ICOs for Dummies
Disclaimer (i wrote this post in summer 2017, and it’s surprising that it is still very much valid 🙂 )
After a few recent conference speeches and meetup appearances, it became clear to me that ICO hype continues; and continues to be surrounded by equally impressive volume of city-legends and misconceptions about crowdfunding and crypto-currency regulations. Since this is a very fluid area, I don’t pretend to know everything (because nobody does and because there is very little to really be certain about). However, there are several basic rules that are helpful, especially given the fact how fragmented Fintech community actually is: some people from Payments ask “what is an ICO?” and some people from blockchain ask “what is PSD2?”. Information asymmetry illustrated.
What is an ICO from the regulatory perspective?
ICO (Initial Coins Offering aka Token Generating Event or Token Sale) is a form of crowdfunding where the funds are collected in cryptocurrencies.
How do you collect the funds?
– Â Collect the funds in bitcoins or ethers or any other cryptocurrency;
– Â Â Issue your own cryptocurrency (in a form of tokens) and sell/distribute;
–  Collect funds in existing crypto-currencies and later exchange it for your own future   coins/tokens;
– Â Do all of the above and add a fiat contributing option into the mix;
The end game is that your company receives the funds you need to be able to develop or deliver whatever it is that you promised to develop and deliver, and the participants get their tokens as a “certificate” of something you promised to them in the future. It could also be that your future promise is nothing and the contributions were pure charity in your favour, but since the number of truly charitable people and charitable causes is somewhat limited, for the sake of regulatory discussion, let’s assume that that there was a promise made to the participants.
DISCLAIMER 2: since this is one of the most contestable topics ever, the terms “money”, “funds”, “value” and all other terms in this article should be understood quite loosely. Its’ just the way it is.
What is a token from the regulatory perspective?
This is actually a million-bitcoin-question. Let’s take it step-by-step.
As I said earlier, ICO is a form of crowdfunding. There are 4 types of crowdfunding, no matter where you go:
– Equity-based
– Debt-based
– Rewards-based
– Donations and charities
Equity-based ICO de-facto means IPO, or issuing shares/securities to all participants.
This is where you say: “We want to collect money to build a company that is going to hunt and cultivate sharks. We need to invest into hiring people, buying ships, training our crew, paying oceanologists for their research, and doing various PR and lobbying activities to make sure we stay out of jail and out of bad press. At the end of the day we want to be the only company in the world that has lots and lots of sharks and knows everything about sharks, and we are going to dominate this market, catch the sharks, farm the sharks, sell their meat and/or rent sharks to the zoos, lease baby-shark to Instagram photographers, universities and sociologists, because in the future everything is going to be based on sharks and what we know about them. We are going to create a community of shark lovers and everyone is going to participate. Every contributor will become a shareholder, will have voting rights in the company, proportionate to each contribution.”
You will not directly participate in management decisions (unless you are also an employee, or one of the directors), but as a shareholder, you will benefit from the company’s economic activity either via increased share value and share buy-back programs or by receiving dividends from future profits. However, if the company goes out of business, shareholders are the last people to get their money out. From the shareholder perspective, a share is a representation of the ownership in the company. Its value is determined (broadly speaking) by how profitable the company is going to be over the long term, how much you can sell your shares for and what is the level of the dividends.
Issuing shares or any other securities is a heavily regulated process, where you have to be incorporated, audited, scrutinized and super-transparent. The company preparing for the IPO must issue a very detailed prospectus, issue certain legally-binding representations and warranties to its investors, and in some cases, examine, vet and qualify its future participants. This is super cumbersome and super expensive and super slow, which is why the main goal of the majority of ICO originators these days is to make sure their activity does not qualify as issuance of securities. (We are going to have a very serious discussion about what is a security and what is not a security later on).Â
Debt issuing is almost as painful, bureaucratic, slow, costly and therefore useless for most ICOs in town. Simply because their intention is not to issue a corporate bond. The “subtle” difference between shares and bonds (from the ICO perspective) is that shares represent the ownership in the company and the bond is a debt or a form of a claim against the company at the specified period in time. If the company is insolvent, bond holders will have the priority to receive their money back over the shareholders.
