Why initial coin offerings are exploding – and how companies can avoid the landmines
Every other day, it seems, a new startup is raising millions of dollars by selling cryptocurrency coins or tokens to raise money — lots of money, really fast.
In May, for instance, Web browser startup Brave raised $35 million by selling its “Basic Attention Tokens” in under 30 seconds. Block.One, developer of the new blockchain platform EOS.IO, announced in July that it raised a then-record $185 million through an “initial coin offering” of its cryptocurrency tokens. Then in early August, Filecoin, a project of Protocol Labs to create a cryptocurrency-powered distributed file storage system, smashed that record by raising $252 million in scarcely more than a half-hour.
What’s going on here? Are ICOs a legitimate new way for startups to raise money? Are all these offerings — some $1.1 billion worth in 89 coin sales this year, 10 times as much as in all of 2016 — turning into a bubble that could pop and destroy all that value? Or worst of all, are they scams taking advantage of a lack of regulatory oversight?
There are varying amounts of truth in all of those concerns. The confusion comes because few people understand the nature of cryptocurrency and token offerings. ICOs may sound similar to IPOs, or initial public offerings of stock. But they’re actually quite different, more akin to crowdfunding than traditional issues of stock, in which investors get ownership of part of the company.
With ICOs, by contrast, “investors” get cryptocurrency tokens in a blockchain, a distributed ledger like the one for bitcoin. They’re intended to serve as the currency for the service they finance, more than a bit like classic tokens in an arcade. But because there’s so much speculation in tokens such as bitcoin, which keeps hitting record highs lately, ICOs have attracted investors hoping for big returns — which some hope to convert into conventional currency to lock in profits.
The problem for companies engaging in ICOs — and at least 110 more are planned this year, according to the token tracking site tokendat.io — is that the lack of laws surrounding ICOs means they can get in trouble as regulators start to step in. The Securities and Exchange Commission, for instance, recently said ICOs are indeed subject to securities law, though it still left a lot of room open for interpretation until it comes up with clearer rules in the next year or so.
To sort all this out, SiliconANGLE Media Chief Executive John Furrier talked recently to Grant Fondo, a partner in the law firm Goodwin LLP, where he is chair of its digital currency and blockchain technology practice. A former federal prosecutor and assistant U.S. attorney in the Northern District of California, he’s helping his firm work with some 20 to 30 companies looking to do ICOs. As a result, he has special insight into the treacherous thicket of laws and rules that regulators are still in the process of defining.
Following is a lightly edited first part of a two-part Cube Conversation between Furrier and Fondo at the Palo Alto studio of SiliconANGLE Media’s theCUBE. The first part, the full video of which is below, focuses on charting the landscape of ICOs and token sales, the uncertain legal and regulatory environment, and some basic advice on potential pitfalls. Part II delves into more detail on specifically how startups need to approach token sales to avoid getting into legal trouble in the future.
Furrier: Take a minute to talk about Goodwin, what are you guys doing in this area?
Fondo: We’ve been involved in this space for three and a half years now, probably. So I got involved in the regulatory side, represented a company at a DOJ in a FinCEN settlement, and that took off my interest in it. I thought this area was fascinating. And the amount of talent and energy in this area is tremendous. So that’s what launched my initial interest. And then from there, we’ve represented a couple of other companies in significant regulatory matters. But we’re also very actively involved in startups, and that’s Goodwin’s bread and butter, particularly in the fintech and blockchain space.
And so now what we’ve really seen, probably over the last eight months, is just a tremendous growth in interest in the token sales. You refer to them as the ICOs. And so we’re probably representing 20 to 30 companies at various stages from just initial concept to launches.
The new Wild West
Furrier: I see blockchain is really one of those disruptive, reminds me of the early days of the web where it truly was the Wild West. This is essentially a rush onto the marketplace because with cryptocurrencies, with decentralization, and people experiencing distributed computing, it’s changing business models. So people are making a lot of cash, if you will, in the raising money side. What are the issues? I mean, because on one hand, it’s a scam, people say, and some people say it’s legit.
