What Are ICOs?

Initial Coin Offerings (ICOs), sometimes called ‘token sales’ or ‘token generation events,’ are a new way for companies to raise money without diluting ownership of the company or having to pay investors back. ICOs are a combination of existing forms of fundraising with a few twists, and the phrase ‘ICO’ seems to have been coined (ha) to evoke connotations with IPOs or Initial Public Offerings of equities. According to icodata.io,220 over 11 billion US dollars was raised between 2014 and mid-2018 using some form of ICO. Early ICOs were Mastercoin (July 2013) and Maidsafe (July 2014) though they used the term ‘crowd sale’. ICOs became popular in 2017.

Traditionally, a company can raise money in any of three ways: equity, debt, or through the pre-ordering of specific products. They can raise money from a small group of investors as is typical in early venture funding, or from a large number, a style of raising money typically called ‘Crowdfunding’ has become increasingly popular.

In an equity raise, investors pay money to the company in return for a share of ownership of the company. Investors receive a share of company profits in the form of dividends and may get voting rights at shareholder meetings, among other privileges. In a debt raise, investors loan money to the company and may get periodic interest payments in the form of coupons. Debt holders expect to get their capital back at the end of the lifetime of the loan. In a pre-fund or pre-order, customers (note, they are customers, not investors) pay money for a product that they will receive later. Often the product isn’t yet ready for distribution. Sometimes there are discounts for ordering early.

Crowdfunding is a recent phenomenon using the power of the internet where a project or company can be funded by raising small amounts of where a project or company can be funded by raising small amounts of money from large numbers of people, often through a web or app-based platform that brings together the projects and the investors, or customers. All types of funding can be raised from the ‘crowd’. Examples of equity crowdfunding platforms are Seedrs, AngelList, CircleUp, and Fundable. Debt crowdfunding platforms include Prosper, Lending Club, and Funding Circle. Sometimes these are called ‘peer to peer lending’

platforms. Pre-funding platforms include Kickstarter and Indiegogo, and work on pledge basis, where a project only goes ahead if a certain target amount of money is pledged. This is popular for products that appeal to a niche. Pre-ordering is popular for book and computer game sales. Different ICOs have different characteristics, and the generalizations I make in this chapter serve to provide a broad overview, but there will be exceptions. The industry is moving quickly, and regulators are starting to clarify their views on this new form of fundraising.

How Do ICOs work?

Companies221 describe a particular product or service in a document called a whitepaper and announce their ICO. Investors222 send funds, usually cryptocurrencies, to the company in return for tokens or a promise of tokens in the future. The tokens can represent anything, but usually represent either financial securities linked to the success of the project (and described as security tokens) or access to a product or service created by the venture (and described as utility tokens). At some stage, tokens may become listed on one or more crypto asset exchanges. Eventually, a product or service is created, and in the case of utility

tokens, holders may redeem their tokens for the product or service.

Whitepapers

According to Wikipedia223, a white paper is an authoritative report or policy paper. The term was originally used by the British government and the earliest well-known example was a 1922 paper commissioned by Prime Minister Winston Churchill, entitled ‘Palestine. Correspondence with the Palestine Arab Delegation and the Zionist Organisation’. As we will see, the term whitepaper is now no longer exclusively used for these  types of documents. Bitcoin’s ideas were documented in a whitepaper by Satoshi Nakamoto224. Ethereum was initially described in a whitepaper225 written by Vitalik Buterin, followed by a technical yellow paper226 written by Dr Gavin Wood. Since then, most ICO projects have included a whitepaper, though over time the whitepapers seem to have become less technical and have become a combination of a marketing document and investor prospectus. Today’s ICO whitepapers usually describe commercial, technical, and financial details of the project, including:

• The goal of the project, including the current problem and proposed solution

• Milestones for the development of the product or service

• The project team’s background and experience

• The expected total fund raise value

• How the funds will be managed and spent

• The purpose and use of the tokens

• The initial and ongoing distribution of the tokens

You can see some examples of ICO whitepapers on whitepaperdatabase.com, though it should be noted that inclusion in that website doesn’t mean legitimacy of the project. You have been warned!

The Token Sale

Although ICOs operate differently, there seem to be two routes emerging for the token sale. A conservative route may be taken by projects whose tokens have a chance of being classified as securities in relevant jurisdictions, and another route is used by projects who are confident that their tokens are not likely to fall under securities regulations.Those projects whose tokens may fall under securities regulations behave as if they are fundraising in a traditional way. This means that they may not widely advertise their offering, and they may only offer tokens to rich people or those with experience in complex and higher risk financial instruments. In the USA, these investors are called ‘accredited investors’ and other jurisdictions use ‘sophisticated investors’ or similar terminology227. Individual accredited investors are self-declared, and the