In the world of sharks, a debt crowdfunding story would sound as following: “We want to collect the money to build a company that is going to hunt sharks. We need to invest into hiring people, buying ships, training our crew, paying oceanologists for their research, and doing various PR and lobbying activities to make sure we stay out of jail and out of bad press. At the end of the day we want to be the only company in the world that has lots and lots of sharks and knows everything about sharks, and we are going to dominate this market. If you lend us your 100 euros now, we will pay you back 200 euros in 3 years time and we will be able to do this, because our business plan shows that we will be profitable in year N+3 from now and this is when we will be able to cover all the investments made and pay you back your money. Since we know what we are doing, we don’t really want any of your advice about how we should manage our company, you don’t need to participate in the company management, and after we pay you back, we part ways and move on to different directions.
From the debt-holder perspective, debt is a claim against the company and if the money is not returned, debt-holders may, for example, request to be paid in sharks or other assets that have a market value and can be sold. The reason I am telling you the sharks story is to illustrate how the future function of the token or the rights promised to token holders may impact whether or not the token can potentially be considered a security.
Rewards-based crowdfunding would be an event where, for example, Lufthansa is collecting funds and issuing Miles-and-More tokens to the participants, or where Starbucks would issue Starbucks rewards or Hilton would issue Hilton points as tokens; and all of these tokens could be used only and solely to buy and consume future goods or services of these companies. In our sharks economy, the tokens could be used to pay for the zoo tickets where you can swim with the sharks, to buy meat for them, to rent cuter sharks at a discount to Instagram them, or to attend a dedicated training about sharks, run by the sharks association. The value of the tokens will depend on what you can do with the sharks, how many goods and services you can buy and how large and fascinating our sharks ecosystem is. Token holders are future customers of the company, they are essentially pre-paying for the goods and services and entertainment, and the tokens represent a form of loyalty points or consumer rebates. Since, this scenario is a purely commercial transaction of purchasing goods and services in advance, it is exempt from the financial services regulations. As it should be.
Is it true that Switzerland and Singapore have the best regulatory framework for ICOs which is why so many of them happen in these jurisdictions?
No, it’s not. Technically speaking, neither Switzerland nor Singapore have specific ICO regulations. They don’t even have specific detailed regulations on crypto-currencies. What all ICO participants are relying on is a general existing regulatory framework in the country, contractual and commercial laws, some public statements or guidelines issued by local regulators, and a basic understanding (a fair point!) that every activity which is not directly prohibited, is legit.
I did my research and talked to a few lawyers from both countries and can definitely confirm that:
a) There are no specific ICO laws in Singapore and Switzerland, all the Guidelines and interpretations are based on existing financial, securities, contractual, consumer protection and other regulations;
b) ICOs are not prohibited in these countries; and
c) Regulators are aware of the recent trends, but they are not ready to regulate the space as a unique subject matter just yet, they are in “observe and learn” mode.
It is true though, that some regulators are less dogmatic and more progressive than others, and it is probably true that MAS, FMA of Liechtenstein and FINMA are some of the most forward-thinking regulators in the world, especially when it comes to Fintech. But it does not mean that you can do whatever you want with your ICO in these countries and it’s going to be OK. There is no carte-blanche.
How is ICO different from IPO?
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IPO is typically a registered event when a company is issuing shares that are going to be traded on a stock exchange. IPO usually signifies the last, most mature stage of the company’s development and corporate governance, simply because it would not be possible to complete all the required due diligence steps before the company is really ready. Shareholders are the owners of the company and there is a requirement to have and maintain a complete shareholder register.
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ICO is often the entry point into the market, when the company as a legal entity may not even exist. Its maturity level often corresponds to the seed-stage investment aka “we just have an idea and maybe a prototype”. Token owners are usually not the owners of the company and it is very common that the tokens are issued anonymously to token holders, which means, nobody really knows who they are.
Does it mean, that ICO is just a tool for raising funds?
- Yes, it could be just another form of Kickstarter or Indiegogo, a form of raising money. However, there are ICOs where token holders are expected to play a dedicated role in the future of the company. It is crucial to think, what is the future role of the token for post-ICO, because this will largely determine how your ICO is regulated.
Tokens like shares = IPO:
- If token holders are given voting rights and are able to make decisions about future strategic development.Â
- If companies announce coins-buy-back programs or promise to declare and pay dividends.
