Raising Capital in the Cryptocurrency Age
Help, my client wants to do an initial coin offering.
Once upon a time, companies looking to raise capital to start
or expand a business venture were limited to a fairly small, highly
regulated set of options — banks, hedge funds, venture capitalists,
and the like. Then crowdfunding through public platforms, like
Kickstarter and GoFundMe, picked up following the proliferation
of the online market economy. While these options often provide
for greater flexibility and ease of access, they leave a mess of
regulatory and compliance nightmares in their wake. Today, the
latest fundraising fad fueling the business world is the initial coin
offering, or ICO.
WHAT IS AN ICO?
An ICO is a means of raising capital by a startup or business
engaging in cryptocurrency. Instead of issuing debt or equity, the
company creates a digital token or coin — a new cryptocurrency,
à la Bitcoin — and “sells” that coin for legal tender, other
cryptocurrencies or, in many cases, promises of goods or services.
The company then uses the capital raised to continue funding their
business projects or operations.
You may be wondering why someone would want to buy into an
ICO. Broadly speaking, these coins derive their value in one of two
ways: 1) by tying their value to the growth of the company, or 2)
by providing utility or value, think early access or pre-order
discounts on a future product or service being built by the issuing
company, among other things.
WHAT ABOUT REGULATIONS?
It is no coincidence if ICOs make you think of IPOs, or initial public
offerings. So, given the high degree of scrutiny placed on securities
offerings, how then are these ICOs treated?
The original intent of cryptocurrencies was to escape government
regulation and advance global decentralized free trade.
Governments and regulatory bodies around the world have a
different take on that. To consider cryptocurrencies and ICOs as
currently regulated would be a stretch, but the regulatory
environment is certainly evolving rapidly as businesses and
consumers increasingly adopt cryptocurrencies.
Some countries, like China, have banned ICOs outright, claiming
they represent illegal public offerings and are fraught with criminal
activity and fraud. Other countries, like ours, are adopting more
coin-friendly, though vague, approaches to ICOs — for now.
In the U.S., cryptocurrencies themselves are classified as property
by the IRS — therefore exchanges of cryptocurrencies are subject
to capital gains taxation, like day-traded stocks. Treatment of the
issuance of a new cryptocurrency, however, is dependent on the
way in which the token derives its value. If the value is tied to the
growth or earnings of the company issuing the coin, that offering is
often subject to securities regulations, like equity financing. If the
value is instead tied to some future utility on a platform or service
created by the issuer, the regulation is less concrete, and for the
most part such offerings have avoided the scrutiny of securities
regulators. For obvious reasons, the majority of ICOs are classified
in this manner, although the Securities and Exchange Commission
(SEC) is becoming increasingly vocal on the subject.
While evaluations are conducted on a case-by-case basis, the
cryptocurrency community has mostly self-regulated itself, applying
the “Howey Test” in determining whether an ICO represents a sale
of securities. The Howey Test, named after the 1946 Supreme Court
case SEC v. Howey Co.
, establishes whether there is an "investment
contract" under the Securities Act based on whether the scheme involves an “investment of money in a common enterprise” with
“profits to come solely from the efforts of others.” If the test is met,
the presumption is the contract is subject to SEC regulations. Issuers
attempting to circumvent SEC regulations then focus on the ways in
which their ICO does not meet the Howey Test.
WHAT COMES NEXT?
The explosion of interest in cryptocurrencies, coupled with their
relatively light regulatory oversight, has made ICOs a popular
source of funding for many companies over the last year. In 2017
alone, Fabric Ventures and TokenData reported a whopping $5.6
billion raised through ICOs.
The trouble is, as with all opportunities offering high reward and
light regulation, misuse, abuse, and outright fraud have plagued
the ICO market — N.Y.-based cryptocurrency advisory firm Satis
Group estimates over 80 percent of all ICOs are scams. One such
scam, PlexCoin, was perpetrated by founder Dominic Lacroix, who
was previously convicted by the SEC of defrauding investors. In his
investment materials, Lacroix committed to delivering returns of
1,354 percent and had false experts corroborate his project and
obscure his past financial crimes. PlexCoin’s ICO raised $15 million
before it was halted by the SEC in December 2017. Lacroix was
jailed and the PlexCoin parent company was fined $100,000. To
little surprise, the Satis Group currently labels less than 2 percent
of all ICOs as “successful.”
In fact, in a recent review of documents produced for 1,450 ICOs,
the Wall Street Journal uncovered deceptive and fraudulent
methods — including plagiarized investor documents, promises of
guaranteed returns, and missing or fake executive teams — were
used to attract investors into 271 of the ICOs, which managed to
raise $1 billion collectively.
Given the rampant bad behavior in ICOs, large tech giants have
begun to act. In January, Facebook announced it would ban all
advertisements related to cryptocurrency offerings, citing the
“deceptive promotional practices” pursued by many issuers. Shortly
thereafter, Google, Snapchat, Twitter, and others announced similar
plans to limit or ban ICO advertisements on their platforms. But that
does not mean ICOs will cease or are a lost cause.
WHAT ABOUT YOU?
ICOs represent one of many possible options for raising capital. For
the right project, an ICO provides a business with valuable funding
flexibility and offers its consumers early-access to discounts,
features, investment stakes, and more. For the wrong project, an
ICO can result in a substantial regulatory burden or legal and
compliance risk. If you or your client is considering an ICO, make
sure to evaluate the opportunity with care. At the simplest level, if
the ICO feels incidental or unrelated to the project — a gimmick if
you will — it probably is.
Cryptocurrency advocate Fred Wilson, partner at Union Square
Ventures, suggests using these criteria when evaluating the merit of a
potential offering: “(1) a relationship between the amount of money
being raised and the complexity of the project, (2) a very clear use case
that requires the decentralization approach brought by blockchain
technology, (3) a reasonable valuation based on the size of the
opportunity being pursued, (4) a credible team, and (5) the technology
has been built, at least to a point where it is demonstrable.”
And when in doubt, as with any new technology or opportunity,
don’t go it alone — seek advice and guidance from respected
experts in the field.
So, when your client or CEO approaches you about a possible ICO,
what will you do?