Are Initial Coin Offerings Here to Stay?
2017 was the year Cryptocurrency grabbed the limelight and took center stage in the Blockchain revolution. There are now over 900 blockchain-based tokens in circulation, according to CoinMarketCap. There is Dogecoin, TrumpCoin and CannabisCoin. Venezuela recently announced the launch of Petro, as an alternative oil-backed token to its failing Bolivar currency and private sector juggernauts like Visa began its own foray into cryptocurrency. Where do all these coins come from? They’re created in ICOs, or initial coin offerings.
Depending on how it’s structured, an ICO is somewhere between an initial public offering and a crowd funding. It’s a way to raise funds by offering investors an opportunity to buy a digital asset, usually at a discount or with some other incentives, in exchange for payment usually in the form of a more established cryptocurrency, like bitcoin or Ethereum, or a fiat currency like U.S. dollars.
If the new token or the cryptocurrency received in exchange rises in value—based on speculation and the laws of supply and demand, like a stock in the public market— the company or the investor makes a profit. Unlike a stock, however, the token does not confer ownership rights in the issuing company although it may provide for distributions to the coin holder much like a stockholder who may receive dividends.
“ICO’s have become very popular. While it is hard to ignore some of the larger ICO’s such as Block.one, which has raised over $1 billion, there are also risks and shortcomings for both investors and entrepreneurs.
In addition to recent enforcement actions by the SEC and other government regulators, investors should also be aware that ICO’s are generally not eligible for Qualified Small Business Stock capital gain exclusions from taxes, which will significantly reduce ROI,” said Asael Meir, partner and leader of CohnReznick’s national technology practice.
Some coins are more legitimate than others. “What we’re seeing now, as you often see in a new and emerging sector, is a lot of abuse with ICO’s,” said David Sorin, office managing partner at McCarter & English and Co-Chair of the firm’s Venture Capital and Emerging Growth Companies practice. “There are, to be sure, scammers and con artists who think this is a way to make some easy money by exploiting the exuberance and interest in the marketplace for cryptocurrencies. And, in fact, far too many of the tokenization transactions out there are garbage. They promise the sun and the moon and they’ll never deliver. On the other hand, there are businesses and financial models that can benefit greatly from tokenization initiatives.”
Because of recently publicized ICO fraud and abuse, expect continued tightening of the regulatory environment. The SEC has issued several warnings, not limited to shutting down the ICO of AriseBank—after it had already raised $600 million. Whereas many states are choosing to preemptively self-regulate ICO’s, ranging from limitations and restrictions to trying to shut them down altogether.
For example, New York has a bill under consideration that will constrain who can issue currencies and who can trade in them. Arizona’s House and Senate recently approved a bill to provide that signatures secured through a blockchain are valid and smart contracts like those underlying Ethereum are legally enforceable. At the end of the crypto-friendly spectrum, Wyoming expressly exempts utility tokens from its state securities laws.
Internationally, nations are lining up on both sides of the debate, with China banning ICO’s, South Korea exhibiting a cautious but largely negative approach, while Switzerland, Liechtenstein and Singapore, among others, pursue a more favorable environment for ICO’s.
“If you are considering an ICO as an alternative fund raising strategy, work with an experienced attorney who can review your offering documents to advise on whether you are selling a security or a utility token. Taking precautions during the ICO planning phase will help minimize issues down the road,” said Meir.
When properly issued, implemented and used, ICO’s present companies with a promising, alternative new way to raise capital without a dilutive effect to ownership or a traditional loan repayment obligation.
“ICO’s give access to larger pools of global/online investors with immediate access to liquidity,” said Meir “If current trends continue, expect funds raised through ICO’s to surpass traditional seed and angel investments in 2018.”
“We’ve done a lot of thinking about what kinds of companies and business models may benefit from this third form of capital-raising transaction,” said Sorin. “In my view, software companies, and other high margin/low incremental cost of delivering the next unit are the preeminent examples of a coin offering as a truly elegant solution.”
Let’s say Software Company X wants to raise capital but does not want to suffer any equity dilution. If it does an ICO, it can sell coins and then give buyers who wish to redeem the coin’s access to its product at a discounted price. This way, the company gets the money, it does not dilute itself, software development happens, and the money is not repayable. Instead, when the coin comes home, the company delivers value to the holder in the form of access to its new software. When the coin ultimately comes home, the company gets the revenue but at extremely high margins and virtually no incremental cost.
Beyond the ICO, digital currencies in general offer the promise of transforming global finance. While few people will be conducting large-scale cross-border transactions with Dogecoins, imagine the implications if an Amazon, Apple, or Exxon were to create their own cryptocurrency. Such currencies could be traded globally reducing or eliminating the friction currently associated with global trade, such as international exchange rates or geopolitical uncertainty.
“We all know it’s the wild west right now, with scams and securities often being sold without compliance,” said Sorin. “Regulators are jumping in, of course, but, in my view, far more important than that is the emergence of real financial institutions and financial experts in the digital assets markets because they will lead the transformation from an often irrationally exuberant marketplace, to highly professionalized, financially disciplined, and increasingly self-regulating market.”
What Does the Future Hold?
You can’t ignore the amounts of money raised by ICO’s, but there are risks and high costs involved. If ICO’s and cryptocurrencies continue to outperform investments in more traditional asset classes, expect growing market acceptance of crypto hedge funds and venture capital-backed ICO transactions. If your company is considering an ICO, it is prudent to be educated on the process, timeline and resources necessary for a successful ICO. For the rest of us, watch how cryptocurrencies evolve in 2018 and beyond, and keep informed of the key players and changing regulatory environment.