- Tokens are issued by the same entity as a commercial entity operating the business and the total number and value of the tokens corresponds to the issued capital of the legal entity in question.
- “Proof-of-stake” privileges are linked to proportionate voting rights and closely linked to ownership in the underlying legal entity.
Tokens like debt = “debt IPO”:
- Token holders are promised to receive the funds back by a certain date. There is an element of a fair value of the debt and a premium (for example, interest rate). Any form of a guaranteed promised return linked to a certain date.
- A contract with token holders defines specific collateral which can be sold or transferred to the token holder in case of default.
Tokens like rewards = not regulated yet: Â
- The commercial value of the token is somewhat established before the ICO event and is clearly linked to the goods or services offered by the company.
- Tokens circulation and redemption rights will be within a (relatively) limited distribution network in exchange for goods and services consumed.
- There is an organic, natural role for the “proof-of-stake” privileges to be a part of future sales of the goods and services, for example, to have access to special offers or receive discounts.
- The value of the token is closely linked to its role in the future ecosystem and users’ community, as opposed to the financial results and profitability of the underlying legal entity.
- In all cases, it’s ok to expect that there will be a secondary market for the tokens. Tokens may change hands and increase in value. The nature of the token is mostly determined by its function within the ecosystem, the rights it represents and its usability.
Does it mean that tokens will soon become the new money?
- The key economic difference between tokens (or any crypto-currencies for that matter) and fiat money is that crypto currencies are very unstable and not widely acceptable. If there is a market panic, meltdown, massive manipulation or a big scam with crypto currencies, the governments will not intervene to maintain stability, will not provide liquidity to cryptocurrency exchanges, will not bail out anyone and will not care about protecting the value of the cryptocurrency.
Are ICOs legal? –Â Yes, they generally are. With some exceptions.
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Breaking the law is never a good idea. And operating the business requiring a license or a special permission without such license or permission is illegal. Which means that whenever your ICO looks and feels like issuing shares or bonds to the general public, and you don’t have a permission, it’s illegal. Rewards-based ICOs are generally not regulated and should be safe.
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Even for a rewards-based ICO, it’s not a good idea to break the law. For example, making false representations, misleading participants, stealing, lying, misusing collected data, ignoring contractual obligations, gathering funds for supporting criminal activity, or running away with other people’s money is illegal. The fact that you are doing an ICO does not mean that all existing laws in the country don’t apply to you anymore. It’s just common sense.
What about USA and US residents? Why so many ICOs block them?
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Technically speaking, rewards-based ICOs are legal in the US and don’t require special permission and there is nothing specific in any law that requires you to exclude all US people from accessing your ICO.
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Issuing securities in the US or to the US residents or using US banking system requires you to follow a special process called IPO. Similar to many other countries. So, in this regard, US is not special.
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Sometimes, US authorities have a funny understanding about what their jurisdictional authority is. Look at OFAC and FATCA, for example. Essentially it means, that if they suddenly decide to harm you or ban you, they can. Like it or not.
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Does it mean that if you are running a rewards-based crowdfunding and you are honestly planning to follow laws and regulations in countries where you operate, you must exclude US citizens or residents? – Not really. US citizens and residents can participate in legitimate crowdfunding activities abroad.
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What you need to know, however, is that if something goes wrong, US residents have the right to complain about it to SEC or CFTC or CFPB, POTUS, and all of the above, can organize class actions and sue you for totally unreasonable amounts, if they feel harmed or misled or just cranky.
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Which is why a lot of lawyers and consultants in the past recommended to exclude US participants from ICO. Just in case. If you are sure that your ICO is legit and that none of your US participants will ever complain, you are on the solid ground. But those are quite big assumptions.
Are blockchain forks legal?
- Yes, they are – because they are not prohibited. Both on the blockchain and in the kitchen. However, if a fork is used to deceive or harm someone or if using a fork would break previously made contractual promise, it would be potentially illegal. Both on the blockchain and in the kitchen. Which is why it’s very important to define clear teams and conditions for each ICO and explain to the users, what may happen in a case if, for example, pro-life and  pro-choice movements within the shark economy would agree to disagree and part ways and what options could be available to contributors.
