On 12 June 2017, a blockchain-based company called Bancor raised approximately $153 million in ether (the coin of the cryptocurrency Ethereum) in just less than three hours by way of an initial coin offering (ICO). 10,855 investors participated in the ICO making it at the time the largest crowdsale campaign in the blockchain industry. A month later, and for the first time in its young history, ICO’s were officially recorded as providing more funding to fintech start-ups seeking access to financing than that provided by traditional angels and seed venture capital. A new phenomenon had been born.
The Bancor ICO contributed to a total of $3.7 billion of cryptocurrency raised by 235 ICOs in 2017, a figure which was attributable as much to Ethereum’s bull run towards the end of last year driven by the cryptocurrency speculation as it was to the ease with which tech start-ups found they could suddenly raise capital without having to surrender valuable equity early-on to institutional investors.
The innovative funding mechanism and dramatic trend of its adoption since the Bancor ICO has generated a significant amount of attention from investors and regulators alike. Yet its introduction to the mainstream has been fraught with obvious growing pains. The mostly unregulated technology has so far struggled to adapt to pre-existing legal parameters concerning the offering of securities to the general public and has quickly become a hunting ground for fraudsters and hackers to prey on previously protected retail investors and deprive them of large sums of cash either through digital Ponzi schemes or via stolen keys to electronic wallets. A flurry of bans, enforcement actions and regulatory alerts has followed closely behind.
This article seeks to take stock of the ICO phenomenon to date with a summary overview of its component parts and a digest of the regulatory response so far before a look to the roadmap for the remainder of 2018 and what needs to happen if the ICO flag is to remain planted. Forward-thinking regulators, issuers and investors each have a vested interest in closing the mostly wild west chapter of last year and finding exactly where the lines in the sand should be drawn going forward.
What is an Initial Coin Offering?
An ICO – otherwise known as a token sale – is a digital method of crowdfunding which uses tokenised assets and blockchain technology. Whereas traditionally a start-up with a promising idea would sell its business plan to interested angel investors, later commit to sequential funding rounds in which venture capital investors would provide scale-up financing in return for a slice of equity, before eventually pursuing an initial public offering (if very successful) to sell some or all of its shares to the general public, the ICO can offer a novel and much faster approach.
That same start-up with a promising idea wishing to ICO would market its (often pre-development) product via a non-standardised electronic white paper, a comparatively lightweight document which goes through none of the rigorous stress testing of a regulated prospectus. Prospective coin – or token – purchasers will then transfer one of the more established digital currencies (typically Ethereum) to the start-up’s digital wallet in exchange for the start-up’s newly developed proprietary token. The token price will be fixed upfront but can often come with an attached discount that reduces at staged intervals until the ICO (or pre sale) either reaches the end of its scheduled investment period or a hard cap of funding is reached (whichever comes first).
If the ICO has gone well, the start-up receives a lump sum of cryptocurrency, the value of which it would never have conceived of on day one of business had it pursued a more traditional funding route and for which it is then accountable to its new token holders to implement its advertised project, platform or related initiative. No equity has been parted with and no debt has been incurred (with the associated restrictions on corporate activity and deadlines for repayment).
(The justification for often receiving such an enormous amount of seed capital without having to properly validate a project concept and show detailed financial forecasts (instead substituted for a ‘roadmap’ of next events in the start-up’s whitepaper) is a topic which deserves almost a whole article to itself and as Dr. Jemma Green, a co- founder of the crypto-company Power Ledger, put it in a recent Q&A session, “could go over your head if not careful”.)
The token holders for their part are now in possession of digitally-scarce representations of value which can be either traded peer-to-peer or on an online exchange soon after listing or be spent or used on the start-up’s platform once functional. The inherent value of the tokens is two-fold. Since they have been created and issued on top of a blockchain (typically the existing Ethereum blockchain using the ERC-20 token standard set of rules but also sometimes on newly-created blockchains) they cannot be copied like traditional digital files or emails and their record of ownership and transfer is immutably tracked via the technology’s open source ledger. Secondly, they are developed in each case in such a way that certain rights are inextricably attached to the token which benefit their holders. Rights can vary wildly between different tokens issued pursuant to different ICOs but common examples can include access to services or products developed by the start-up (often at a discounted price), use of the start-up’s software application, the right of redemption at a profit or the right to vote on future corporate decisions to be taken by the start-up (often where the start-up itself is looking to invest in other crypto-assets as a fund platform). The token is structured as what you may have previously heard described as a ‘smart contract’, a set of pre-determined code which determines the behaviour of the token.
