Advocates of initial coin offerings see them as a quick and simple way to raise money for blockchain-based start-ups, while sceptics warn of get-rich-quick schemes and a 'Wild West' market. Joy Macknight looks at the drivers behind this new way of fundraising.

Raising crypto capital

Initial coin offerings (ICOs) have exploded in number and value over the past year, attracting the attention of regulators across the globe. Put simply, an ICO, or token generating event, is when a blockchain-based company sells digital tokens to fund its business operations, software development or community initiatives.

The total amount raised in 2017 (as of October 9) is $2.7bn from 176 ICOs, according to crypto-currency statistics compiled by CoinSchedule. September saw the greatest amount fundraised via ICOs – about $700m. The largest ICO to date is Protocol Labs’ Filecoin, which generated $257m for the blockchain-based storage network.

In 2016, by comparison, 46 firms raised a total of $96.4m, and the largest ICO of the year garnered $16.4m for Waves, a crypto-currency platform. Undoubtedly, ICOs have come a long way since the early days when Ethereum raised $18.4m in 2014, in one of the first token sales.

Under the radar

Until this year, ICOs have flown below the radar of public consciousness and regulators, mainly because they involved a small, specialised group of investors focused on the blockchain ecosystem. “In the early phases, an ICO was often seen as a way of attracting a different kind of investor – ones that were tech savvy,” says Harriet Territt, a partner at global law firm Jones Day.

Many of those initial investors had made money by investing early in crypto-currencies such as Bitcoin, and were “sitting on large profits and interested in reinvesting in the fintech sector”.

In June, ICOs surpassed angel and seed venture capital (VC) funding globally for the first time, according to CoinDesk Research. “This is a real shift in how early-stage companies raise money,” says Oliver Bussmann, president of Swiss-based Crypto Valley Association (CVA), which is looking to position Zug as a global crypto and blockchain hub.

While still not necessarily well known by the general public, financial message boards are seeing much more chat about ICOs and the supposed potential for “getting rich quick”, says Ms Territt.

Regulatory rigour

The spectre of huge losses among a wider section of society has prompted a rash of regulatory responses over the past four months, without a clear consensus as to the correct approach. China and South Korea have taken the toughest stance, banning all forms of token fundraising.

Other jurisdictions, including the US, the UK, Singapore, Canada, Russia and Hong Kong, have taken a more liberal approach. But almost all have issued warnings about the potential dangers, such as high price volatility in digital currencies, and the lack of due diligence and anti-money laundering compliance.

Some countries have already reported problems with financial fraud, pyramid schemes and other criminal activities. The $50m hack of the Decentralised Autonomous Organisation in 2016 was what spurred the US Securities and Exchange Commission into action.

Ms Territt says: “Most ICOs are legitimate, but some people will see them as an opportunity to make money from less sophisticated individuals. That is one of the reasons why global regulators have acted – though not always in a consistent way. There is, however, some consensus emerging that ICOs should be examined on a case-by-case basis, as each one can be very different from the next.”

Definition difficulties

As Ms Territt indicates, the trouble financial regulators are facing in harmonising their approach to ICOs comes down to the difficulty in classifying, and then applying existing regulations to, diverse token generating events.

In September, the Stellar Development Foundation and Luxembourg House of Financial Technology released a white paper, ‘Understanding initial coin offerings: technology, benefits, risks and regulations’, which attempts to bring some clarity to the discussion.

“A token is a crypto-graphically secure digital representation of a set of rights. Depending on the token, this could include the right to access and use a network or software application, the right to redeem the token for a unit of currency or a good, the right to receive a share of future earnings, the right to vote on decisions made by the organisation, or more,” the white paper says. It identifies five common types: usage tokens, equity tokens, work tokens, community tokens and asset-backed tokens. But they can also involve a mixture of two or more types.

Mr Bussmann uses the example of Storj, a decentralised cloud storage provider that raised $29.2m via an ICO in May. “A customer can buy a Storj token to use for [cloud-based] storage space, but they can also become a storage provider for others and get paid in the token. The token is also equity, so the customer owns a part of the company,” he says. “There is an incentive to use the token because if the company does well then the token’s value rises. This is a new way to monetise things.”

For financial regulators, the crux is whether the token can be classified as a security, tied to the future profits or success of a business, for then it would be subject to their oversight. But, as Mr Bussmann’s example illustrates, ICOs can perform many different functions.

“Not only is it difficult to speak of ICOs as a single category, but regulators in different countries also have diverging definitions of what a security is,” says Ms Territt. “Some countries have very precise definitions, whereas others take a much broader, principles-based approach to what can be considered a security.”

New classification method

While it may not be possible in the short term to harmonise regulators’ definitions of securities, a common classification system could prove useful. In October, CVA members Blockhaus and MME, a law firm specialising in blockchain, released a white paper proposing a new method for token classification and introducing the concept of blockchain crypto-property (BCP), which is defined as “digital information that contains all elements of a property right that is registered on a blockchain or in an alternative digital ledger”.

Luka Müller, a partner at MME, argues that besides helping policy-makers, an agreed framework could also provide investors and issuers with standard tools to evaluate, mitigate and communicate risks in token design and launches.

The structured analysis is based on three layers: functionality, underlying technology and distribution. “The classification is helpful because we can create a communication protocol, so that all the stakeholders and participants in the event, including supervisory authorities, banks, ICO candidates, advisors, etc, can speak about the same token or product,” says Mr Müller.

