Why Startups and Investors Love ICOs and Regulators Don’t
Ethereum’s ICO raised $18 million in 2014 by selling tokens that facilitate online contracts. Ethereum’s founders were fed the right capital at the right time, and their investors have been abundantly compensated for their support, and Ethereum’s platform has spawned a plethora of new ICOs,
Today, the tokens have a market cap of around $30 billion.
So what are ICOs, what are the risks and why do investors and startups like them?
Huge profits = Massive interest
The huge profits made through some early ICOs such as Ethereum have led to massive interest in ICOs. Over two billion dollars in early stage funding has been distributed through ICOs, peaking in mid-2017.
In response, startups have dramatically increased their use of initial coin offerings (ICOs) to generate funding.
What is an ICO?
An ICO is a method of fundraising that developed out of blockchain technology.
Investors benefit from buying tokens that increase in value because the underlying service is progressively gaining popularity. Early investors can sell their tokens on secondary markets very quickly. ICOs also allow buyers to pre-purchase a product using digital currencies, similar to crowdfunding.
For example, Brave is a browser that was introduced by the blockchain start-up Basic Attention Tokens (BAT) to help its users earn money if they agree not to block online ads while surfing the web. BAT pays original content publishers and viewers for ads viewed on the Brave browser.
By distributing tokens in an ICO, a start-up gives buyers early access to its technology and a chance to partner in the venture. In the case of BAT, early token buyers could use their tokens to buy advertising through BAT, or they could sell it at a profit to advertisers who want to use BAT tokens.
Get rich quick with ICOs?
As with all high-return investments, buying an ICO is risky. It is crucial to understand that currently, buying into an ICO is not the same as buying stock. Equities give shareholders a partial ownership of a company and benefit from significant oversight.
Cops and robbers, regulators and fraudsters
ICOs allow startups to raise money without ceding any control through shares, and without the paperwork burdens of an equity IPO.
Critics, meanwhile, worry that ICOs are occupying a grey area susceptible to fraud. Examples of companies defrauding investors led the SEC’s Office of Investor Education and Advocacy to issue an investor alert about the risks of ICOs.
The DAO debacle
The SEC focused on a 2016 offering known as The DAO which issued ICO tokens on the Ethereum blockchain. The DAO ICO became a fiasco after hackers stole tokens, and ensuing legal fights triggered an investigation.
The SEC guidance explained that any ICO meeting the requirements of the ‘Howey Test’ is considered a ‘security’. The Howey case challenged the prevailing view of what a security is and isn’t by looking at three elements. If:
- Money is invested
- In a ‘common enterprise’, where the fortunes of the investor are interwoven with the efforts of those selling the investment, and
- The purchasing party has an expectation of profit
… then the ICO would be considered a security.
The expectation of profit element is tricky because even if a launch states that “there is no financial incentive,” speculative investor behavior could show an expectation of profit. This would result in capital gains tax for the buyer and greater regulatory hurdles for the issuer of the ICO, and it is a violation of US federal law to sell securities without SEC approval.
“Coins” or tokens can look a lot like traditional securities because they enable companies to take investors’ cash while offering the potential for profit. Regulators will ask: “Is an investor entering into a speculative enterprise?”
On the flip side, ICOs typically argue that the tokens they issue are not securities, but are instead a form of credit akin to subway tokens that give owners access to the network.
New age of startup capital?
We have money pouring in, blockchain technology has the power to improve our lives, we have speculators earning huge profits, but we also have cheats who are trying to cash in on this boom period.
Regulation offers stability which will help investors benefit from knowing that their crypto investments have protection and oversight similar to traditional investments, which will pave the way for more access to funds for startups.
If regulation is able to be investor friendly while protecting consumers, ICOs have the potential to become a dominant source of startup capital in the future.
Image credit: Ethereum
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