How does an ICO differ from an IPO?
The likeness of the ICO acronym to ‘IPO’ is somewhat of a misnomer. An initial public offering is the end fundraising goal for a mature company with a proven track record to sell its shares to the general public for the very first time. The process is a lengthy one (certainly not less than three hours!) which involves a cast of advisers and comprehensive regulatory oversight. In return for purchasing the company’s shares, investors can expect the prospect of a capital gain in the secondary market or pursuant to a trade sale or buy back and have a right to attend certain meetings and vote on key decisions in their capacity as new shareholders.
One of the principal attractions of the ICO format from the crypto-investor perspective however is the sudden democratisation of early stage investment. Whereas previously only financial institutions (i.e. venture capital funds) and high net worth individuals could access the ‘pre-IPO’ valuation of a company’s shares with the promise of lucrative returns once the shares were floated much later to the general public, retail investors are taking advantage of the less regulated ICO system to not only purchase tokens whose initial value will reflect the early-stage nature of their issuer but can also be traded for a profit once admitted to online exchanges weeks after the ICO. It is worth noting however the increasing trend in the space for companies fundraising via an ICO to permit access to their ‘pre-sales’ only to identified high net worth individuals, venture capitalists and friends and family (who enjoy the steepest discounts on the tokens’ initial valuation).
From a founder perspective, instead of diluting their stake in the company through various rounds of private financing and spending a vast amount of time and effort on building up both a brand and a customer base, the issuance of proprietary tokens to over 10,000 investors (as was the case with Bancor for example) creates an immediately incentivised populace willing to spread the company’s name if it delivers on its promised product or service whilst simultaneously having not given away a single share of the company to institutional investors.
Is a Token a Security?
The nature of each token, project, or issuing entity can vary greatly, making the overall classification of ICO’s from a legal perspective much more difficult. In particular, a lot of attention has been focused on whether tokens should qualify as a form of security, a virtual currency or as an asset more relatable to property or commodities.
The task of classification becomes even more complex when the tokens are held up against the framework of existing laws which were not drafted in contemplation of regulating highly liquid, cross-border digital assets or blockchains. The result is a wide scope for interpretation on a case-by-case basis (time consumptive) and legislative loophole exploitation. If the latter is then identified by the regulator and enforcement action levied, it is the investors who are most likely to suffer where it financially hurts, with no financial ombudsman or other recourse obviously available (save for a complex rescission process) to return the committed crypto capital.
A popular approach taken by some of the regulators (notably the Securities and Exchanges Commission in the US (the SEC)) has been to consider which of the two following categories a particular token falls into:
Utility tokens – tokens structured in a manner as described earlier in this article, i.e. they represent access (or future access) to a specific right (or rights) which are hard-wired in to the token’s code at the time of the issue.
Security tokens – represent ownership or participation rights (such as profit sharing or interest payments) analogous to a share in a company and with no immediately obvious applicative use case for the token.
If a clear utility token with immediate usage characteristics, then the tokens issued pursuant to the ICO may be able to skirt the extensive rules and requirements that form the basis of most international securities legislation and be issued in what remains a mostly unregulated environment for the time being.
If a security token, competent authorities across the world continue to make it very clear through the form of official statements or post-enforcement verdicts that such tokens, their marketing and subsequent sale will be treated as subject to the relevant securities laws and that a failure to comply is an increasingly risky path to follow. In July of last year, the SEC indicated as part of a wider report on ICOs that unless a token is clearly a ‘utility token’, then the ICO must be registered with the SEC or rely on an available exemption. The obvious difficulty for any company considering an ICO is that more than likely the tokens are linked to a platform or product that is some time away from functionality and so there is no clear utility to the token at the time of issue (beyond the ability for holders to sell on the secondary market). One working solution to this paradox was the development towards the end of last year by the community (led by the US law firm Cooley) of a token sale framework labelled the ‘SAFT Project’ which is designed to allow pre-project issuers to sell a supposedly standardised and compliant security product to investors which later converts into tokens only once the platform becomes live. However, the proposal in its current guise has not been without its detractors.
What has been the Global Regulatory response to ICOs so far?
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 concerned with securities offerings, market integrity and consumer protection.
China and South Korea continue to uphold their respective bans on domestic ICO participation and Israel (home of the Bancor ICO and generally regarded as a hospitable jurisdiction for start-ups) is reportedly considering implementing tougher short term regulation.
