- An article by Ivan Oshry
- This article is intended as a brief overview only of the rise of ICO's and should not be regarded as legal or other advice. The views contained herein represent the views of the author and not necessarily the views of Kemp Strang
What is an ICO?
An ICO is an 'Initial Coin Offering'. In its simplest form a company issues coins or tokens in exchange for money. It's the new venture capital funding tool.
Is this new phenomenon a scam or a legitimate fundraising tool? As with any venture capital raise, this will depend on the company raising the money and the purpose for which it is being raised. To avoid tears, ensure you do adequate due diligence!
What is a coin/token?
The crypto currency issued is generally referred to as a 'coin' in line with the popular crypto currencies such as Bitcoin, Litecoin etc. In fact, it is more accurate to describe it as a 'token' and more recently this has become the preferred term. Irrespective of what they are actually called, coins / tokens will usually fall into one of three categories:
- 'Security' tokens – entitle the holder to participate in the revenues, profits or underlying assets of the company. These tokens are viewed in the same light as shares and will be subject to existing securities laws worldwide. For obvious reasons, ICO companies will seek to avoid their tokens being viewed as securities;
- 'Access' tokens – do not entitle the holder to any benefit other than the right to participate in an upcoming business venture; and
- 'Utility' tokens – to avoid being subject to securities regulations, these have become the most popular form of tokens. They entitle the holder (only) to redeem the token for products sold or services provided by the company or its associates - much like a pre-paid voucher or promotional coupon. They do not entitle the holder to any share of profits, revenues or to attend or vote at company meetings.
What the token actually is will depend on the facts and circumstances. Very often they fall into grey areas and it is in these instances that the expertise and experience of professional advisers will become paramount to avoid the tokens being interpreted as having characteristics they are not intended to have.
What is a SAFT?
A practical difficulty often faced by a company considering an ICO is that the tokens are (usually) linked to a platform or product that is some time away from launch. So at the time of issue, the token has no clear benefit to its holder (unless it can be sold on the secondary market).
A solution to these circumstances is the SAFT, being a 'simple agreement for the future sale of a token'. It might also have application for a company that wishes to raise seed money to prepare for an ICO but has not yet completed its white paper or determined its tokenomics. The SAFT bridges the gap between pre-raise and the ICO.
The SAFT is itself a security product which later converts into tokens once the project goes live. As such the SAFT is aimed at a select group of investors who will fall within an exemption to securities laws – such as accredited or sophisticated investors and the like.
Why an ICO and not an IPO?
Under an IPO – the Company issues shares to the public and the existing shareholders are diluted.
Under an ICO - no shares are issued. It is like raising debt without having to repay the loan (hence their popularity) – although upon successful launch of the project being financed the company will have to exchange the tokens for goods or services. Accordingly the company does retain obligations which will impact on cash flows and these must be taken into account when structuring the entitlements of the token.
What type of company conducts an ICO?
ICO companies are typically start-ups as most are too early stage to raise equity capital and even if they could, it would have too much of a diluting effect on existing shareholders. But some mature companies (such as Kodak and Success Global Media) have also gone the ICO route of issuing tokens for redemption of products and services.
The typical conundrum for the issuing company is how to sell the coin as an investment when it cannot be an investment? How to promise a return when no return can be provided? The solution will lie in the inherent value (use) of the token and this will be the feature that distinguishes the genuine ICO's from the scams or quick money grabs.
What's in it for a buyer of tokens?
The principle is that participants in an ICO are part of an eco-system that will use tokens as a form of currency. For the buyer, the main reasons are:
- A hedge against inflation – i.e. tokens are bought at current prices to redeem for future goods and services that may become more expensive over time or the tokens may become more valuable as a result of increased demand;
- The right to participate in an exclusive community – i.e. access to premium goods and services or events or utilities which may be paid for only by tokens. In this way exclusivity will also drive up the value of the tokens; and
- Ease of payment – i.e. no credit cards, exchange rate fluctuations, banks or other middlemen and no additional fees!
In reality however, tokens are, for the most part, purchased for speculative investment. Usually, a fixed number of tokens are issued. The value is therefore driven by the simple economics of supply and demand. The greater the usability –the greater the demand and (theoretically) the greater the value. This differs from fiat currency where the government will keep issuing more currency to meet its needs, keeping constant the threat of devaluation.
Why the fuss?
The spectacular value increases of Bitcoin and Ether in 2017 created an atmosphere where typical herd mentality and the fear of missing out has led to hundreds of ICO's and billions of dollars being invested.
Coin purchases have been based primarily on the hope that investors could sell their coins at a profit (although ICO's where the token holder derives a real price benefit on redemption are becoming more prevalent).
Why the concern?
