Initial Coin Offerings | the current state of a rapidly changing market

Published on 10th Oct 2017

Unless you’re actively involved in blockchain technology or interested in cryptocurrencies, it’s likely you wouldn’t have heard of an Initial Coin Offering (ICO) until just the past few months. To say this is a rapidly growing and evolving market would be an understatement. According to the research site Coindesk, there were two ICOs globally in May 2017 and industry experts are estimating there are now 1,000 ICOs being offered every single day. In the past six months, ICOs have raised in excess of $2 billion.

While the growth in ICOs is staggering, the market, the mechanics of the offerings, the regulatory environment and the funding strategy for early stage companies is changing just as quickly. This article will cover the evolving state of the ICO market, the standards being developed and the wider implications. For further background on ICOs and the state of the global regulatory environment, please read our most recent publication here or our extensive report on blockchain.

What is an ICO?

In basic terms, an ICO is a newly-developed funding mechanism for early stage companies. Instead of raising a round of venture capital or crowdfunding a project, a company can now sell a “token” to investors who pay in cryptocurrency such as Bitcoin or Ether and the company can then use that capital to develop the product and expand the company. The company doesn’t sell shares in the company, but rather sells tokens, often in the form of a cryptocurrency created for that company, with the transactions verified on the blockchain and in many cases the company’s technology also being built on the blockchain. The token holder purchases the token hoping it increases in value or in exchange for services (e.g. cloud storage) or for access to the company’s technology. A company can raise a few million dollars in a matter of days via an ICO, or hundreds of millions in the case of Filecoin which raised $250 million in August 2017. Though each offering varies dramatically, the average purchaser contributes $13,000 for their tokens and the typical ICO will usually have a few thousand investors. Many times, the tokens will be subject to a lock-up period, after which the investors can cash in their tokens on the rapidly growing secondary exchange markets.

For a company looking to raise capital via an ICO, a number of trends and best practices are emerging and the process is becoming more sophisticated as more and more companies are competing to sell their tokens. Initially (only a few months ago), some companies successfully raised millions of dollars simply by publishing a whitepaper detailing their technology and touting massive appreciation of their token. Now, the ICO process can take months of planning to consider the technology, legal and regulatory environment and marketing strategy necessary to ensure a successful offering. The focus is now largely on the technology and the services the token purchaser can access and not the appreciation of the token itself. Pre-ICOs are also popular, in which the company raises a few hundred thousand dollars from a small group of investors to cover the technological, marketing and legal costs of an ICO.

Similar to crowdfunding, ICOs can be offered before the technology is developed, so companies will create a product roadmap, determine the utility of their token and select the technology platform for the tokens (e.g. Ethereum). Having the right technology platform, smart contracts and security protections are essential, as a security breach is one of the biggest risks in an ICO and can sink the offering as it famously did with an early ICO for an organisation called DAO, where hackers stole $50 million.

Marketing the ICO is critical and companies are increasingly creating a full marketing strategy and roadshow campaign. Just as in crowdfunding and venture capital, success can be determined based on having a credible founding team and advisors, the technology and a well marketed / pitched offering. Companies give thought to who the typical investor will be (e.g. institutional or retail), where the investors will come from (the Japanese currently invest more into ICOs than any other nation), where to issue the ICO (company operational center, tax and legal considerations) and which countries to exclude (due to regulatory compliance issues). A full marketing and PR campaign is now the norm in order to create excitement for the technology and to build an ecosystem of likely investors. Once the offering is complete, investor relations has become an important part of maintaining a positive community of token holders.

The legal and regulatory challenges

In these planning stages, the legal and regulatory components of the ICO and both how and where it is offered are as important as any other considerations. The regulatory environment is changing rapidly, as regulators are now turning their attention to the ICO market to ensure investor safeguards are followed. Currently, in many jurisdictions, these offerings often operate in gray market without certainty as to what regulations need to be followed. The debate is often over whether a token should be treated as a traditional security and thus an offering of the token be required to follow the same regulatory protocols as offerings of traditional securities. As each token is different, with varying utility, this is typically determined on a case-by-case basis and is difficult to predict. This summer, the US Securities and Exchange Commission determined that DAO’s token was a security and thus subject to securities regulation, issued an investor warning and recently brought fraud charges against two ICOs. Other countries have started to offer guidance and a view as to how OCIs will be treated. In countries such as China and South Korea, the governments have taken a more drastic step in placing a temporary ban on ICOs in the country in order for the government to create a regulatory framework.

As the regulators catch up and begin addressing some of the challenges and risks around ICOs, we’ll see the market mature with higher standards that sift out the lower quality offerings creating a safer environment for investors and predictability for companies. In fact, a handful of companies recently had fully subscribed ICOs after following all SEC security offering procedures around disclosures, investor due diligence and filings as a means to mitigate regulatory risk. Whether offering tokens in the US or abroad, these types of precautionary measures as a means to safeguard against regulatory uncertainty may become the market standard until a formalized regulatory framework is put in place.

In only a few short months, ICOs have quickly grown from an esoteric alternative means of fundraising to now outpacing all venture capital funding for blockchain-based companies. Alongside this rapid growth, we are starting to see a more standardized process for offerings as the ecosystem matures, which hopefully helps to lower the risks for both companies and purchasers. The global regulatory environment for ICOs is also in a state of flux, but we should see more certainty in the coming months as further regulatory guidance is promulgated. The market has come a long way in a very short time and will continue to rapidly develop over the coming months.


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* This article is current as of the date of its publication and does not necessarily reflect the present state of the law or relevant regulation.

Interested in hearing more from Osborne Clarke?