Initial Coin Offerings (ICOs), a business fundraising event similar to an initial public offering in which investors purchase company-issued tokens with digital currencies (i.e. Bitcoin) for equity, are increasing in frequency as cryptocurrency become more widely accepted across the globe. (Please see Part 1 of this blog post for a more detailed explanation of the most common forms of ICO tokens). This new system of fundraising holds as much promise as peril for companies seeking to use different ICO methods to attract investors. Below describes the prevailing issues concerning each:
Security tokens: Security tokens may seem like an ideal way for a company to sell stock to outside investors, but they come with one major catch. As described in Part I, security tokens allow for companies to directly sell stock in their companies to investors. The challenge here is that many companies seeking to launch security tokens as investment vehicles do so as an attempt to skirt regulations that traditionally oversee these types of transactions. Ideally, companies seeking to launch these would first seek regulatory approval in order for security token offerings to be deemed legal,, yet this process may appear too timely and costly for many startups looking to security tokens to boost cash reserves. Companies seeking to use security tokens should make sure that they can demonstrate compliance with the Howey Test, the result of a 1934 Supreme Court case that established the four characteristics of an investment contract transaction:
1.) An investment of money
2.) Expectation of profits from the investment
3.) The investment of money is in a common enterprise
4.) Any profit comes from the efforts of a promoter or party
So how can companies sell stock in their company without investors expecting profits (point 2 above) in the form of dividends? That’s a great question. Until it is answered, companies seeking to use security coins need to be particularly careful of regulatory agencies such as the Securities and Exchange Commission that have already warned companies that ICOs attempting to circumvent securities laws may be prosecuted under federal law.
Equity Tokens: Equity tokens, a category of security tokens, are still subject to the regulations detailed above. However, equity tokens could become a robust method for companies to raise early-stage funding by democratizing the opportunity to invest, should a company receive adequate legal approval to use an equity token. However, one of the current limitations of equity tokens is timing. In order to succeed, equity tokens will need to rely on blockchain-enabled smart contracts between the equity issuer (the company) and the equity purchaser (the investor). Smart contracts are legal agreements between two parties that are stored for transparency and posterity on a decentralized blockchain using cryptography code. The challenge here for democratization involves context: if only the most sophisticated contemporary investors understand complex transactions involving the blockchain and smart contracts, will they actually empower the “everyman” investors to participate? Only time will tell, but the not-too-far-off future looks bright for companies looking to legally leverage equity tokens to raise early stage capital if they are able to comply with federal laws.
Utility Tokens: With utility tokens, the possibilities are endless. As described in Part 1, a consortium of major banks are planning to use utility tokens to improve interbank transactions. Other utility coin examples include:
– Brave, a web browser company, has a Basic Attention Token (BAT) that provides advertisers with utility tokens based on user attention.
– Kik, a messaging service, has Kin, a token provided to developers responsible for a transactions their service provided on the platform
– Filecoin, a decentralized storage network, allows network members to earn Filecoins for hosting files on their unused Hard Drive space, which can then be exchanged for used for USD, Bitcoin and other crypto currencies.
One major future challenge with utility tokens involves whether or not they can maintain a competitive advantage for their issuers. For instance, if Amazon monitored Filecoin’s success and decided they would like to replicate their model while providing higher value for their network members at scale, would Filecoin be able to leverage network member engagement with its token to prevent token holders from leaving the network? Industry behemoths have become notorious for replicating competitors products (i.e. Facebook with Snapchat) and it remains highly likely that behemoths may follow suit with successful companies reliant on utility coins to retain network members.