An initial coin offering (ICO) is a method for companies to raise money to fund the venture. Basically, the company creates its own digital or virtual currency like Bitcoin or Ethereum. In doing so, the company creates its own digital platform. The platform allows for the transfer and storage of the virtual currency. The company creates a token or coin that represents future value on the company’s platform. The company distributes the currency to individuals interested in owning the currency. The virtual currency is not able to be used immediately to purchase services; but, it is believed the currency will be used in the future on the company’s virtual platform. There is generally a fixed number of tokens or coins to create a sense of scarcity among holders. The coin has a current token value (or is sold at a set price) that is less than what it represents on the virtual platform, thus investors wish to hold it. Basically, the company is selling an asset indirectly. The token or coin is a speculative asset (it has a perceived value) that may ultimately represent actual value on the company’s virtual platform. If the company’s platform never fully develops, the token or coins will have little or no value.
No Debt or Equity in an ICO
The Initial Coin Offering (ICO) allows the startup company to raise money without selling equity or taking out debt. Incurring debt burdens the company to repay the debt and make interest payments. This can stifle the company’s ability to use revenue for growth and development. Selling equity in the company diminishes the founders’ ownership interest and ultimately surrenders a level of control to the investors. Further, unlike debt and equity, selling tokens or coins does not entitle the purchaser to anything. If the virtual platform is never completed and the token or coins ultimately lose or have no value, there is no recourse for the coin issuer.
Earlier Access to Capital
The ICO generally allows the issuing company to raise capital before it would otherwise be able to through venture capitalists or lenders. Venture capitalists generally require the company to have stable operations and signs of dependable growth. Lenders look for company assets to secure repayment of the loaned funds. The Initial Coin Offering generally takes place before the company’s platform is fully developed. Whatever product or service is being offered by the company (generally some form of software as a service) is generally not fully developed. As such, there is not dependable source of growth or assets to meet the requirements of investors or lenders.
Availability of Technology
The mechanics of the coin offering are generally far less daunting than it appears to non-technologists. Companies do not have to entirely construct their own platform for issuing and storing tokens or coins. The software used to build a virtual currency platform, such as Bitcoin and Ethereum, is generally available for free as an open-source platform. As such, the company is able to employment this structure and make modifications to the system to accommodate the specifics of the token or coin offering. This makes the coin offering process less burdensome and available to a greater range of companies.
Lower Competition for Purchasers
In today’s investment environment, managers of money funds seek to be a part of the newest trend with the greatest potential for return. This is why Bitcoin and Ethereum became so popular with investors. Traditional securities are part of an established market. The depth of knowledge of these securities makes pricing more accurate and reduces the potential for major gains from buying and selling them. ICOs are still the new kid on the block. There are less tokens or coins from ICOs than other forms of securities (such as stocks or bonds). Investors don’t want to miss out on the offering’s potential upside, so they are more will to purchase the asset with less knowledge or insight about its current value.
Regulators have been slow to respond to the emergence of Initial Coin Offerings. The current regulation regime is poorly constructed to deal with these coin offerings. The result is that ICOs have been made illegal in certain countries, such as China and South Korea. In the United States, ICOs fall under the regulatory control of the Securities Exchange Commission and state regulators as a “security”. 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 primary determination is whether the expectation to earn a profit from purchasing and holding a virtual currency is “derived solely from the efforts of others”. Many coin offerings meet this defection if the token or coin is ultimately backed by the issuing business. In some cases, however, the coin offering is issued on an independent or open-sourced platform. The token or coin is decentralized and not directly backed by the company. The issuer simply represents that the independent value of the token or coin will be respected by the company, along with other forms of currency. These types of issuances are difficult to construct, by can fall outside of standard securities regulation. In such a case, this makes the issuance outside of the current securities regulatory regime.
For these reasons, company founders strongly prefer the coin offering to the these traditional methods of raising capital.
LawTrades Knows Virtual Currencies
Undertaking an initial coin offering is fraught with risk. A company must be careful to navigate the applicable securities regulations. If you are considering an initial coin offering, contact the legal professional at LawTrades. They can advise you on an investment contract and every step of the process to avoid the many potential legal pitfalls.