Initial Coin Offerings (ICOs) – essentially, crowdfunding the sale of a digital bearer instrument whose sole record is on a blockchain – threaten to disrupt traditional funding methods, including public offerings and venture funding. Their popularity is blossoming along with the spread of blockchain technology and budding global investor interest in digital currencies such as Bitcoin and Ether.
In 2017 through July 31, there have been 92 ICOs collectively raising $1.25 billion, and in recent months ICOs have outpaced global angel and seed stage internet venture capital funding. More important than the crowdfunding feature is the embedded incentive to create an initial user base for digital products and services on the blockchain, which defines a "utility token."
Louis Lehot and Mark Radcliffe, partners at DLA Piper in Silicon Valley, recently hosted an event and panel discussion produced by DareToKnow founder Sam de Brouwer around the topic "Is the ICO the Next Killer App on Blockchain?" Special guests included Spencer Bogart, managing director of Blockchain Capital; Juan Benet, founder and CEO at Protocol Labs that makes Coinlist, and just completed an initial SAFT offering for Filecoin; Vinny Lingham, co-founder and CEO at Civic Technologies; Natalia Karayaneva, CEO at Propy; and Matt Chwierut, head of research at Smith and Crown.
Following the standing-room only event, regulatory agencies have intervened and provided some clarifications related to ICOs. First, on July 25, 2017, the Securities and Exchange Commission (SEC) issued a press release, detailed statement and full investigative report that certain tokens would be considered securities. You can learn more about what the ruling means in The Venture Alley blog.
Then, on August 1, 2017, the Monetary Authority of Singapore issued a statement clarifying that not only were certain tokens likely securities, but that issuers must also take precautions to comply with anti-money laundering and terrorist financing regulations.
Below are highlights of the panel hosted by DLA Piper, including the viewpoints of executives from companies that recently completed ICOs.
Introduction to ICOs
Spencer Bogart kicked off the event with a nine-minute presentation on the history of ICOs: What they are, why they are conducted, reasons for participating, what the market is like, as well as providing various considerations. On the plus side, Spencer highlighted universally empowering technology, the ability to control your own financial assets, money, identity and permissionless innovation.
On the negative side, Spencer noted behavior similar to penny stock manipulation involving securities issuers and promoters. On the irrational side, Spencer noted a kind of irrational exuberance developing among participants, many of whom may be investing without thinking it through.
What's the value of holding an ICO?
Spencer Bogart, CFA, head of research at Blockchain Capital: There are two primary reasons that a company would hold an ICO. One is to build and incentivize its user base, and the other, clearly, is to raise funds. Blockchain and Bitcoin are empowering innovation at a very rapid pace. On the other hand, there has been questionable behavior and reckless profit-seeking in some parts of the market. This can happen in new and largely unregulated markets.
What's ahead for the token and ICO market?
Spencer Bogart: The future is wide open, but I am confident that it will be positive. At Blockchain Capital, we've both done an ICO and invested in ICOs. We've raised a venture fund through an ICO. We think this can be an improvement in liquidity over a traditional venture fund. I think we'll see ICOs and tokens disrupt the VC market.
And we wouldn't be investing in the ecosystem if we thought that's where it would stop. The only real question is the breadth and depth of the impact – and whether it will occur within the traditional financial system or outside of it. It's a square-peg-round-hole problem. Most financial institutions can't work with this kind of technology – it's hard for traditional financial institutions to use.
Another important area to be determined is the regulatory treatment. Government regulation could discourage the best developers. There will still be international jurisdictions, but if there is a regulatory framework for doing this responsibly and, in a high-quality way, you'll see better teams.
However, it is inevitable that we'll see the growth of blockchain and ICOs. These things are just more functional than their offline counterparts, so the impact is going to be significant. Two examples are multi-signature transactions and time-lock transactions. Both under traditional methods require hours of legal time and establishment of trusts. In Bitcoin, that's reduced to a couple lines of code.
Louis Lehot: Anyone considering an ICO needs to consider the regulatory environment, both in the United States and everywhere else. Many issuers are considering using entities in Switzerland and Singapore but they need to understand the trade-offs. Leveraging our global footprint of offices in over 40 countries, DLA Piper is working hard to help companies and investors analyze these options, noting that seven out of every ten ICOs are being directed at participants outside the United States. Being able to coordinate those activities is a key factor in selecting advisors.
[After the SEC announcement, Lehot commented to Bitcoin Magazine that this analysis of trade-offs is even more important.]
Mark Radcliffe: I agree with Louis that the dynamic regulatory environment means that companies considering an ICO need to understand the risks. In addition to securities laws, issuers may need to consider the money transmitter and tax laws.
Another very exciting opportunity presented by tokens is to solve a significant problem in the open source ecosystem: rewarding contributors to open source projects. The dramatic growth of open source projects has outstripped the supply of developers who can contribute to them without compensation. Tokens offer a means of encouraging such contributions.