In the US, where a clear edict is hampered even further by the different voices of state and federal authorities concerned with the regulation of ICOs, authority has mostly been imposed through enforcement actions and verdicts, with serious inquiries currently reserved only for the most pressing and harmful cases. The SEC’s ‘Cyber Unit’, a task force established last September with the mandate of tackling blockchain and ICO-related misconduct, sent an unequivocal statement of intent to prospective token issuers with its initial enforcement actions; the first, an emergency asset freeze to halt a fast-moving ICO fraud by a company called PlexCoin which had raised $15 million from thousands of investors by promising a 13-fold profit in less than a month, and a second cease-and-desist order directed at a Californian company called Munchee in which Munchee voluntarily agreed to halt its ICO on the basis that its conduct had constituted unregistered securities offers and sales. Jay Clayton, Chair of the SEC delivered a warning shot to non-compliant ICO issuers at a Senate hearing in the US two weeks ago, by admitting that “every ICO I’ve seen is a security…those who engage in semantic gymnastics or elaborate re-structuring exercises in an effort to avoid having a coin be a security are squarely in the crosshairs of our enforcement provision”, (although Mr. Clayton did strike a generally bullish attitude towards the future of regulated cryptocurrencies).
In Europe, the competent bodies have watched on intently, but mostly reserved their active position for now, save for formal announcements to both warn investors thinking of participating in ICOs of the inherently high risks involved and to alert issuers to the fact that they must “give careful consideration as to whether their activities constitute regulated activities”. ESMA also identified a non-exhaustive list of relevant EU rules for issuers to consider, including the Prospectus Directive, the Markets in Financial Instruments Directive and the Fourth Anti-Money Laundering Directive.
As a follow-up to its September consumer warning, the UK Financial Conduct Authority (the FCA) issued a feedback statement in December in relation to an earlier discussion paper on blockchain technology in which it declared its overall regulatory philosophy as “technology neutral” and additionally that:
“a well-functioning ICO market, where issuers are not only sensitive to any regulatory obligations they have but actively take appropriate steps to manage the risk of harm to the public and to the markets more broadly can materially contribute to the development of [blockchain] technology”
However, the FCA was still sure to re-confirm that if an ICO does involve the issue of an instrument which is capable of being a specified (i.e. regulated) investment, proper authorisation is required in advance of any regulated activities.
Finally, some of the reputable offshore jurisdictions (Cayman Islands, Isle of Man) and tech-savvy jurisdictions such as Singapore and Switzerland continue to position themselves as potential destinations of choice for issuers and advertise their administrative, legal and banking flexibility in an effort take an early advantage of the lucrative inbound revenue streams. Switzerland’s financial supervisor (the Swiss Financial Market Supervisory Authority) published renewed guidance last week on how it would view tokens on a case-by-case basis and made it clear that some functional utility tokens are definitely not securities, a clear rebuttal of Mr. Clayton’s words the previous week.
The cacophony of messages, warnings and advertisements means an ambitious ICO can face a significant set of hurdles to remain compliant. Any cross-border offering requires not just the identification of which jurisdiction is the most regulatory friendly for it to host an ICO but also a thorough analysis of each potential participant’s jurisdiction to understand the local marketing and sale restrictions. Add the proper implementation of anti-money laundering and “know your customer” procedures at the point of sale and the potential of on-going tax reporting requirements on behalf of certain investors and the exercise can suddenly become a more daunting venture than the token issuer first anticipated.
The Road Ahead
If 2017 was the year where ICOs introduced themselves onto the investment stage as a disruptive and highly efficient funding mechanism, 2018 should be the year where new standards, practices and uniform legal frameworks are developed in order to ensure the longevity of the technological breakthrough. The collision of a new technology in applied cryptography and decentralisation and existing regulations designed for traditional fundraising is a fascinating one as it has demanded a serious re-evaluation of first principles for those involved and has unlocked investment access to start-up capital for the masses.
Regulators, in addition to continuing to closely monitor market developments and taking enforcement action where appropriate, should prioritise accommodating the fundraising method with uniform legislative parameters without stifling it with new rulebooks hastily drawn up for criminals. An international ICO certification body established to specifically award certification to prospective ICO’s which have demonstrated compliance in their pre-ICO structuring seems a natural step forward in standard-setting and it is promising to see certain crypto exchanges beginning conversations about collective self-regulation. As legitimate ICO’s start to demonstrate their credibility with compliance with best practices, investors will hopefully be able to take comfort that their cash is more likely to be treated as an investment and not a gamble, and other prospective issuers should follow the market leaders, recognising the benefits of adopting a proven model.
