ICOs and hybrid token offerings — a legal perspective

Whether it’s to launch products or raise capital, startup companies are increasingly looking to new forms of financing enabled by distributed ledger technology.  

Although publications have reported different numbers regarding the amount raised through initial coin offerings (ICOs) and token sales the amounts are impressive nonetheless, ranging from $4 billion to $6 billion in 2017. The recent success of Telegram’s ICO, in which the pre-sale reportedly raised $850 million, is an example of this potential.

Many of these ICOs represented the first round of capital raising for companies that otherwise would never have been able to fund raise from traditional venture investors using conventional capital structures.

We are also seeing a parallel trend for VC-backed startups: These companies too are exploring how to ‘tokenize’ their business, using blockchain technology and raising non-dilutive capital through an ICO.

Existing businesses that decentralize themselves by issuing tokens in the company are described as “reverse ICOs,” but we believe that a more appropriate name is a “hybrid token offering.”

The regulatory and legal landscape for tokens and ICOs

The legal status of tokens remains uncertain, with an alphabet soup of federal and state regulators claiming jurisdiction over token sales; from the CFTC to the FTC, and the OCC to the SEC and all their counterparts among state regulators.

Companies selling tokens as part of ICOs in the first part of 2017 often presumed that the tokens they sold were not securities, referring to them as “utility tokens” akin to a Kickstarter project and therefore not subject to federal or state securities laws.

In July 2017, the SEC issued a report after investigating tokens offered and sold by a virtual organization known as The DAO (decentralized autonomous organization). The SEC found that The DAO’s tokens were securities and subject to federal securities law. In The DAO enforcement action, the SEC stated clearly that tokens in such ICOs would need to be registered with the SEC absent a valid exemption.

Since The DAO decision, the SEC has issued a plethora of additional enforcement actions, including the termination of a token offering by Munchee Inc., a restaurant review platform.  In Munchee, the ICO was designed to fund the tokenization of its existing restaurant review application. In recent days, the SEC has been reported to be undertaking a broad investigation of ICOs, their investors, sponsors, advisors and vendors.

Given the legal ambiguities associated with tokens, many companies in the last months of 2017 structured their fundraising in two steps: the sale of Simple Agreements for Future Tokens (SAFT), where tokens would be issued in the future to accredited investors, with a ‘token sale’ deferred until the platform is eventually completed and the tokens have ‘utility.’ The untested theory is that tokens with sufficient ‘utility’ would no longer be securities.

What factors should a startup consider when evaluating an ICO?

Entrepreneurs and startups should consider several issues when considering a token issue. First, is the application of blockchain technology. Assess whether the business can really utilize blockchain technology and the business goals that blockchain technology will help it achieve. A reverse ICO requires the use of blockchain technology.

One major issue that ICOs may remedy is the cold start problem – the challenge of creating a new business based on a network that must attract large numbers of users to bring a product to market.

Second, consider industry-specific issues for the company that may arise in tokenization of its product. For example, a VC-funded startup in the financial services market should consider whether it needs regulatory approval from the relevant financial regulators to implement blockchain solutions.

Finally, consider whether existing investors would approve the hybrid offering and what types of control those investors should have over its terms.

Key terms of hybrid token offerings

Startups and boards of directors should consider several key terms for a hybrid offering. First, they need to determine the identity of the issuer of the tokens. Although some VC-funded startups will issue the tokens themselves, many startups are considering using issuers located in countries with favorable tax regimes, such as the Cayman Islands, British Virgin Islands, Gibraltar and Puerto Rico.

These startups are also considering the use of independent foundations to manage the development of the open source blockchain projects. This structure is like many traditional open source projects, such as the OpenStack Foundation and HyperLedger Project, hosted by the Linux Foundation.

Next, startups need to determine the terms of the token offering and, in particular, the role, features and purpose of tokens (often referred to as tokenomics). Allocation of tokens varies widely and depends on the business model for the specific blockchain project.

The most common categories are (i) developers of the blockchain project; (ii) “miners” to run the blockchain project; (iii) research and development for future development of the blockchain project; (iv) governance, grants and community development (frequently through a separate foundation); and (v) investors.

Finally, consider the role of the blockchain project in the exit of a VC-funded startup. The blockchain project may be a significant asset of the startup – and the ability of the startup to include the blockchain project or control of the blockchain project may be critical for a successful exit.

The ultimate resolution of these issues is still evolving, but the value of token and cryptocurrencies is significant enough to consider them as demanding of study and consideration. We anticipate that 2018 will see the further development of industry norms for conducting hybrid token offerings.

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