Using ICOs to Raise Capital
Using an Initial Coin Offering as a mechanism to raise capital seems to be in vogue. But how does this financial mechanism actually work? And how it is better than just raising capital with traditional currency?
Creating a Cryptocurrency
Creating a new cryptocurrency it extremely simple. You only need to decide on the following points:
- Total supply (# of coins)
- Name of your new currency
- Set the number of decimal places for the coin
- Coin symbol (like a stock ticker symbol)
With that and a click of the mouse, you can create a new digital currency. But creating a coin and marketing/selling it in exchange for real money are two entirely different things.
Marketing Your Currency
The road show is fully electronic in the ICO world. Instead of holding multiple in-person meetings with money-people, as is done for a traditional IPO, most ICO issuers create a white paper that describes their project. The white paper is then distributed to potential investors.
Dodging the SEC
Isn’t an ICO really just a capital raise (or IPO) in disguise in an attempt to dodge SEC Regulations?
Kind of. Yeah. At least is would seem that is frequently the case.
Sure, there are “Utility Tokens”, which are coins that are created for a specific operational purpose. And they have their place. But you can be sure that all the media hoopla isn’t about Utility Tokens. It’s about digital coins that act like Securities. And that is the crucial difference from a regulator perspective. Is the coin a “Utility Token” or is it a “Security”?
What’s the SEC’s position on ICOs?
On December 11, 2017, Jay Clayton, Chairman of the SEC, wrote a “Statement on Cryptocurrencies and Initial Coin Offerings”. While still under review, the Chairman’s thoughts can be summed up in the following excerpts:
“By and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws. Generally speaking, these laws provide that investors deserve to know what they are investing in and the relevant risks involved.”
“I have asked the SEC’s Division of Enforcement to continue to police this area vigorously and recommend enforcement actions against those that conduct initial coin offerings in violation of the federal securities laws.”
In a separate, earlier statement on July 25, 2017, the SEC wrote:
“The Commission stressed that those who offer and sell securities in the U.S. are required to comply with federal securities laws, regardless of whether those securities are purchased with virtual currencies or distributed with blockchain technology.”
“Depending on the facts and circumstances, the offering may involve the offer and sale of securities. If that is the case, the offer and sale of virtual coins or tokens must itself be registered with the SEC, or be performed pursuant to an exemption from registration. Before investing in an ICO, ask whether the virtual tokens or coins are securities and whether the persons selling them registered the offering with the SEC.”
“If the virtual token or coin is a security, federal and state securities laws require investment professionals and their firms who offer, transact in, or advise on investments to be licensed or registered.”
While regulators have issued position statements, it seems they are waiting to see how the market for digital coins unfolds before writing new regulation on the topic. Or perhaps they will decide that existing regulations are sufficient.
What Makes a Coin a Security?
Traditionally, the SEC has devised specific criteria to test if an instrument is a security. This test is called the “Howey Test”. The Howey test relies on three components, which all must be met to call a particular offering a security:
- An investment of money
- An investment of funds in a common enterprise
- An investment with an expectation of profits predominantly from the efforts of others
#1 is generally met with all ICOs… in that actual government-backed fiat currency is used to purchase cryptocurrency, which is then used to buy / invest in the new ICO currency. So, point #1 = TRUE.
(Technically, new ICO coins are often purchased with more established digital currencies like Bitcoin and Ether, which were in turn purchased with established fiat currencies, like the USD.)
#2 is also generally met with ICOs. In fact, it’s difficult to think of examples where this wouldn’t be true for ICOs. Perhaps if the funds were used as a fund-of-funds scheme to invest in a multitude of enterprises… but this seems like splitting hairs since the fund itself is a common enterprise, although one step removed from the end investment.
#3 is where it gets opaque. And I suspect SEC rulings on this point will be in part determined by the language of the marketing material (white paper) as well as common-sense reasoning. Does the cryptocurrency serve a utility-purpose, or is it just an investment into an enterprise?
ICO’s Using Reg D Exemptions
If issuers of the new digital coins follow the reporting requirements for Rule 144 and file an exemption (like a Reg D exemption), I suspect the SEC would not care if the offering was in traditional fiat currency or in digital form.
NOTE 1: The SEC’s Rule 144 allows for public resale of securities if certain conditions are met, mostly centered around the sophistication of the investors (as defined by their income or net worth) and the number of total investors.
NOTE 2: I hope it is obvious that this is not legal advice, but merely my unqualified opinion.
Why Do an ICO?
If an issuer is going to file an exemption with the SEC, why issue a digital coin and not just traditional shares in exchange for dollars? I can think of a few possible reasons, most not sufficiently compelling, except the last one:
- To capitalize on the current hype of digital currencies. This is purely a psychological reason, not an operational reason.
- To potentially reduce transaction costs and improve coordinated governance, given the ease at which digital currencies are created, traced and transferred.
- To better facilitate a secondary market of shares/coins because of the traceability of digital coins.
- The coin has actual real-life utility that allows the company to achieve an operational objective. For example, the ability to make micro-payments, especially for gaming companies.
ICOs are simple to create and are new enough that their actual role in the capital raising process has yet to fully solidify. The question remains – is there a notable benefit for an ICO if it mostly behaves like a traditional security? My opinion, without a utility value associated with the coin, the benefits are minimal… at least for now. But technology evolves.