ICOs and the future of capital raising - Amazon Web Services

1 I ICOs and the future of capital raising

When the cryptocurrency Bitcoin launched in 2009, few market observers expected digital coins to become anything more than a novelty. Less than a decade later, however, the number of digital coins has exploded — and the corporate world is taking the technology seriously.

This is partly due to the fact that initial coin offerings (ICOs), in which digital coins or tokens are issued to investors for a certain price just as a security would be, are booming. In 2017, ICOs raised a total of US$6.6bn, according

Companies are beginning to experiment with innovative methods of raising capital, and regulators are grappling with how to protect investors.

to cryptocurrency analysis firm Token Report, and the market was on pace to raise another US$3.6bn in the first quarter of 2018 alone.

Many questions remain about the usefulness — and legality — of ICOs and token raises. In early April, for instance, the SEC filed fraud charges against the co-founders of financial services start-up Centra Tech, alleging that the company made false claims in its 2017 ICO that raised US$32m. The likes of Google, Twitter and Facebook have also banned

advertisements of token sales on their websites amid concerns about fraud.

Will digital coins become part of the financing ecosystem of the future? We spoke with four industry experts to gain insight on the subject.

ICOs and the future of capital raising

Will digital coins and blockchain play an important role in capital markets?

Contents

The what and 2why of ICOs

Glimpsing the future 6

Can U.S. 10 regulators oversee ICOs effectively?


The what and why of ICOs

Do you think initial coin offerings (ICOs) could serve a meaningful purpose when it comes to corporate capital raising?

Digital coins are far easier to create and trade than the typical securities we see, and if they become another form of debt or equity, then certainly they can have a meaningful role. They would then become one other strand by which companies can raise money.

However, you would then likely lose the advantage of being either largely or completely unregulated. It's hard to say where we're going to be in five years. Five years ago, barely anyone had heard of Bitcoin, and initial coin offerings were in their infancy. Now that we're looking at values in the billions of dollars, regulation is coming, and I think that's going to have the greatest effect. If companies could raise money with no regulatory costs, then everyone would flock to it. That is not going to happen.

There are a number of companies that have obviously used ICOs as a means of fundraising,

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Peter Henning, Wayne State

University

Grant Fondo, Goodwin Procter

Grant Fondo Partner and California Litigation Leader, Goodwin Procter

Elliot Han Managing Director, Argon Group

Peter Henning Professor of Law, Wayne State University

Arianna Simpson Founder and Managing Director, Autonomous Partners

The experts


both internationally as well as domestically. I think it's currently a strong trend in the U.S., but I think it has been tempered somewhat given the SEC's pronouncements in the Munchee decision, and then some of SEC Commissioner Jay Clayton's statements. Certainly, the form of some of these offerings is changing as a result of that additional guidance, which I think was helpful. I do think that token raises, rather than just initial coin offerings, will continue to be something that entrepreneurs evaluate and use as a fundraising tool.

I think the ICO model is definitely an important one, because it has the potential to open early-stage investment up to a broader class of investors. That being said, I think it's extremely important that thoughtful regulation be put in place to monitor who is investing and how these sales are being done. While I think the model is important, I think it's also important that we put some parameters in place to avoid fraudulent activity and other issues.

Yes, I do think they will become a more mainstream method of capital raising. I don't think they will replace the traditional forms we have seen work for many companies in the past, but ICOs will become a supplement and, depending on the nature and

Arianna Simpson,

Autonomous Partners

Elliot Han,Argon Group

stage of the company, will serve as a complement as well. Where they fit in the timeline of a company's fund-raising, only time will tell, but it's clear they can serve as a seed round where there might be a strong idea, and a little further down the corporate life cycle where there is a minimum viable product and they are looking to take it to the next level.

What do you see as the potential advantages of digital coins over traditional debt or equity vehicles, if any?

When it comes to advantages of digital coins over traditional debt or equity vehicles, I think it partially depends on the form of the raise. If it's a true utility token — and I think in the U.S., the regulators have said those are few and far between — but if it's a pure utility token, I think the ease with which it is cross-border can be helpful for fundraising, even while it also creates regulatory issues. Particularly if the other jurisdictions do not view it as a utility token, then it can create problems going cross-jurisdictional.

Secondly, I think it allows for much greater division of ownership. The tokens are very fluid, so they can be broken down into smaller parts. I think there's a sense that it is easier to

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“The ICO model ... has the potential to open early-stage investment up to a broader class of investors."

