Initial coin offerings (ICOs) have provided start-ups with more than $3bn in capital this year — more than venture capitalists. The process is simple. A start-up simply creates a run of cryptographic tokens, tradable on a blockchain, and sells them to people who want to buy them.
For start-ups, the main appeal of ICOs as a means of capital raising, when compared to the more traditional methods of selling equity or debt, is the low barrier to entry.
To launch a cryptocurrency, start-ups require a whitepaper and very little else. People buying cryptocurrencies do not subject start-ups’ business models to the same rigorous analysis as a venture capitalist would. Nor will a cryptocurrency exchange require a start-up to make the same sorts of disclosures as are mandated for a start-up selling bonds or shares.
It is, for many, the cheap and easy way to get hold of some cash. Add in the fact that you can do it without diluting your holdings (or paying the money back as you would with bonds), and it’s a no-brainer.
For people who buy the tokens? Well, tokens come in many varieties. Some offer profit shares in a collective enterprise, while others are tokens required to make use of an application.
Still, the biggest reason for most investors is 1320%. That’s the average return an ICO offers investors, according to figures from Mangrove Capital Partners. As a speculative asset in such an unbelievably frothy market, the potential rewards are huge.
The downside is that this may all be illegal.
The US Securities and Exchange Commission published a report in July indicating that it would apply the 'Howey Test' to determine whether or not cryptocurrencies fall under securities regulation.
The Howey Test states that any investment of money in a common enterprise with the expectation of profit derived primarily from the managerial efforts of others constitutes an investment contract or security.
As such, the issuer is required to disclose a description of the company’s properties and business purpose, a description of the security on offer, information about management, and financial statements about the company, certified by independent accountants.
No cryptocurrency seller has yet gone through this arduous process. Instead, start-ups are seeking workarounds or safe havens. Filecoin sold its tokens only to verified accredited investors, taking advantage of Reg D 506, to avoid having to register the tokens as securities.
Making a compliant coin?
Importantly, it applies only to “already functional utility tokens”, and not to investment tokens (those which pay a dividend, for instance) or to tokens designed to function within a network that has not yet been built.
The SAFT is a contract allowing start-ups to raise capital from investors in order to build their platform then, once the platform is functional, deliver functioning usable tokens to investors. While the SAFT contract itself is a security, its creators believe that the subsequently issued tokens, since they have a function, are not securities.
The SAFT whitepaper (published on October 2) claims that “a genuinely functional token’s value is determined by a variety of market factors, the aggregate impact of which likely predominates the ‘effects of others’ [criterion of the Howey Test]”.
They further argue that, while the tokens and platform were designed and sold by a start-up, their subsequent change in value does not derive from the managerial efforts of others.
These contentions have already been challenged by sceptical lawyers on a number of grounds.
Firstly, to expect a platform and token to function without any intervention after launch indicates a grossly optimistic assessment of normal business practice. With such a new technology, post-launch bug fixes are an inevitability. Some believe this will fulfill the "efforts of others" criterion.
Secondly, even if tokens have functions, many investors are buying simply for speculative value, rather than for their utility. Given the nature of some of the marketing surrounding cryptocurrencies, some lawyers argue that it could constitute “efforts of others” and have a material effect on investors’ expectations of profit.
GlobalCapital has no position on whether or not the SAFT will prove a watertight means for start-ups to circumvent securities regulation.
The result may depend on whether the SEC decides to be lenient based on start-ups making a ‘best effort’ to comply, or whether it takes a dim view of attempts to sell unregistered securities through a loophole. Both views appear to have some validity.
But while the project is a laudable effort to provide a legal means of running ICOs without raising the barriers to entry, if the SEC decides to take a harsh approach, even a theoretically 'compliant' coin will have to have its day in court.