WHAT ARE Initial Coin Offerings – 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. Initial Coin Offerings (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, 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’ that 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 PHENOMENON

Crowdfunding is a recent phenomenon using the power of the internet where a project or company can be funded by raising small amounts ofwhere 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 Indegogo, 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 Initial Coin Offerings (ICOs) have different characteristics, and the generalisations 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 Initial Coin Offerings (ICOs) work?

Companies describe a particular product or service in a document called a whitepaper and announce their ICO. Investors 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 cryptoasset 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 Wikipedia, 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 Nakamoto.
Ethereum was initially described in a whitepaper written by Vitalik Buterin, followed by a technical yellow paper 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 typically cover a range of aspects related to the project. These include the goal of the project, milestones for product development, the project team’s background, expected fundraise value, funds management, token purpose and use, as well as token distribution details.

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!

Initial Coin Offerings (ICOs): The Token Sale

Although Initial Coin Offerings (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 terminology.

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 pre-sales, at least until the project has delivered a useful product and the tokens could be re-defined as utility tokens.

Projects sell tokens

Those projects who sell tokens that are likely to be classified as non securities have 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. Initial Coin Offerings (ICOs) can go from the first funding round to having their tokens listed on a cryptocurrency exchangefunding 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.

Initial Coin Offerings (ICOs) 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, which was devised and popularised by digital currency lawyer Marco Santori among others, in an effort towards industry self-regulation.

The SAFT is an agreement that is modelled on a Simple Agreement for Future Equity, 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.