Arianna Simpson, Autonomous Partners


transfer ownership of them than it is with a particular stock certificate, for example, or a contractual relationship or LP arrangement. I think it can be useful in that respect.

One advantage of tokenization is the fact that it potentially provides liquidity in a way that has not been possible before. The average time to IPO has gone from something like four years around 2000 to 10-11 years now. Obviously that's a huge difference, and the issue is that a majority of returns are now concentrated in the pockets of VCs and other accredited investors who are able to invest in early-stage equity rounds. This is not the case for most people, who just don't have access to those deals. What that means is that public market investors are no longer able to benefit, or they benefit in a much smaller way, because those years of growth are not available to them. I think the ability to have meaningful liquidity options and the ability to have a broader, more diverse class of investors seeing returns from early-stage tech development is important.

There are several advantages for companies. I’ll name a few that are usually top of mind. The first is speed – with the right amount of pre-marketing, funds can be raised quickly and

Arianna Simpson,

Autonomous Partners

Elliot Han, Argon Group

efficiently without the added cost and bulk of traditional fund receiving and settlement mechanisms. Another is cost – of course there will be a cost to any fund-raising method, but, simply put, the level for ICOs is significantly lower than using traditional methods. And a third major advantage is settlement, which is done via the blockchain, so it requires fewer resources, as well as less time and effort. It is also immutable and secure, since it’s on the blockchain.

From an investor’s perspective, what do you think are the potential advantages to digital coins over other kinds of securities or debt?

At this point, as the market is developing, they are easier to trade, and also unlike debt or equity, they can be cashed in for services, or even used for day-to-day transactions. So that is certainly an advantage — that they are spendable, whereas I can't spend a share of IBM, or I can't spend a bond issued by CVS, which recently issued US$40bn in bonds. The interesting question is going to be whether digital coins are investments or something else? If they are investments, then they're likely to morph into something closer to equities, but perhaps still be tradable. Again, that's the open question here: Are they coins, or are they really just

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University


securities masquerading as coins? It is certainly an advantage if they develop into something that is much more tradable.

I think there remains a lot of interest surrounding coins, and any time there is interest in a particular type of offering, it can be attractive both from the company side and for investors. It's easier to make money on it if there is robust interest in it. From the investor perspective in particular, if it's a utility token, it is easier to manage from a regulatory point of view. However, I think right now there are very few of those in the U.S. that the SEC would say are not securities.

As I mentioned before, one major advantage is liquidity. If you have an equity position in a company, it's very difficult to exit that position until the company has a liquidity event of some sort, either a sale or an IPO. That may be five or ten years away, which is a fairly meaningful period in which your capital is locked up. If you have a token position, obviously there still may be a lock-up period, but in general it is much more liquid. So having the ability to say, “Okay, I've held this position for two years and now I need


Arianna Simpson,

Autonomous Partners

to take some or all of my money off the table," is potentially advantageous over a traditional equity investment.

There are various benefits, but think the largest potential advantage is that it brings forth investor democratization, allowing more people to be investors – not just institutions but also the "small" investor. This is only advantageous if there are appropriate frameworks in place to ensure the investor is protected, and I believe government agencies will become effective at regulating this market. Right now, it's an education process – for all involved – to ensure there is a dynamic market for potential investors, but also a secure market where those investors can and will be protected.


“Right now, it's an education process — for all involved — to ensure there is a dynamic market for potential investors, but also a secure market."



Glimpsing the future

Whether or not digital coins become mainstream, do you think the technologies underlying them, such as cybersecurity protections and blockchain, will become part of more traditional fundraising platforms and methods for companies?

I don't know about cybersecurity protections, but certainly the idea behind blockchain is going to spread far beyond cryptocurrency. It is a way to track transactions and transfers of property, so I think we'll see it in the home mortgage and home sales arena, and perhaps in certain financial transactions. It could be used with letters of credit, for example, and in that way it's another form of protection. But the concern at the back of everyone's mind is going to be hacking.

When it comes to blockchain, I think of the example of assigning unique numbers to things. We already do that with cars — they're called vehicle identification numbers. In that regard, the technology is nothing new, but having a public ledger updated in real time is something I think we're going to see spread to other types of

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University

The experts

Grant Fondo Partner and California Litigation Leader, Goodwin Procter

Elliot Han Managing Director, Argon Group

Peter Henning Professor of Law, Wayne State University

Arianna Simpson Founder and Managing Director, Autonomous Partners


transactions. I suspect we'll see it in the securities area with regard to stock ownership, with your shares being assigned a unique identifier.