Regarding Ms Territt’s point, he adds: “As different jurisdictions have divergent concepts of securities, such a classification needs to be as functional and generic as possible, avoiding, at this early stage, a legal identity.”

Issuing tokens

While the main reason start-ups consider an ICO is because it is a quick and easy fundraising mechanism, Hannah Meakin, partner at law firm Norton Rose Fulbright, lists other reasons. “There is a mixture, ranging from wanting to raise money because more traditional options are not available, to those that are primarily using the ICO to develop a specific product and want to distribute the tokens that are native to that product to a broad range of potential users to ensure that the product is widely adopted,” she says.

For example, Mihai Ivascu, CEO and founder of Modex, which built the peer-to-peer mobile payments application Moneymailme, wanted to expand Modex’s product offering by building a marketplace for blockchain development tools and smart contacts. “The platform will connect smart contract developers from all over the world with companies and individuals in need of blockchain development,” says Mr Ivascu.

Instead of another conventional funding round, Modex opted for an ICO because Mr Ivascu believes the marketplace will provide value for the whole community. “So why not allow the community to participate in the platform’s financing? We want to pay developers in MDX, our crypto-currency, to develop on the Modex platform and add value to this marketplace. A token offering allows us to engage developers before they begin developing on it. Working with creative developers is the key to widespread adoption.”

Thus, the fundraising method also promotes an accelerated deployment of blockchain technology. “We could grow by raising VC in various stages. But we have opted for a major funding with a token offering, which eliminates the typical challenge of VC fundraising that most tech start-ups have to repetitively endure,” adds Mr Ivascu.

Modex is issuing 197 million tokens during its ICO, which can be purchased by using Ethereum or Bitcoin. The company’s three-year roadmap is laid out in its white paper, which is directly overseen by a group of senior business advisors. Mr Ivascu reports that 40% of the proceeds will be used to incentivise the community. “Instead of spending 80% on marketing, we believe the best marketing is generated by happy programmers,” he says.

Concerns persist

For Mr Bussmann, the quality of the start-ups white paper should be paramount for investors. “[The white paper] is almost like a prospectus in the initial public offering [IPO] world. It explains the idea and the business roadmap, etc. But again, the publication’s requirements are not defined,” he says. He believes that there needs to be greater transparency – as in the IPO world – and more education for investors because it is a high-risk investment, saying: “As with most early-stage companies, there is always a risk that they will fail.”

Likewise, Hugh Halford-Thompson, chief innovation officer at BTL Group – a Canada-based blockchain start-up that tapped the capital markets to fund the business – is concerned about companies putting out white papers that are “not well written, with no disclosure, no real business plan and a blatant disregard of regulation” yet can still raise millions.

Mr Halford-Thompson warns investors to check whether the company is properly incentivised to provide value to clients. “The first question I ask is about their business plan and what they will do with the money. Many say that they will work it out later, or some even admit that it is a good way to raise money without any liabilities because these investors are not shareholders.”

Calls are widespread for a code of conduct on ICO issuance. The CVA is working on such a code, developed in conjunction with the global community, while Modex is working with Silicon Valley Innovation Centre on a similar initiative. Additionally, at the beginning of October, 16 industry players launched Project Transparency, aimed at creating a self-regulated, industry-led movement to improve regulatory procedures and disclosure within the digital currency sector.

Alternative view

Despite these industry initiatives, the sceptics persist. For example, Brad Garlinghouse, CEO of blockchain company Ripple, comes out strongly on the side that views ICOs as “radioactive”. In his opinion, ICOs are preying upon investors who are buying tokens without having complete information or transparency around, for example, the business’s financials. “I predict that some ICOs will end up with class action lawsuits and the entrepreneurs will end up in litigation for many years,” says Mr Garlinghouse.

He does not believe that ICOs make capital more accessible. “That suggests that capital wasn’t accessible before – but the amount of capital available to entrepreneurs has never been higher, through crowdfunding sites, accelerators, incubators, angel funds and so on,” he says.

Mr Garlinghouse also points out a misconception about ICOs. “When a company raises $50m through an ICO, they don’t have that money in their bank account, but are holding $50m-worth of Ethereum, for example, at a digital asset exchange,” he says. “It isn’t really $50m if you can’t pay people with it.”

As for some start-ups’ plans to pay developers in digital tokens, he says: “While some employees will find that interesting, others will need dollars, pounds or euros to pay their rent.”

Here to stay?

ICOs will persist for specialised products, start-ups and investors, says Ms Territt, but the level of interest in using ICOs for a broader range of products may wane because of the regulators’ actions. “The less relevant projects around the edges are likely to disappear and the main focus will be on core technology projects, particularly those tied into blockchain,” she says.

Ms Meakin is more doubtful. “If this is the way of financing in the future, more investment banks should be interested in this space – but none really are, probably because they can see the risks,” she says. “And if any of the large token sales turn out to be a fraud or scam and individuals lose significant amounts of money, ICOs could become regulated in a much more active way."

Unsurprisingly, Mr Ivascu is bullish on ICOs and believes they will continue to be a good way to raise capital. “But under one condition – that they are done properly,” he adds. “They should become better regulated, where clear visibility on the product and team, and due diligence on the whole process, is assured.”


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