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How ICO’s Work

Cryptocurrency has taken off in recent years and now account for billions of dollars raised by companies, but how do ICO’s work?  Initial Coin Offerings allow startup companies to raise money without taking on debt or selling an equity interest in the company to investors. Rather, the startup is able to raise money by selling a virtual currency that they have created.  A company undertaking a coin offering creates and sells a virtual currency that is similar in nature to Bitcoin. The token is either tied to a monetary investment, or allows access to an online platform where the token can be exchanged for services or proprietary information.  

 

Benefits of an ICO

Though more complex than traditional fundraising, there are many benefits of an ICO.  This method allows a company to raise capital before it would be able to access capital through traditional methods, such as venture capitalists or lenders. Also, the company does not lose control or become beholden to new company owners. The downside for purchasers of coins is that they have little rights or recourse if the company or platform that the company is building never materializes.

 

How Digital Currency Works

Before understanding ICO’s, it’s important to understand how digital currency works.  The issuing company uses a technology platform that it has created or is in the process of creating to initial sell, transfer, and store the offered coins. Companies carrying out the initial coin offering generally take one of two approaches to building a platform for the offering. They either contract (code) a platform from scratch or employ the technology contained in existing platforms. The software used to build a virtual currency platform, such as Bitcoin and Etherum, is often open source and available to anyone for free. A computer coder with an understanding of how the platform operates can make modifications to the system to accommodate the specifics of the coin offering.

 

Digital Currency Values

Another important factor to consider is that digital currency values are inevitably tied to the platform where they’re used. The company will generally authorize a fixed number of coins, so as to create a sense of scarcity. During the initial coin offering, the coins are generally sold at a set price. The coins will later be traded on a virtual currency exchange or via direct trade between coin holders accessing the initial distribution platform. Naturally, the startup maintains control of a large number of coins in hopes that the value will increase as demand increases.

 

Effective ICO Marketing

Because the coin holder generally does not receive any equity or ownership percentage of the issuing company, it’s important to put a lot of emphasis on effective ICO marketing to attract investors.  Again, because the coin is inevitably tied to the platform, it’s important to make a strong case for the utility and value of the overall service you’re providing, and the potential it has in the larger industry.  If any investor doesn’t see a future for the company, there isn’t a use for the currency, so it’s best to make ICO marketing a priority during the process.  

 

What are Some ICO Regulations?

There are a variety of ICO regulations depending on the type of service you’re creating.  Some cryptocurrencies, including the currency issued in a coin offering, have been made illegal in certain countries, such as China and South Korea. In other countries, the coin offerings are heavily regulated. This is true for certain types of coin offerings within the United States. In the United States, virtual currencies are subject to regulation if they are categorized as securities. Section 2(a)(1) of the Securities Exchange Act of 1933 (“1933 Act”) provides a definition for what is a security. The long list does not include modern digital assets. The catch-all type of security is known as an “investment contract”. The question then becomes whether a cryptocurrency is considered an investment contract, and thus a security, under the securities laws. In determining whether a cryptocurrency is an investment contract, ask this question (known as “Howey Test”):

 

1) Is there an investment of money,

2) into a common enterprise,

3) with the expectation of profits,

4) derived solely from the efforts of others?

 

The central issue is whether the expectation to earn a profit from purchasing and holding a virtual currency is “derived solely from the efforts of others”.

By its nature, an initial coin offering meets all of the elements of the Howey test. It is an issuance backed by an issuing business entity. As such, coins or tokens issued in an ICO are considered securities, and their sale or exchange will be subject to securities laws. If the coins offering is centralized, but are structured more like a consumer item than a security, then it may escape securities regulations.

 

Consult a Cryptocurrency Lawyer

Undertaking an initial coin offering is fraught with risk. A company must be careful to navigate the applicable securities regulations. Further, the company must be careful in making any assurances or representations to purchasers. If you’re considering an ICO, LawTrades works with some of the most experienced cryptocurrency lawyers in the country. They can advise you on every step of the process to help make your platform launch as successful as possible.