Fondo: I think in many industries, especially new industries, there’s uncertainty. And I know the attention goes to the scams, right, but I think that’s really the minor, very minor component of it. What you’re seeing is a lot of good companies with great ideas who have developed a new model to develop their platforms. And part of what you saw on digital currency that people loved early on — you’re seeing it in blockchain and now you’re seeing it in token sales — is the democratization of their industries and their platforms. You see all these marketplaces being created. And tokens is a way to facilitate that, not only in the context of obviously raising money, but also providing a platform for people to participate on that platform.
Furrier: What’s driving all this, besides the new way to finance or a new way to provide value?
Fondo: I think there’s a couple things. One is the interest in the blockchain and the greater understanding. You know, eight months ago it was really more crypto people doing the token sales. Now we’re getting calls from all aspects of industry, some historically conservative ones. And so what I think people are seeing is this blockchain technology is really here to stay. It’s really a transformative technology.
And it’s technology that applies to so many different industries. It’s not just a crypto technology. It’s a technology for everybody. And it also allows so many different participants and transparency. So people are really fascinated by it. And they’re using the token sales in part to help build that industry.
Furrier: What’s the playbook? Take us through a day in the life of what’s going on at Goodwin as you guys are dealing with people knocking on the door saying, hey, help us. And what are the pitfalls should be avoided?
Fondo: There’s a couple initial decisions that you have to make. The question we often get is, people are trying to stay within the boundaries. The problem is the boundaries are still very uncertain. And so you try and work with a brand new technology and a brand-new concept with regulatory regimes that are a little bit older and not quite built for it. And so part of what the initial questions are when people call us, is how do we fit what you want to do within the frameworks and try and minimize any risk? Because in any business there’s risk, but the smart thing to do is try to minimize it.
And nobody who calls us is trying to scam anyone. They’re trying to do this, launch a fantastic business, one that will be truly disruptive in their industry. And so one of the things we first deal with is jurisdictional issues. Where do we set up companies? People have this common perception if I just set up a corporation abroad, will I be fine? And that’s not the answer. And so you set up corporations and entities that make sense for that business, where the people are located, the executive team is based here in the U.S., that changes the dynamic. We also get a lot of foreign companies that call.
Utilities versus securities
Furrier: You’ve talked about the notion of utility versus securities, a concept that’s well known in business, but can you explain how people should think about that?
Fondo: I break it down in two kind of examples. The typical utility token would be, remember when there were arcades, and you would go to an arcade, and you’d stick the token into Space Invaders or whatever the game may be? That’s a utility token. Does that token have some utility on the platform, is it doing something on the platform? That’s what the model is, so people avoid some of the regulatory hurdles with a security.
Typically, Silicon Valley was built on companies selling parts of themselves for equity and people buying into the company and getting stock. Most token sales are trying to avoid being termed a security, where someone is getting an interest in the company, an interest in the profits, control over the company, and instead what the model is based is on this utility token. The test is called a Howey Test, and it’s basically, if you hit certain criteria, you end up being a security. If you don’t, hopefully you stay in the token regime. The best way to do that is you build a token that truly makes sense on your platform, that people can use it to build, to transact, to exchange goods, to build ideas. And they’re not running the company. They’re just using that token in a sense, much like an arcade token is used.
Furrier: So it’s not like a security, like a stock, so there’s no stock option plan, there’s no token plan. You can’t think about it that way, is that what you’re saying?
Fondo: You raise a very interesting issue because there have been some companies that have set up tokens like vesting over time, or tokens for employees or tokens for advisers. There’s a risk that the SEC says, wait a minute, that looks a little bit like an option or a security. So one of things we advise is do not set up token plans or vesting token plans.
Furrier: One of the areas we’re seeing is the Brave browser with the BAT token that’s disrupting the web browser or the user experience. Steam does like a bit of a Reddit clone. And then there’s one that’s democratizing venture capital. So we’ve seen some activity around folks were using cryptocurrency to invest in companies. Talk about the dynamics between those two approaches and mainly the funding one. Is it still kind of Wild West, undefined, or how does that work?