criteria are usually based on some combination of net worth, annual income, and experience in complex financial instruments. The country of residence or citizenship of the investor is sometimes relevant, and some ICOs will not sell tokens to American citizens, or people living in certain countries. These ICOs will have private sales but no public sales or presales, at least until the project has delivered a useful product and the tokens could be re-defined as utility tokens.Those projects who sell tokens that are likely to be classified as non securitieshave more freedom to sell their tokens to a global audience and will usually engage in a private sale, one or more pre-sales, and a public Sale.Usually projects offer discounts or bonuses to encourage investors to invest, with more attractive deals for those participating in earlier rounds. This can be achieved by creating limited investment opportunities, either based on time, where the price gets worse over time, or based on amount raised, where the price gets worse as the amount raised increases. For example, in Ethereum’s initial crowdsale, early investors received 2000 ETH per 1 BTC whereas later investors received only 1337 ETH per 1 BTC. Today, it is not uncommon for early investors to get up to an 80% discount on the intended public sale price.This has similarities to funding rounds for startup companies, though the time scales and investor demands are different. ICOs can go from the first funding round to having their tokens listed on a cryptocurrency exchange funding round to having their tokens listed on a cryptocurrency exchange in a matter of months with no product or commercial traction, whereas a traditional startup would usually take years between angel investment and IPO, and investors require demonstrable commercial success or Potential.

ICO Funding Stages

Private sales

In private sales, the investments, discounts, and bonuses are negotiated bilaterally between the project and each investor. The process is similar to a traditional startup raising a round of angel or seed funding. There is usually, but not always, a contract that details the legal agreement between the project and the investor. A popular template is the Simple Agreement for Future Tokens, or SAFT,228 which was devised

and popularized by digital currency lawyer Marco Santori229 among others, in an effort towards industry self-regulation. The SAFT is an agreement that is modeled on a Simple Agreement for Future Equity230, a template popular with startups. A SAFT document is an agreement that says that an investor pays money now (the form of money is irrelevant and can be fiat or cryptocurrency) and will receive tokens at a later date. The SAFT is a type of convertible note, or more generally a forward contract. The SAFT itself is a financial security, irrespective of the classification of the token.

Public token sales

Increasingly, public sales are avoided by those whose tokens may be classified security. However, they are still popular with some projects due to their global reach, ease of fundraising, and hype-ability. The project usually creates an Ethereum smart contract231 for receiving funds and displays the address on their website. Investors send money to the smart contract and receive tokens in a process automated by the smart contract or a series of smart contracts.

For some projects, the tokens may be ERC-20 compliant tokens recorded on the Ethereum blockchain. For others, especially projects that are creating new blockchain platforms, the tokens may be initially recorded as ERC-20 tokens on Ethereum, to be redeemed later for tokens on the new blockchain, when the new blockchain is up and running232. Ethereum’s own crowd sale accepted bitcoins as the funding currency and The Bitcoin address used was 36PrZ1KHYMpqSyAQXSG8VwbUiq2EogxLo2. Public sales tend to be well-hyped. Countdowns and widgets displaying amounts raised are popular and often displayed prominently on the project’s website. Social media, chat rooms, and bulletin boards are used to promote upcoming public sales.

Token pre-sales

Pre-sales are the ‘sale before the public sale,’ usually at a discounted price per token or with bonuses available to investors depending on the amount invested. They encourage investors to invest at a cheaper price and form part of the hype for an ICO. An oversubscribed pre-sale is a great psychological draw for investors in the main public sale.

Whitelisting

Both public sales and pre-sales may have some address ‘whitelisting’ as part of a project’s efforts to identify their investors. Before the token sale, potential investors click through a series of web pages, declare their identity information, perhaps upload a picture of their passport, agree that they do not live in certain countries, accept terms and conditions, and provide the cryptocurrency address they intend to send funds from. During the actual token sale, the smart contract receiving funds will only accept funds from those cryptocurrency addresses that have been Whitelisted.

Funding Caps

ICOs will declare funding caps in their whitepapers. These are floors and ceilings to the amount of funds the projects are willing to accept at any stage of the sales processes. A soft cap usually represents the minimum amount of funds needed for the project to go ahead (similar to Kickstarter’s ‘funding goal’), and a hard cap usually represents the maximum the project will accept. Not every ICO will have a hard or soft cap, and some may change them according to demand.

Treasury

Projects will often create more tokens than are sold in token sales, keeping some proportion behind in reserve. These reserves may be used keeping some proportion behind in reserve. These reserves may be used to reward founders, pay staff or contractors, or to stabilize the price of the tokens on exchanges. The project may self-impose limits on how fast the reserves can be spent, a sort of vesting schedule, which offers investors some confidence that the project is not going to sell a large number of tokens held in treasury immediately after a sale and cause downward pressure on the price.

Once a token is listed, the project will have some idea as to the value of the tokens they hold in the treasury. In accounting terminology, these tokens are held on the company’s balance sheet, and so they impact the equity valuation of the company. Shareholders, particularly venture capitalists, may like ICOs because they can create value on the company’s balance sheet out of nothing!

Exchange Listing

Some investors may buy tokens at ICO to use the eventual product, service, or blockchain, but often investors want to make money by selling the tokens at a higher price than they bought them for.

