October 1, 2017

The Rise (and Fall?) of Initial Coin Offerings

Shawn S. Amuial

Initial Coin Offerings (ICOs) have risen from relative obscurity not much more than a year ago to a multi-billion-dollar investment bonanza this year. Despite their origins in a fundraising experiment gone wrong with the collapse of The DAO (more on this later), extraordinary returns and high liquidity have attracted the likes of marquee investment and venture capital funds eager to get in on the action. However, investing in ICOs is not for the faint-of-heart, or investors and businesses that do not appreciate the potentially unpredictable and mostly uncharted nature of this emerging investment space. ICOs are impacted by several regulatory regimes, often across several jurisdictions and numerous government regulators. Filecoin’s recent capital raise is one example of an attempt to bring greater certainty to the space, but, as described below, the Simple Agreement for Future Tokens (SAFT) that was used by Filecoin resulted in a financing transaction that was quite far from an actual ICO and may indicate a real change in the future of ICOs.

For readers who are not yet familiar with ICOs, first and foremost, you should know that in general  anyone with access to the internet can make the transfers necessary to invest in an ICO without breaking a sweat. Even creating an ICO as an issuing company is relatively simple from a technical perspective. To date companies making ICOs are typically seeking seed-stage funding for the early development of new businesses involved in leveraging distributed ledger or blockchain technology to disrupt a particular industry. Investors make their investments by transferring to the issuing company either fiat currency (government-backed legal tender) or cryptocurrency (e.g. Bitcoin or Ether), in exchange for a proprietary cryptocurrency issued by such company; frequently called a “token,” it’s the “Coin” in Initial Coin Offering. On some level, certain ICOs can be likened to a Kickstarter campaign on steroids where a funder’s right to receive the cool new thing can be traded on an exchange that is similar to a stock exchange.

The simplest example of a token is a coupon for a product or service of the issuing company. For example, an early-stage company might offer for each token it sells the right of the holder of such token to receive a widget that will be created sometime in the future. Beyond the inherent value resulting from the potential difference between the eventual sale price of such widget and the discount received by a token holder, many investors in an ICO ultimately intend to sell purchased tokens on one of several exchanges that provide for appreciated tokens to be sold to other investors for a return at any time. Such exchanges can make tokens a highly liquid investment.

To date, ICOs have been completed with virtually no regulatory oversight making them a faster and easier way to raise capital. With investors and businesses eagerly moving forward without the protections that are typical of other types of investments, the issuing businesses selling tokens may find the SEC knocking at their doors (or if accompanied by friends from the FBI, knocking down their doors) in the not-too-distant future. The SEC has shown some of its hand in its recent report regarding The DAO.

The DAO was established in early 2016 as one of the first high-dollar ICOs (though it was not branded as such at the time) on the Ethereum blockchain. Soon after it raised over US$150 million, approximately a third of this amount was stolen in an attack that exploited a bug in The DAO’s software, sending the venture into a tailspin. On July 25, 2017 the SEC issued a report focused on the events surrounding The DAO. The SEC’s report unsurprisingly establishes that organizations issuing tokens are subject to federal securities laws if those tokens meet the definition of a security and the SEC concluded that the tokens issued by The DAO were, in-fact, securities. Many businesses have gone to great lengths to brand, or rebrand, their tokens as “utility” tokens or “appcoins” in an effort to differentiate their tokens from those of The DAO. Some, however, sought a more conservative path, which led to the establishment of the SAFT.

Styled off of the popularity of a Simple Agreement for Future Equity (SAFE) in early stage startup investing, the SAFT captures the excitement around ICOs without actually issuing any tokens or creating a market for any tokens. The SAFT says to investors, “Make your investment now and we’ll make sure that you get tokens at a discount if we ever offer tokens later.” If an ICO doesn’t happen prior to a certain date or certain events, the investor theoretically gets his, her or its money back (if there is any money left to pay back) without any interest or any other return. Until then, an investor in a SAFT has an illiquid non-transferable investment that is really nothing like a token. With a SAFT there is certainly the potential from an investor’s perspective to receive a token at a discount at some point in the future and that potential economic upside should not be ignored, but at their core SAFTs are really about businesses ginning up investor interest by raising money relating to this hot new way to invest called an ICO (even if there is no ICO)..

Media coverage of the recent SAFT offering by Filecoin is surprisingly inaccurate from most outlets. Not recognizing the nuance that each investor has entered into a SAFT and not purchased tokens, numerous outlets describe the “Filecoin ICO” raising over US$200 million.  There has not been any Filecoin ICO and, based on its SAFT documents, Filecoin hasn’t even promised its SAFT investors that it will do an ICO at any time in the future. This was a two hundred million dollar branding coup.

With that, the SAFT may spell the beginning of the end for ICOs as we have known them to date for two primary reasons:

First, the turn towards a SAFT as the investment vehicle is a clear indication of the understanding of sophisticated parties in the ICO space that regulatory impediments are imminent. In addition, as venture and securities lawyers in particular begin to lay out the parade of potential risks associated with ICOs, even extremely risk tolerant entrepreneurs are likely to flinch. The SAFT itself is also a concession, in many respects, that the tokens sold in ICOs (however those tokens are branded) are securities that need to be registered or exempt from registration under applicable law and, perhaps even more importantly, the exchanges on which tokens are traded also have registration requirements under applicable law.

Second, there is a high likelihood that even where there are very clear investment documents, investors in SAFTs will feel duped by an investment structure that gives them none of the benefits of an actual ICO unless an ICO actually happens at some point in the future. In the absence of an ICO, SAFTs typically won’t need to be repaid for a number of years, and meanwhile those investors will hold a totally illiquid “investment” with no possibility of a return.

Although blue chip entrepreneurs and investors may start to sour on the types of ICOs that we have seen over the past year, it will take quite some time for such ICOs to fall off the radar as the cryptocurrency world continues to support them despite regulatory risks. But as the old ICOs slowly fade, we see a new type of ICO on the horizon that will perhaps be more complex, not as open, and will be designed to fit within the requirements for securities and exchanges in a regulatory environment that investors and businesses have lived under since the 1930s.

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