Structural safeguards such as founder vesting of tokens (to prevent ‘pump-and-dump’ schemes) and the staggered release of the ICO funding to the start-up based on the achievement of milestones in the roadmap (as voted on by the token holders) should be promoted as industry norms to be adopted by issuers in order to give further comfort that investors are not being misled and that management teams begin the implementation phase with a clear-headed focus and not with a crypto-millstone around their neck to deliver immediately.
Finally, companies should consider seriously whether the novel funding route is truly useful for their business and the merits of a well-run ICO versus the potentially permanent damage to goodwill and reputation resulting from a poorly executed ICO. The remainder of 2018 is likely to witness more mainstream corporates use the ICO as a form of marketing tool in order to generate the customer interaction described earlier in the article (case in point, Kodak’s questionable resurrection last month) and a hybrid approach of token raises and equity issuances being utilised together by companies already possessing a mature project or functional product and now looking to boost capital expenditure by multiple funding options.
Although the first ICO was held almost five years ago now, the fundraising method only truly made its presence felt last year. Fraught with complexity and often not so hidden dangers, it certainly needs its success stories this year to demonstrate it is a viable fundraising option for issuers and investors alike and has made clear inroads to tackle the associated evils. If the regulatory and security challenges are soon overcome, then we may see an investment and fundraising route which delivers a much more credible use of the technology than mere currency speculation. As Silver Lake Partners’ Genn Hutchins pointed out to the Financial Times in a recent interview when making the distinction between the recent pure currency speculation and the promise of the underlying technology benefits, Levi Strauss made more money selling jeans in the Klondyke than most prospectors did finding gold.
The views and opinions expressed in this article are those of the author.
References:  Hyperlink text: https://www.bitcoinadstrain.com/2017/11/24/bancor-raises-153-million-creates-a-new-record-in-ico-history/  Hyperlink text: https://www.cnbc.com/2017/08/09/initial-coin-offerings-surpass-early-stage-venture-capital-funding.html  Hyperlink text: https://www.coinschedule.com/stats.html?year=2017  Hyperlink text: “The Story of Power Ledger with Dr. Jemma Green”, 16.32m: https://www.youtube.com/watch?v=vcxgjDZUaaU&t=1111s  Hyperlink text: https://blockonomi.com/erc-20-token-guide/  Hyperlink text: https://cointelegraph.com/explained/sec-ruling-on-the-dao-and-ico-explained  Hyperlink text: https://saftproject.com/  Hyperlink text: “Not so fast – risks related to the use of a “SAFT” for Token Sales”: https://cardozo.yu.edu/sites/default/files/Cardozo%20Blockchain%20Project%20-%20Not%20So%20Fast%20-%20SAFT%20Response_final.pdf Hyperlink text: https://www.sec.gov/news/press-release/2017-219 Hyperlink text: https://www.sec.gov/news/press-release/2017-227  Hyperlink text: ESMA Statement issued on 13 November 2017 and accessed here: https://www.esma.europa.eu/sites/default/files/library/esma50-157-829_ico_statement_investors.pdf (Investors), and here: https://www.esma.europa.eu/sites/default/files/library/esma50-157-828_ico_statement_firms.pdf (Firms)  Hyperlink text: https://www.esma.europa.eu/sites/default/files/library/esma50-157-828_ico_statement_firms.pdf  The European Securities and Markets Authority  Hyperlink text: https://www.fca.org.uk/publication/feedback/fs17-04.pdf  Hyperlink text: https://www.finma.ch/en/news/2018/02/20180216-mm-ico-wegleitung/  Hyperlink text: https://cointelegraph.com/news/uk-coinbase-cexio-other-major-crypto-firms-create-first-self-regulating-trade-body  Hyperlink text: https://www.coindesk.com/kodak-launching-cryptocurrency-photographers/  From a legal perspective, hybrid approaches will demand a significant amount of attention to companies’ pre-existing contractual framework, i.e. should tokens be subject to constitutional pre-emption rights? Will future sales be caught within the list of restricted activities in debt documentation? A new set of stakeholders will require accommodation without the toes of incumbent stakeholders being stepped on.  Hyperlink text: “Bitcoin price is a distraction, says big technology investor”: https://www.ft.com/content/7b9797bc-ec09-11e7-8713-513b1d7ca85a