Fondo: Initially it was Wild West. You had basically crypto people investing in companies and buying these tokens. Now what you’re seeing is the VCs. We represent a bunch of them. And they’re aggressive, in the sense of they’re not afraid to take risk, and they’re constantly on the move for new ideas. So I’m getting a lot of calls … about what are the risks here, how do we invest, how do we minimize our risk? It’s a new paradigm, but it’s a paradigm that I think the traditional financing vehicles are paying a lot of attention to now.
Furrier: How does it look from the entrepreneur’s perspective? And how should they deal with these new, progressive investors?
Fondo: The entrepreneurs are looking at it, quite frankly, as an alternative to VC and loans. And I think that they view it in part as, it’s a quicker and easier way to raise money, in a sense, but also that there are potentially less strings attached. And I think there’s some truth to that, but I think one of the key components is when you raise that money and you apply, you have to do it in a truthful, honest manner, and you can’t mislead people. You need to be pretty forthcoming about your disclaimers and things like that.
Furrier: From an entrepreneur perspective, this sounds like it’s going to cost me a lot of dough to get this done. What are the fees like?
Fondo: So I think it depends on what type of token sale you do. If you do an unaccredited token sale, which is the majority of them, fees are a lot less. If you do an accredited sale it’s a little bit more. But I think there’s a couple different components. There’s not only legal. You can get sort of the Mercedes version of, we’ll write you 10 memos about the following, but most entrepreneurs don’t take that approach. So the fees are probably not as much as you would think.
Where the fees start to escalate is there’s a lot of different components to this. One of the fascinating things about digital currency, blockchain and now token sales, is there’s so many components to it. And so for the entrepreneur, it’s not only the legal, which I think they’ll find is actually one of the least expensive parts of that process, but getting tax advice. So you’re bringing in all these token sales. You really need good tax advice to make sure that you’re maximizing your tax benefits when you do it. That can get expensive.
Furrier: And the tax issue could be significant because I’m sure even the government hasn’t figured out, is it revenue or is it investment?
Fondo: I think the IRS would look at it as revenue.
Furrier: What’s the best practice of a company says, hey, I want to do an ICO. What do I do?
Fondo: I don’t think there’s a best practice. Every company is different. But there are guideposts. And so I think the biggest guidepost is, where are you located? If your team is in the U.S. and you want to get U.S. dollars, you have to assume you’re going to be regulated by the U.S. regulatory regime. So you have to deal with that reality and you structure things differently.
The next question is, are you going after accredited or unaccredited token purchases? Most people want to do unaccredited. So then the measure of protection is, okay, is our token truly a utility? If you’re going abroad, you really have to be completely abroad, meaning no U.S. money, no U.S. executive team, the company’s abroad, the business is abroad, etc. The U.S. takes a very broad view.
Furrier: So they’ll see right through that mirage.
Fondo: They’ll see right through it. If there’s any impact in the U.S., they have jurisdiction over it. And if U.S. people have been harmed, they will take notice.
Furrier: How about the Cayman Islands or other countries?
Fondo: The Cayman Islands is a great option for tax purposes. So a lot of token sales are being run out of the Cayman Islands because of the tax benefits. It’s not a regulatory protection in my view, unless you happen to be all abroad, and you’re not seeking U.S. money.
Furrier: There haves been rumors that the FCC and the federal government’s going to be putting things in place at the end of this year, maybe early next year. What is the concern on regulatory, and how is that impacting people in the blockchain ICO market?
Fondo: About three weeks ago, the SEC came down and issued some guidance. And I say that with a little bit of a grain of salt because I don’t think it was a tremendous amount of guidance, but there’s a couple of takeaways. One is if you are, if act like a security, they’re going to view you as a security.
The second component, which I thought in many ways was very interesting, was they implied that some token sales are not securities, which we always believed, but it was a nice tacit concession. That’s where the battleground is. What was frustrating about, I mean one other aspect, too, was they mentioned the term “participants.” So if they believe that a token sale is a security, not only will they necessarily go after company, but they will go after participants of that token sale.
Furrier: Like, potentially VCs or investors, or who?
