uniqueness of the asset and allows smart contracts to function as tradable tokens (as ERC-20 tokens).
ERC-721 tokens are almost always utility tokens, though they are much harder to sell during an ICO. They are sometimes called “collectible” tokens, as each of them has unique data and different rarity levels.
Fungible tokens are developed according to the ERC-20 standard. There is one important distinction between ERC-721 and ERC-20 that you have to remember: fungible tokens are divisible. This means that one can transfer a part of an ERC-20 token. Non-fungible ERC-721 tokens cannot be shared and must be purchased or sold completely (just like a stamp in your collection).
Within a group of interchangeable tokens, there are the following types:
- system-motivation token: This token is set to motivate network members to show an acceptable demeanor. dApps usually do not require their own token to ensure motivation for users to show a certain demeanor, but sometimes, one needs to utilize a native token as motivation due to the necessity to correlate the cost of this token (to isolate from secondary-market speculations with the utility token of the root system, like ETH in Ethereum).
- voting/management token: a token necessary for network management rights. Management tokens allow their owners to vote for significant features of the network.
- participation tokens: These tokens are necessary to access platform services. Typically, such platforms use an equity mechanism that ensures the accountability of the parties involved. As a rule, a share token is a participation token, as well; that is, it provides access to the platform, and at the same time, the platform requires transactions with the token.
For investors, utility and security tokens are both good instruments with different targets for returns. Most people buy a token with utility functionality (that is, just the internal currency of a project) and expect to sell them on the stock exchange at a higher price, which is the only way to get a return on a utility-token investment.
Securities can also be sold on the primary or secondary market at a higher price, but they are related to revenue or profit shares of company activity (dividends, percentage on a bond, a share of generated revenue in crypto or fiat currency, etc.). At the same time, a huge number of projects are either initially a scam or simply do not justify the hopes of investors, and are gradually shut down. Of course, investors are losing money on such projects, and with the absence of regulation, they are not protected from fraud at all.
Tokens are perceived differently by regulators in different countries. If we are talking about the USA, then it is necessary to have lawyers who will provide a legal opinion of your project. On the one hand, this is “insurance at an emotional level;” on the other, it will help you to enter the cryptocurrency exchange. The listing, in turn, allows you to attract a bigger audience (on average, ICOs gather an audience of 4,000-5,000 investors).
Cryptocurrency exchanges are not ready to risk or place tokens that do not comply with regulatory standards. And if you plan to go public, you should bring your coin as close as possible to the utility token to reduce the likelihood of interaction with the SEC.
A Final Word
The ICO process has incorporated the functions of the IPO (public sale of shares of a company) and crowdfunding campaigns, while at the same time eliminating almost all restraining and controlling factors. Holding an ICO is not regulated in any way: developers receive money for the development of their project without any legal delays. Therefore, ICOs the easiest and most profitable method of obtaining investments. This is now causing a stir.
Now that you know how ICO tokens differ from traditional investments, you can predict in advance how justified your investment will be. Before you buy a coin, decide whether you want to make money on exchange trading in the future, or just want to support the project. Will you use the coin for its intended purpose, or are you planning to exchange it for a more popular cryptocurrency soon?
The answers to these questions will help you make the right investment decision.