So the ability to easily sell the tokens is important to investors. Although tokens are immediately transferable between people once they are assigned to investors, and therefore tokens may be bought and sold ‘over the counter,’ the listing of the token on crypto asset exchanges is a key event in the lifetime of an ICO because exchanges make the tokens more liquid. The transferability of the token makes the token different from rewards-based crowdfunding, such as Kickstarter, where participants are not able to easily resell their rewards to others.

Listings may be positive or negative for the price of the token and price volatility can be high in the first few days of a token listing. If the project is popular, the listing can create an opportunity for new investors to be popular, the listing can create an opportunity for new investors to accumulate the tokens, causing a rapid increase in price. If the project is unpopular, early investors may use the listing as an opportunity to sell their tokens, causing a rapid fall in price.

Token listings are such an important event in the project that exchanges can charge projects significant amounts of money to list their token.Listing fees of over a million US dollars are not uncommon. The exchange may also provide liquidity services, creating a market for the coins. When a token is listed, the project will monitor the price carefully, and some have strategies of buying tokens back when the price is low. The ethics and the legality of this is a popular source of discussion. Traditional

companies may issue shares when stock markets are high and perform share buybacks when prices are attractive, however, this is not an exact parallel of what happens in ICO-land, and traditional companies pay more attention to regulations about disclosure and trading activities.

The number of exchanges, reputation of exchanges, and liquidity on those exchanges are important for the project and for investors. Investors prefer to see a token listed on multiple reputable exchanges with large numbers of customers and lots of liquidity.

Despite the importance of exchange listing, projects tend to avoid discussing exchange listing timelines, especially those who are trying to keep their tokens from being classified as securities. This is because discussion of exchange listing adds weight to classification of the token as a security, since there is arguably more of an expectation of profit from Investors.

It’s worth noting that while traditional stock exchanges impose requirements on the companies they list, such as periodic public disclosure of financials, crypto asset exchanges usually do not have such listing requirements, nor are the exchanges obligated to perform any due diligence on projects whose coins they are listing. Some cryptocurrency exchanges are happy to list any token, even those with a low likelihood of success (known colloquially as ‘shitcoins’) because the exchanges make revenues from trading fees, and so are indifferent to the quality of the project or the absolute value of the tokens they list. The exchanges make money as long as there is price volatility.

When Is a Token a Security?

Earlier, we discussed that projects take different actions based on whether they think their token is, or could be classified as, a financial security. The classification of a token as a security is important as it impacts who can do what with the token, because activities relating to Financial securities are regulated in most countries. Note that tokens themselves are not regulated, but activities relating to them are.

So how do we decide if a token may be classified as a security or not? In the USA, the ‘Howey Test’ is a well-known test that was created by the United States Supreme Court in 1946 during a case ‘SEC vs. Howey’. According to the FindLaw website233:

Payment tokens are synonymous with cryptocurrencies and have no further functions or links to other development projects. Tokens may in some cases only develop the necessary functionality and become accepted as a means of payment over a period of time. Utility tokens are tokens which are intended to provide digital access to an application or service.

Asset tokens represent assets such as participations in real physical underlyings, companies, or earnings streams, or an entitlement to dividends or interest payments. In terms of their economic function, the tokens are analogous to equities, bonds or derivatives. FINMA suggests the following framework235, for determining whether a token is a financial security or not, and this seems reasonable in the current stage of industry development: In June 2018, William Hinman, Director, Division of Corporate Finance at the United States Securities and Exchange Commission (SEC) said in a Speech236.

‘Based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value’..

He differentiates the manner in which something (a token) is originally sold, and the later use and sale of the token. A token can have utility and also be offered as an investment contract, i.e., a financial security. He Explains, 

‘The oranges in Howey had utility. Or in my favorite example, the Commission warned in the late 1960s about investment contracts sold in the form of whisky warehouse receipts. late 1960s about investment contracts sold in the form of whisky warehouse receipts.Promoters sold the receipts to U.S. investors to finance the aging and blending processes of Scotch whisky. The whisky was real—and, for some, had exquisite utility. But Howey was not selling oranges and the warehouse receipts promoters were not selling whisky for consumption. They were selling investments, and the purchasers were expecting a return from the promoters’ efforts’. This means that, irrespective of what a token represents, the manner in which it is offered and the utility of the token at the time of offering is important. We will see over the coming years how this important speech impacts the manner in which ICOs are conducted.

Conclusion

Although we are in the early stages of the token industry, we can see that It is already beginning to mature. In early ICOs, projects would write disclaimers in small print stating that the tokens are not an investment or a security, hoping that this would be enough to protect them. These investment rounds were sometimes described by the projects as ‘donations’ or ‘contribution rounds’ in order to disassociate with legally sensitive terminology. There was a clear disconnect between investor expectations of the tokens and the wording in the investor documents. Unfortunately for those with that view, wording matters less than the economic realities, as projects are finding out

ICO token is very risky investment so always check there whitepaper and do lot off research before investment in it..