Initial Coin Offerings (ICOs), an alternative financing mechanism increasingly used by tech businesses, have grown at a spectacular rate in the past two years. According to CB Insights, over $2 billion has been raised across 250+ ICOs as of January 2016. The rate of acceleration is astonishing given that ICOs only appeared in 2013/14. Regulators around the world, including the Securities Exchange Commission (SEC) in the US, the Financial Conduct Authority (FCA) in the UK and the People’s Bank of China have weighed in with concerns over the potential for fraud and breaches of securities regulation, whilst the Isle of Man is paving the way for a legally compliant ICO. The pace at which this market is developing is bewildering. So what exactly is an ICO, why the hype that surrounds it and what is the next step in the evolution of cryptocurrencies?
Unlike an Initial Public Offering (IPO), an ICO does not technically offer the sale of shares in a business and thus ICO ‘investors’ are not considered shareholders of said business. An ICO is rather more like a crowdfund than an IPO; the process involves the issuer offering tokens, in effect a new cryptocurrency based on blockchain akin to the likes of Bitcoin and Ethereum. Supporters of ICOs therefore are essentially exchanging fiat currency, usually in the form of Ethereum or Bitcoin, for tokens which incorporate predefined and codified smart contracts that determine how they can be used, for example for the exchange for services or products offered by the issuer. ICOs can therefore, in theory, be an excellent mechanism to crowdfund the development of a specific product or service whose value lies in the utility created for its backers who can exchange their tokens to benefit from that utility without diluting the founders’ stake in the business. Equally, should the product or service work as expected, more users will be attracted to it, which will increase demand for the tokens, resulting in an increase in their value. Early adopters and holders of these tokens could therefore benefit from this increase in value.
This latter attribute, namely the potential increase in value of tokens in the future, introduces uncertainty as to whether they can be considered securities and thus are in the purview of regulators, or whether they simply fall out of current securities regulation. ICO supporters claim the fundamental purpose of the ICO is to provide financial capital to support the development of a specific product or service and the tokens received in exchange do not represent a share in the business. The Howey Test, the result of an SEC case to determine whether an offering is a security or not, yields an interesting conclusion in this context, and many ICOs: If there is an investment of money in a common enterprise with the expectation of profit from the effort of others, the investment is considered a security.
The meteoric rise in value of Bitcoin and Ethereum, and the successful raises of numerous ICOs, seems to have distorted the aforementioned fundamental purpose of the ICO, with large pools of capital speculatively chasing similar rises in value of these alternative tokens. Such speculation clearly fails the Howey Test. So much is the hysteria that a recent ICO, launched by an anonymous individual as a satirical take on the mechanism, issued Useless Ethereum Tokens (UETs), plainly and transparently offering nothing; the ICO raised just over 310 Ethereum tokens, equivalent at the time to approximately US$95k. That there are individuals willing to ‘invest’ in such ICOs suggests that many don’t fully grasp what they are getting themselves into, or perhaps ICOs are being used to launder money, in the same way for which Bitcoins have been used.
Although the UET example was not intentionally fraudulent, numerous examples of fraudulent ICOs exist, including those endorsed by irresponsible celebrities such as Paris Hilton, Floyd Mayweather and DJ Khaled. For this reason, the UK’s FCA and the SEC in the US have both issued advice to investors, heeding caution. The SEC has also decided that any ICOs issuing tokens that function like securities will be treated as such, though as illustrated earlier determining this is far from straight forward. The People’s Bank of China has gone as far as banning all ICOs and has required issuers to return all money raised to their ‘investors’.
Given that a successful ICO may result in a business potentially never having to raise any traditional venture capital, VCs are beginning to wade into this space, investing as both as GPs, directly gaining exposure through buying tokens or via equity in businesses issuing tokens, as well as LPs in funds established exclusively to invest in tokens. The jury is out as to whether ICOs are a fundamental threat to the traditional VC model in the long term.
Cryptocurrencies, tokens and the blockchain technology on which they are built clearly have the ability to revolutionise a range of industries. In this world, it is still very much the digital wild west where responsible governance, both through self-regulation and restraint, and perhaps regulatory intervention, will be needed. Only time, and inevitably some unfortunate disasters as fraudulent ICOs and their uninformed speculators work their way through the system, will determine how this market develops. For the time being, the old adage ‘buyer beware’ cannot be emphasised enough. Stay tuned.