John China, head of technology, Silicon Valley Bank: As the leading commercial bank in Silicon Valley, and a champion of innovation, we look for ways to work within the regulatory environment to support new technologies and ideas. Given the level of attention, this is an area of consideration since it's clear that both startups and large companies see opportunity in blockchain technology and ICOs.
What makes a specific business model successful on blockchain?
Natalia Karayaneva, founder of Propy, Inc: Blockchain is a very efficient technology for the transfer of digital assets. For instance, in the real estate sector, you have one of the largest asset classes in the world, yet it's still not tradable like most other core assets. Blockchain may create opportunities to make this asset more tradable.
While historically governments have applied archaic technologies for tracking and recording various property transfers, visionary governments around the world are starting to trust blockchain, including those in Delaware, Switzerland, Estonia, Singapore, Dubai, and most recently Ukraine.
Juan Benet, founder of Protocol Labs: You should think about crypto assets as any financial instrument embodied in a digital way. This is very general technology. What are tokens and how can they be used in a business model? You should model the exchanges of value potential as a token. A lot of people say that tokens are a lot like equity, but that's not quite right. In some token structures, participants who share assets can participate and win more tokens, or they can get the value of their tokens to increase by doing other things.
Is a token a security?
Juan Benet: Just because tokens have certain market aspects of securities doesn't mean they are securities. When you create a service, you should think about modeling that economy. Model it with an asset and then consider whether you have a viable business model for a token. Only then should you think about an ICO.
Natalia Karayaneva: Organizing a token sale for Propy, I witnessed the crypto community and lawyers define two types of tokens: a security token and a utility token. If your goal as a token creator is to grow the ecosystem and attract people to your platform, the utility token is perfect because it can represent a future good or service and unlock associated smart contracts. It allows token creators, from a regulatory perspective, to run the token sale with low legal risk. It also allows the network growth pools, as at Civic and Propy, to attract users to the platform.
I see security tokens as similar to a share of a company, entitling holders to a portion of its revenue, dividends, or to vote. They may also include investment arrangements where holders depend on others to develop the company or its network in order to make profits.
To issue a security token and comply with the US laws, the token issuer may need to register the transaction or comply with an exemption. Many security token creators avoid selling tokens to US residents out of regulatory concerns. However, having the secondary market could attract US purchasers to buy those tokens at exchanges. If your business model is built around product or service development and not around a fund or DAO development, consider a utility token with precise attention to the model that does not give rights and dividends to token holders. Security tokens have a longer, more complicated and risky path.
Juan Benet: The best teams pay very close attention to the structures of the network. They are careful to create a very open environment. Usually, these projects start months or years before considering an ICO. They focus again on the economy and creating an economy of value.
Classifying something as a security sometimes means you can only offer it to accredited investors, meaning they must have money. The problem is some of these people who are not accredited investors are most equipped to develop and invest. Perhaps there's an opening here, when we think about creating a market itself for people who can produce.
Vinny Lingham, chief executive officer and co-founder of Civic: Token offerings are going around the traditional financial system of securities and stock exchanges. There are millennials who want to take on risks. With the way capital formation is changing, they want access to crypto assets. In the future, there may be financial assets – real securities – transferring on a peer-to-peer level, not through traditional stock exchanges. Stock exchanges have regulations to comply with, but they can do that in a decentralized fashion. You can do all customary regulations in a smart wallet and transfer it to someone else. If something isn’t allowed, the smart contract can block it. If we take too hard a stance in the US and lock this down, we’d be going down the wrong path.
Will traditional and Fortune 1000 companies enter the space?
Matt Chwierut, head of research at Smith & Crown: Kik is the best example of an established company with an established user base that has announced its intent to hold a sale. We do think there is a lot of potential here. What makes sense on a blockchain? Ten years ago, we asked what made sense on a social network. It's usually easy to spot bad ideas on the blockchain, but every month, we come across models we've never seen before.
The industry uses a distinction between security tokens and utility tokens, but we think there are further distinctions. The 'utility' of any particular token varies immensely, and this variation has implications for a project's business model, token valuation and even regulatory concerns. This is an area of rapid experimentation in the industry right now, and we think tokenization will continue among new and established businesses.
Juan Benet: All financial and legal transactions that happen around the world have two characteristics – high transaction and high settlement costs. With blockchain, the transactions and settlements are virtually free. We're just agreeing on the code. And we're agreeing to behave exactly as the code implies. We're seeing the transformation of a whole bunch of different transactions and industries because this significantly reduces those transaction costs. That will translate into more traditional players entering the market.
[Following the event, Juan Benet's Filecoin, a decentralized cloud storage network, raised almost $188 million in the first hour of its offering through CoinList, after raising $52 million the previous week in a pre-sale to advisors of simple agreements for future tokens that will convert automatically in the future into tokens.]