I absolutely believe these technologies are here to stay, whether or not they become part of a more traditional fundraising platform. What I think ICOs have done is dramatically accelerated the use of blockchain, and has caused some of the cybersecurity concerns and other potential issues with the technologies to be addressed more rapidly.

I would equate the development of these technologies to the internet in some ways. When the internet boom began, there was a massive explosion of companies trying to do different things with it. Some of them may seem silly today, but good or bad, one very positive aspect was that they accelerated the use of the internet overall and the various benefits it can provide from a technological, business and societal perspective. I think you'll see the same thing with digital currency and blockchain.

The potential of these technologies extends far beyond cryptocurrencies. Financial applications and distributed ledgers are certainly a meaningful part of what can be done on the blockchain, but that's only one piece of the


Arianna Simpson,

Autonomous Partners

equation. I believe many of the future use cases that will become ubiquitous have yet to be discovered. We're less than a decade into the period since the Bitcoin white paper was released, and we're probably still five to seven years away from blockchain-based applications gaining mainstream adoption. So realistically, it's still very early. Ultimately, I think these technologies will eventually become embedded in all kinds of industries, in the same way the internet touches almost every imaginable business in a meaningful way today.

Yes, it's the very nature of these technologies and their advantages of faster settlements, reduced costs, transparency and user control that excite the industry. The key is now to find methods to implement them appropriately and securely.

Some more established companies such as Telegram and Kik have begun launching ICOs to raise capital. Do you think this fundraising method will eventually gain legitimacy if more high-profile companies begin issuing coins?

When you say “established companies,” I think more along the lines of larger, publicly traded companies, and I think at the moment they're going


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University

“Certainly the idea behind blockchain is going to spread far beyond cryptocurrency."

Peter Henning, Wayne State University


to be afraid to touch this market because of the uncertainty surrounding regulation. There was talk of Kodak issuing KodakCoins as a way to track photographs and ensure that the photographers got their royalties when an image is published. But I wouldn't call Kodak an established company — it has gone through bankruptcy and is struggling to survive. I think the bigger companies, or the more well-established companies, are not going to dip their toes into the water until they see what the regulatory landscape looks

like. They're used to normal everyday SEC regulations and they don't like to go into areas of uncertainty. One or two may try it, but if I'm the lawyer for one of those companies, my message is: “Beware — this could blow up on you.”

I think in any industry where more high-profile companies join in, whether it's through token sales or otherwise, it does help to increase the activity’s legitimacy. At the same time, I think rules and regulation that are understandable and easy to follow also bring legitimacy to the space. I also think that governments helping to facilitate outlets for this interest, meaning liquidity, in a regulated way helps promote interest as well as legitimacy. I certainly think the recognition of the regulatory environment is much higher than it was two months ago.

The method has very quickly risen to prominence, and concerns remain around exactly what is and isn't allowed. It's pretty clear that there are ways to do compliant ICOs, and there are a few different options for how to do them — Reg D, Reg S, etc. They are obviously more expensive to conduct, more difficult, and slower, but they can be done. I do think that having high-profile companies conduct ICOs can help accelerate the pace of adoption — but there is still a high degree of


Arianna Simpson,

Autonomous Partners

Source: Token Report, Wall Street Journal, Bloomberg

US$7,500The value below which

Bitcoin fell in March 2018, from a high of more than

US$19,000 in December 2017

80The number of

subpoenas and information requests sent by the SEC to companies in the digital

coin market in recent months

197The number of ICOs

launched in March 2018, which raised an

estimated US$1.44bn


regulatory and compliance risk. It's important to note that just because something hasn't been explicitly declared a security doesn't mean it is not a security. So I think a lot of people have been using what I somewhat jokingly refer to as “the ostrich method,” which basically means they hide their heads in the sand and hope that no one comes after them. That's a very dangerous approach to take. I hope that some of the higher-profile ICOs can help the regulatory bodies come to good conclusions about how they should regulate, as more guidance will help the industry mature.

I think what will add "legitimacy" is not the name brand of a particular company, but the robustness of the business model of any company looking to raise funds. This has been an integral part of evaluating potential investments when seeking to raise via the traditional methods and will remain this way for this method as well.


