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Initial Coin Offerings: Fad or a New Form of Corporate Financing?

When we think of Initial Coin Offerings (ICOs), it's tempting to think of Bitcoin. However not all ICOs are grand projects designed to disrupt the social order by replacing central banks with a peer-to-peer network of distributed ledgers.

Partner Daniel Bastide and Trainee Solicitor Mark Gough examine whether ICOs are a fad or a new form of corporate financing.

What is an ICO?

When we think of Initial Coin Offerings (ICOs), it's tempting to think of Bitcoin. 

However not all ICOs are grand projects designed to disrupt the social order by replacing central banks with a peer-to-peer network of distributed ledgers.  
ICOs can be a source of crowdfunding for project financing. Businesses may issue cryptocoins (or “tokens”) which subscribers can then use to purchase certain goods or services from the issuer, which they wouldn’t normally be able to buy. A good analogy is buying tokens at the entrance to a fairground to spend on the rides. 

It is no accident that the term ICO sounds like IPO – Initial Public Offering – and in many ways it makes sense to think of cryptocoins as something more akin to shares in a company than a tradable currency like Bitcoin. 

How do ICOs work?

An ICO begins with a white paper – much like a prospectus – which describes the issuer’s intentions and the number of coins to be issued. Most issuers are start-up firms and will use an ICO as a form of crowdfunding whereby subscribers subscribe to the tokens to purchase future services or products from the issuer. 

Any company can hold an ICO, but tech companies with a background in blockchain technology are more likely to do so because ICOs come more naturally to such business models. But there is no reason why a company couldn’t partner with a blockchain business to hold an ICO.

ICOs are also often managed using “smart contracts.”  Each subscriber pledges to buy a certain number of tokens. If the amount of tokens subscribed to does not meet the minimum subscription level required for the venture to proceed then the subscribers’ cash is automatically returned. If the minimum number of tokens are subscribed to then the ICO proceeds and the investors’ cash is converted into tokens. 

Once in circulation, the value of the token may fluctuate according to the market demand for the product or services against which the token can be redeemed. Of course, there is always the chance that such tokens could cross over and become traded currency rising in value above the worth of the goods against which they are redeemable.  

What are the benefits?

For the issuer, an ICO is relatively quick and easy to set up compared to the lengthier and regulated procedure of an IPO with its scrutiny on a verified prospectus that provides greater investor protection. Legal fees for an ICO are considerably lower than for an IPO because the tokens are (at least initially) only redeemable against future products or services rather than tradable as regulated stock and there is a reduced level of regulation. 

An ICO provides the issuer with access to a wider pool of investors than might be available through the traditional venture capitalist channels. And there is no disputing that ICOs can certainly raise a lot of capital. According to the Financial Times on Monday 26 March 2018 so far, in 2018, 150 new ICOs have already raised more than $4.7 billion between them.

The ICO itself can generate publicity and act as a marketing tool for the issuer, with the trading of tokens advertising the business. Furthermore, the creation of tokens may create a sort of closed ecosystem of customers, and the subscription to these tokens is a measure of customer loyalty to the issuer. Social networking businesses are particularly well-positioned to take advantage of ICOs. For instance, the chat app Kik (with 300 million registered users) held an ICO to launch its “kin” token in September 2017. Tokens can be used by subscribers to purchase in-app products. Kik also uses its kin tokens to reward its users and developers for their contributions to the Kik community network.

ICOs are not exclusively used by smaller firms and don’t only disrupt the venture capital markets. 2017 saw the announcement of the first ICO by a blue chip company. KodakCoin is being launched as a token which subscribers can use to buy and sell digital images through Kodak’s online platform. 

