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Blog // 18/01/2018

Initial coin offering (ICO’s) and crypto ‘tokens’ explained

Initial coin offering (ICO) and the latest on cryptocurrencies explained

As 2017 drew to a close we heard all the usual comment about how ‘it had gone by so fast’ and how ‘it felt like January only yesterday’. One of the biggest stories of the year was the rise and rise in the value of Bitcoin, but behind this there are potentially even more exciting developments around crypto ‘tokens’ and ICO’s.

ICO’s, bitcoin and the blockchain (cryptocurrencies)

(other cryptocurrencies and tokens are available)

I appreciate that we need to start with a little explanation about what an ICO is. To do this it is first important to understand how Distributed Ledger Technology (DLT), such as the blockchain, works.

Read our introduction to blockchain.


What is an ICO?

What is an ICO?

An ICO is an Initial Coin Offering and is a means of a business raising funds which is neither debt nor equity. In fact its legal designation is far from clear and ultimately will come down to how it is set up, with the authorities yet to provide clear guidance. This is because there is no guarantee that the money used to purchase the tokens will ever be repaid.

However some tokens do infer rights on the holders, for example a company called Storj which had an ICO offered storage space in exchange for their’s. So much like a company may crowdfund on a platform like Kickstarter, potential investors may also invest by participating in an ICO and buying tokens.

Another important note is that someone buying these tokens is investing in a project rather than the company as a whole, so from the shareholder’s point of view they are not selling any of their business.

How are cryptotokens different to Crowdfunding?

The difference between these and crowdfunders is that tokens are trade-able and therefore in theory the performance of the company will increase the tokens value. That is at least how the older tokens have worked, i.e. as a currency in a similar way to bitcoin. There have been some significant growth on these tokens which have resulted not from the performance of the company, but instead from speculators looking to capitalise on what they see as the ‘next bitcoin’.

Consider this, in 2017 bitcoin grew by an astonishing 1,000%, but there were seven cryptotokens that exceeded this, with the largest growth in Ardor which saw an increase of a, not too shabby, 16,809%.
Note: Arbor is a platform that offers blockchain as a service.

But how does an ‘Initial coin offering’ work?

The leading blockchain platform for ICO’s is Etherium, which has its own crypto currency called Ether. The actual process of creating a token is more detailed than I will go into here, but essentially you create what is called an ERC20 token.

Once the token is created it can then be listed on a website like coinist – which also provides guidance on launching an ICO – (or on the entities own website) so that potential purchasers can see it.

However there is a lot of work to do before getting to this stage. Companies looking to raise money through an ICO will need to pre-announce that they are planning to have a token sale with a white paper. This would set out the story of the project and its goals as well as details of the tokens including their cost and the total value of the sale. This will need to be carefully marketed to raise awareness of the project and get people excited about buying the tokens. On the pre-determined date the interested parties can then purchase the tokens using ether, bitcoin or sometimes normal funds, which in the crypto world are known as ‘fiat’ currencies.

Read Techcrunch’s FAQs on ICOs.


Regulation

As I alluded to earlier, the regulation of ICO’s is tricky. Both the Securities and Exchange Commission (SEC) in the US and the FCA in the UK have released guidance which discusses both the risk and how they are regulated. The FCA stating that ICO’s are not regulated and the SEC confirm that there are cases where ICO’s will be classified as securities and also cases where they are not.

Overall it is a difficult area to understand, the underlying message is to proceed with extreme caution. Certainly some companies are trying to avoid their tokens being classified as securities to avoid the regulation, but this is at the expense of consumer protection.

What will happen in the future is hard to say, but a particular issue is that tokens may be purchased from anywhere in the world and this makes regulating more complicated. For example can the SEC make any demands of a South African ICO or an Australian investor?


Tech bubble?

The internet is awash with speculation about whether the whole crypto scene is a bubble. My feeling is that as with anything there will be winners and losers, but I don’t want to sit on the fence. In my opinion, bitcoin and the rapidly growing market that has come about since it launched is a bubble. The value of all of these rapidly growing cryptocurrencies and tokens will fall. It is just a matter of how much and when.

When this occurs the strongest will survive in a more settled atmosphere, however with no rights being held by the token owners the burden will not fall on the business owners themselves, but on the investors. Bitcoin surged in the latter part of 2017 because normal people (i.e. not tech geeks) saw what bitcoin was doing and wanted a piece of the action. I hope that the losses individuals will inevitably make are limited to those people who can afford to lose, those who invested as part of a wider, more balanced investment portfolio.

Read the story of one such token sale.


What can you do?

It is imperative that you obtain professional advice whether you are considering launching an ICO or investing in one.

To launch one there is a considerable amount of work and technical know-how required in ensuring that your project is investable and is presented in the best way possible to ensure you achieve investment. This should be considered alongside other more traditional routes for obtaining financing and we would welcome a discussion with any companies thinking about financing to see whether this is the best route.

When thinking of investing in one it is important to know that this is very high risk. Though I cannot provide any financial advice I would highlight that this should not be a first step into investing and financial advice should be taken. Those who can afford to lose all of the money invested may be able to ‘take a punt’ but no one should be putting their life savings in an ICO or any cryptocurrencies.

Mike Ayres is a member of Menzies Business Services team specialising in the Financial Services sector. If you have any further questions on the above, please contact Mike by phone on 01252 894911 or by email at MAyres@menzies.co.uk.

More about Menzies Business Services advisory services.

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