10 I ICOs and the future of capital raising10 I ICOs and the future of capital raising

Over the last year, initial coin offerings (ICOs) have thrived in part because they avoided strict regulatory scrutiny. U.S. and foreign regulators alike are gradually cracking down on the activity, however, as the market booms and investors are exposed to billions of dollars in potential losses. The question is: How effective will government agencies be at reigning in token issuers?

Where things standSince late 2017, U.S. government agencies have been ramping up their oversight of ICOs and cryptocurrencies. Securities and Exchange Commission (SEC) Chairman Jay Clayton issued a statement in December 2017 warning that many of the tokens being issued in ICOs appear to be securities under U.S. law.

That same month, the SEC sent a cease and desist letter to Munchee, a food review service, to halt its ICO that was attempting to raise US$15m, saying the token to be issued was a security masquerading as a utility coin. The Munchee decision is considered a landmark ruling for the industry.

The distinctions between various types of coins – virtual currencies, utility coins, security coins, and hybrids of the three – are critical to how they should be regulated. As a result, government agencies and industry players are attempting to define them more clearly.

For instance, some token exchanges only allow trading of coins that have not been issued by a company or government, such as Bitcoin. Many companies that hold ICOs have argued that their coins are a utility, meaning they can be used as a form of exchange for a product or service to be offered by the company. Regulators have mostly argued that these tokens are in fact securities, however. SEC Chairman Clayton said in November 2017 that all the ICOs he had seen have the “hallmarks of a security.”

In February 2018, the SEC took a step further in its supervisory efforts, issuing at least 80 subpoenas and information requests to companies that have sold tokens and advisory firms that have worked for them. Commission Enforcement Director Stephanie Avakian said in March that they were conducting dozens of investigations into cryptocurrencies, and in early April the SEC pressed fraud charges on two co-founders of start-up Centra Tech, which raised more than US$32m in an ICO in 2017.

The path forwardExperts and industry participants have been expecting more robust regulation of digital coins. And some believe it will actually encourage further adoption of the technology.

“I hope that regulators issue more specific guidance soon, because there are a lot of companies and funds out there that would like to be compliant,” said Arianna Simpson, a managing director at cryptocurrency fund Autonomous Partners. “More detailed guidance can be very helpful in ensuring that the industry is able to evolve effectively.”

Can U.S. regulators oversee ICOs effectively?

“The question is whether the square pegs of digital coins ... fit into the round holds of SEC and CFTC regulation."

Peter Henning, Wayne State University

11 I ICOs and the future of capital raising11 I ICOs and the future of capital raising

The CEO of online retailer Overstock echoed this sentiment in March 2018 after a subsidiary of his company, tZero, came under SEC investigation for an ICO it held late last year. “The more of a regulatory spotlight they bring, the better we look,” Overstock CEO Patrick Byrne told the

Wall Street Journal after the probe was announced. The company had raised at least US$100m in the offering as of March 2018, of a total US$250m it was seeking, but had not yet issued the tokens.

The SEC has arguably taken on the biggest role thus far in policing ICOs, but other agencies have indicated they will exercise oversight as well. In March 2018, the Financial Crimes Enforcement Network (FinCEN) said it would apply the agency’s anti-money laundering rules to companies that hold ICOs. A U.S. court ruled that same month that the Commodity Futures Trading Commission (CFTC) could also regulate virtual currencies.

A tall taskUltimately, the current regulators may not be up to the task of supervising the complex ICO space, said Peter Henning, a law professor at Wayne State University.

“The question is whether the square pegs of digital coins and the ICO market fit into the round holes of SEC and CFTC regulation,” Henning said. “These are completely new phenomena and so far, they have been undefined. I'm not sure that the SEC or CFTC have the tools on their own.”

Some, including Henning, have floated the idea of establishing a cyptocurrency exchange commission to provide supervision of the space. Congress would likely need to act in order to create such a regulatory body.

As the market evolves, a new agency with exclusive supervision of tokens could help clarify what all the rules are at a given time. After all, the main objectives of regulation can be clouded when different agencies are constantly weighing in, said Grant Fondo, a partner at law firm Goodwin Procter and a former federal prosecutor.

“I think there is still some confusion out there and some of that has been created by the regulators,” Fondo said.

“I don't mean that critically, but just in the sense that there have been a number of announcements from the likes of FinCEN and others.

“Hopefully, there will be a regulatory environment in place that allows the regulators to do what they do, which is primarily protect consumers, and let the businesses raise funds or use tokens in a manner that promotes business and keeps that business in the U.S., as opposed to going offshore.”

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