The cryptocurrency market is still young and at remains unregulated. As such there is always the risk of fraud and manipulation. Add to that the fact that most investments in ICO's are being made seemingly without rational investment decisions, memories of stock exchange crashes and the tech wreck come flooding back.
This is the time for professionals to step up and ensure that ICO's are conducted for the right reasons and that white papers present a proper picture of the company and its project.
What are the risks?
There are a number, including:
- The major risk remains the absence of regulation. The company conducting the ICO issues a document known as a white paper which is the equivalent of a prospectus under an IPO. Because the white paper does not have to be registered or approved by any regulatory authority it may not contain all the information necessary for the "investor" to be able to form a considered view before "investing". Similarly, from the company's point of view, it remains vulnerable that future regulation will have some retrospective prejudicial effect to tokens it has issued under an ICO.
- A further real risk is that the tokens issued are like cash in your wallet (although there are no actual physical notes or coins and no central repository). If you lose your computer or electronic device on which the tokens are stored or you lose your key or log in details it will have the same effect as losing your wallet full of cash. Your tokens will be lost and you will not be able to apply for substitutes in the same way as you can presently apply for a new password if you have forgotten yours.
- Theft can occur through hacking - hence the recommendation in every white paper that tokens be immediately transferred to cold wallets and that computers be regularly backed up.
- ICO's operate in a virtual economy. All transactions are carried out over the internet and without direct contact between buyer and seller. This will always be fraught with risk.
- A number of ICO's have turned out to be outright scams, where promises of the new cryptocurrency or project were never made good. The actions of the SEC (in the USA) in prosecuting some companies engaged in this fraudulent behaviour and the promise of further policing in this area and investors becoming more ICO savvy have hopefully curtailed this risk.
What is the future of crypto?
Despite the risks, the negativity and the soothsayers, cryptocurrency could very well become the next universal world currency, particularly within an eco-system or community. It is easy and secure to transfer funds between two participants to a transaction. There is no need to involve a bank or credit card companies with their associated charges or suffer fluctuations in exchange rates. Additionally, recording the transaction on the blockchain ensures the transaction is transparent and a permanent record.
The blockchain is an online ledger that is simultaneously transferred to all computers participating in the blockchain. This instant and communal verification process keeps everyone honest and means counterfeiting is impossible.
ICO's represent a reincarnation of the venture capital industry – they are not going away!
Are ICO's legal?
Provided that the ICO complies with current anti money laundering (AML) laws and know your customer (KYC) procedures and that the token issued does not constitute a 'security' then it is generally considered that the ICO is not subject to any securities or financial advisory laws but only to the usual consumer protection laws of a jurisdiction. Even if a token is regarded as a 'security' or a 'financial product' – it does not mean the ICO is unlawful, merely that it must comply with relevant securities or financial advisory laws.
What are the regulators doing?
The sheer speed with which the popularity of ICOs have taken a grip of the investment landscape has resulted in a mixed response from regulators. Other than China and South Korea where ICO's have been banned, most other countries are keeping a watching brief with the promise of future regulation.
ASIC and the MAS (in Singapore) have issued regulatory guides confirming that if the token comprises a security or financial product then it is subject to existing securities and financial services laws.
Europe remains more complex where member states may have different views, delaying unified action. Some national regulators, including in Germany and the UK, have issued warnings over the risks associated with ICOs, while others appear to be waiting for European watchdogs to act first.
In the US - the chairman of the SEC has endorsed the benefits of start-up fundraising via ICO's but has highlighted the lack of investor protection and the threat of fraud and market manipulation. As such he confirmed the policy of the SEC is to continue to ramp up enforcement of non-compliant ICO's.
Hopefully 2018 will be the year in which new standards, practices and uniform legal frameworks are developed in order to ensure the longevity of this new form of fundraising.
What should you be doing?
Individuals – If you are seeking to purchase tokens under an ICO then you should treat the opportunity in the same manner that you would evaluate a start-up company. Importantly, research the team behind the company and its advisors and figure out why the company needs to issue a token. Does it have a clear purpose or is it merely a fundraising tool with no return or benefit for the token holder.
You should also analyse the total economics - i.e. how many tokens are being created and will the software platform generate new tokens? This is all relevant to understanding whether the tokens will become inflationary.
Finally analyse the business plan and financial projections. Is enough money being raised? Alternatively is too much money being raised?
But most importantly – consult your professional adviser.
Companies - if you are seeking to issue tokens/coins then you must treat the issue in the same manner as if you are conducting an IPO. Select your team carefully, design the entitlements of your tokens (including the number to be issued) with precision and ensure your white paper contains as much information as possible. A poorly executed ICO is likely to have long lasting damage to your goodwill.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