Fondo: It’s an open question, what “participants” mean. Historically, if you look at securities, and I used to do securities litigation … “participants” would be like investment banks, for example. So if there’s a pseudo-investment bank involved, and I think they would view that term broadly, because it’s typically not investment banks in token sales. But the SEC might say, listen, you’re a participant. You benefited, you helped launch the sale, etc. So I think for participants there’s potential risk as well. But they left the door open for the token.
Furrier: So it sounds like they’re giving some guidance, like hey, we’re watching you, but we’re going to let this thing play out a little bit more.
Fondo: I think it’s two things. One is they said, historically, those that launched earlier, we’re probably going to let that pass, as long as you didn’t commit fraud. And then the second component is that we are watching you, and you’re on notice now. So don’t cross that line.
Furrier: A couple of these ICOs pulled in over $200 million. That’s some serious cabbage, as we would say back east. Are there rules on market-making, what you can say, how you promote it? How should people watch the lines on how this gets done?
Fondo: If you’re doing a utility sale, and your position is that you’re not a security, general advice is you should not be marketing your token as an investment opportunity, that our token’s going to go up in value. You don’t want to be publicizing like, here’s a great way to make money, buy our token. That looks like a security.
You mentioned Reg D. So Reg D related to accredited investors in the U.S. And generally the rules are you can’t publicize your token sale if you’re targeting accredited investors. Likewise, you shouldn’t be putting things on your website targeting all types of people. That’s where people will get in trouble.
Furrier: It’s a lot of promotion going on [in social media].
Fondo: And the nice thing about a lot of these token sales is they’re building these communities. But the downside of these communities and these constant communications is you have to be very careful with your language. So when you have these Reddit community hosts that are helping you with your launch, for example, be very careful what you say. You can’t in any way imply that … the tokens will go up in value, or trying to protect the value of the tokens. So you have to be very careful, and that’s a tough thing.
Furrier: If we’re doing a utility token sale, what’s safe language? Can I say, hey, get your coins, join our platform? Do I market it like software? Do I market it like a technology?
Fondo: I think you market like a token at an arcade, in a sense. It’s a simplification, but I think the concept’s the same. You’re marketing that this token sale, this token has this great use on your platform. And people should be really excited about joining your platform. And they should be excited about buying those tokens so they can use them on the platform, whether it’s to make money, whether it’s to access games. You’re selling your platform. And you’re selling just a mechanism to get onto your platform.
Furrier: Where’s the scar tissue [for law firms so far]? What have you learned?
Fondo: I think it’s tempering people’s expectations. You get excited for your clients and you have these clients that approach you with these great ideas. And some of them are like mind-boggling. [But] you have to temper that a little bit, and temper their natural enthusiasm to say, okay, listen, there’s a right way to do this, and there’s a wrong way. Or there’s not necessarily a wrong way, but a more gray area. And if you want to really be more in the right area, here’s how we have to do it. It may not be quite as lucrative. It may not be as easy. But it’s the right way to do it. And let us help you get there.
Furrier: What are some of the operational bumps that you guys have hit, and where’s it been similar to existing legal practices within the firm?
Fondo: There’s just not a lot of people that really know the space. I get calls a lot, and people will say, my god, you’re a lawyer who actually understands what we’re talking about. And so even in a firm like Goodwin, we have a team, and so we understand the language. But not everybody does, right? And so I get calls, even internally from the firm, can you help us out on this?
Furrier: You must be sitting there pinching yourself, like man, this is pretty wild. What’s your vision of how this plays out longer-term?
Fondo: We’re in the beginning stages. When I got involved with digital currency four years ago, I didn’t know where it was going, but I knew it was going somewhere. And I knew that no matter what we projected, it would go in a different direction. And it has. It’s such a great technology. So I think the token sales will continue. I think as the regulatory regime becomes more certain, we’ll continue to figure out how things go. But I think it’s here to stay. The amount of interest outside the Valley now and other tech hotbeds is extraordinary. It’s transformative, and I just think we’re at the beginning of that wave.
Here’s the full Part One of the Cube Conversation:
Featured photo: geralt/Pixabay
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