The objective of KodakCoin appears threefold: it funds the company’s new online platform; it generates great publicity for Kodak; and, most importantly, it is designed to enable Kodak to enforce image copyright to capture more royalties in the absence of a single global rights management platform for image licensing. Kodak’s web crawlers will search for licensed images and enforce copyright on those images that match its database list. Smart contracts will be used to invoice image users while simultaneously paying the rights holders in KodakCoin. It remains to be seen whether the KodakCoin will take off as a currency for buying and selling images. But the markets were impressed: Kodak’s share price tripled following announcement of its ICO.

For the investor, ICOs open up opportunities – especially in the venture capital market – that had previously been blocked by the layers of brokers and fund managers, and restrictive entrance rules. 

Retail investors can invest smaller amounts and purchase tokens directly from the issuer, rather than minimum buy-ins and paying commission to a broker. The accessible nature of cryptocurrency exchanges mean that investors can also sell their tokens whenever they find a buyer, rather than being locked into an investment for a minimum period.

Of course, the danger is that start-ups are inherently risky and open to speculation. Most new cryptocurrencies are quickly forgotten. The coins either fail to attract take up or the projects they were created to fund fail. Estimates of failure rates vary widely  – from 58% to 99% – because there are no reporting requirements or reporting standards for ICOs. This brings us to regulation.

Regulation

In April 2018 in the USA, the Securities and Exchange Commission chairman appeared to warm to ICOs as having incredible promise. Nevertheless, he objected to the terminology of “tokens” to describe what he argued are securities – pure and simple – and should be subject to the same rules as securities: 

"If I have a laundry token for washing my clothes, that's not a security. But if I have a set of 10 laundry tokens and the laundromats are to be developed and those are offered to me as something I can use for the future and I'm buying them because I can sell them to next year's incoming class, that's a security.”

In the USA, securities offerings are exempt from registration if they are intended for “accredited investors” only (those with an annual income of $200,000 or $1 million net worth). At present - just to be safe it seems - KodakCoin is open only to accredited investors. 

In the UK, at present, ICOs are unregulated. Or – more precisely – ICOs may already be subject to regulations, but this remains untested. The FCA’s position is that “Whether an ICO falls within the FCA’s regulatory boundaries or not can only be decided case by case.” The FCA was content merely to issue a consumer warning in September 2017 of the risks of investing in ICOs.

For instance, if tokens are defined as a “transferrable security” then, pursuant to section 85 FSMA 2000, issuers will be required to complete a prospectus. EU Directive 2014/65/EU currently defines “transferrable security” as something tradable on the capital markets. While this may apply to Bitcoin, it doesn’t yet apply to, say, Kin. Similarly, if trading tokens falls under the prohibition of a regulated activity pursuant to section 19 Part II, FSMA 2000 then only authorised or exempt persons can trade them. But until the Treasury makes an order specifying tokens from ICOs as a “specified investment”, anyone can trade them.

The most immediate form of regulation likely to target ICOs in the UK will probably take the form of anti-money-laundering measures. 

Indeed, the economic secretary to the Treasury told Parliament in November last year that the UK and the EU were currently in negotiations to “bring virtual currency exchange platforms and custodian wallet providers into Anti-Money Laundering and Counter-Terrorist Financing regulation” under the control of national authorities. New measures are likely to require trading platforms to check transactions involving large sums of money with the aim of removing the anonymity of investors in these tokens. On Thursday 19 April 2018, the European Parliament voted in favour of regulating cryptocurrencies.

Summary

In summary, given last year’s Bitcoin bubble, investors are right to be cautious of each new ICO. However, it would be a mistake to dismiss ICOs as a fad or a game for speculators, as ICOs are potentially lucrative opportunities for corporate financing. The proven benefits of ICOs are not just limited to funding start ups. Larger firms such as Kik and Kodak are already taking advantage of ICOs to develop loyal user communities, sell unique licensed products, improve revenue flows, and raise publicity by growing their brand, as well as their share price. 2018 is likely to see attempts to regulate ICOs and may even define crypto-tokens as a new type of security.

Watch this space.


 

IM Connect Spring 2018

Key Contact

Daniel Bastide