Initial Coin Offerings: A new capital market takes wing, but not without controversy

S&P Global
Written By: John Kingston (lead author), Eric Turner, Thomas Zakrzewski and James Rilett
S&P Global
Written By: John Kingston (lead author), Eric Turner, Thomas Zakrzewski and James Rilett

Capital markets have long found new ways to provide funding for economic institutions of all shapes and sizes. One of the more novel ones has helped raise hundreds of millions of dollars in just the past two years, marking it firmly as a new entrant in the world of decentralized nontraditional capital markets: the initial coin offering (ICO). ICOs are based on the distributed ledger technology of blockchain initially used for bitcoin, but they can frequently be on bitcoin's challenger, Ethereum, which has its own unique distributed ledger. Here, we answer questions about this growing--albeit confusing--method of providing startup funding, raising sums that barely cross $1 million to as much as, or more than, $150 million.

Let’s start with the basics: what are ICOs?

ICOs are a form of crowdfunding to develop blockchain-based applications, with the fund raising taking place on a blockchain. Because it is crowdfunding, individual investors are looked to as the pool of potential buyers, and it's not unusual since the value of the tokens spiked in spring 2017 to hear individual investors boast that they bought a token for $250 and sold it for many times over. (Ironically, the products in an ICO are rarely referred to as coins; tokens is the preferred word.)

Instead of seeking investment from venture capital or angel investors, an ICO allows a larger group of people or entities to purchase as many, or as few, tokens as they wish. A series of successful ICOs has led some investors to enter the space hoping to profit from getting in early on a promising platform. Some of the early numbers from the spring and early summer of 2017 reflect tremendous gains.

If an individual makes a purchase on an ICO, what's he or she buying? Is it shares in the company?

No. An ICO does not offer equity. It provides the ownership in a full or partial share of the token that is for sale. It isn't a debt instrument; the company that sold the token owes nothing to its owner other than the use of platform services equal to its value.

If I'm not buying equity in a company, like I would in an IPO, then let's revert to the original question: what I am buying?

There are several things you could get if you bought a token. Mark Williams, master lecturer at Boston University, described it this way: "Each platform is different, and the role that a token plays also differs widely from platform to platform. Usually, a token gives the owner the access or right to participate in specific activities inside the platform. If the underlying demand or value of these activities increases, the token usually increases in value. Sometimes tokens are purchased as a bet that underlying value of such access and blockchain related activities will increase in value. It is also possible for platforms to become adopted without the token gaining much value. The potential for token appreciation depends on the specifics of the economic design of the application."

A good  example is the ICO-funded company Storj. The company's product is described as "distributed cloud storage.” It links available data storage space through a blockchain connection, running open-source software Storj developed. Storj first raised capital in 2014 through an ICO measured by the 910 bitcoins investors supplied. At the time, digital currency information and news provider CoinDesk valued the money raised at about $460,000. (At a mid-June value of about $2,200 for 1 bitcoin, that figure would be more than $2 million.) To reiterate a key point, the buyers in that auction did not get equity in Storj. Instead, they got Storjcoin, a digital currency tied to the Storj platform.

A buyer may also be looking to participate in any upside or notional capital value growth from that token, which would convert back into more bitcoins, ethers, or even U.S. dollars.

Can you give another example?

There's a very good, non-technical example in the white paper produced for the ICO of a company called Bancor, which recently raised a whopping $150 million in a June ICO: "For example, a musician may collect funds to record an album, which would be sold online exclusively in exchange for the issued tokens. A successful album would generate high demand for the tokens, driving up their price and rewarding those holding them." If an application tied to an ICO produces a blockchain-based application that becomes successful, potential customers will be clamoring to use it. The entrance fee to use that application will be a token. Its value presumably would rise with the increase in demand for the token, whose quantity is generally fixed and capped by the developer. (As an aside, S&P Global Chief Economist Paul Sheard, in looking at ICOs, noted the way a token is described sounds close to the classic definition of equity. “It sounds like equity in the project, not the enterprise,” Paul wrote. “Equity is a ‘residual risk’ claim: your payoff is anything between zero and unlimited upside. This sounds very similar to the description of a token.”)

You mentioned a white paper. Why not a prospectus, like with an IPO?

That's another unique aspect of the token ecosystem, as it is often referred. The traditional prospectus that would be released for an IPO of equity or for a debt offering has been replaced by a “white paper.” They differ in length, style and specifics. But they are the declaration of the entity offering the token as to what the developers plan on doing with the cash raised by the token offering. A white paper format also better serves potential token investors. While a prospectus is designed to ensure that investors understand a company's operations, a white paper is more technical and ensures token purchasers understand how a platform will work. The style of disclosures in a white paper also help to differentiate a token sale from a traditional equity offering, which for now at least can help keep ICOs away from regulatory restrictions.

Are some of these ICOs scams?

No doubt. Everybody in the token ecosystem agrees with that. It's a market that doesn't have agreed-upon standards, regulation or any specific oversight. A true scam would obviously face criminal prosecution, but that can hardly be considered “regulation.” Even if some of them aren't scams, others might be legitimately promising an application that they then fail to produce even after their funding through the ICO is in place. One thing that would make a scam transparent pretty quickly: the value of the token sold in the fraudulent ICO. It would collapse as its owners realize they've been had. If the price of the cryptocurrency is transparent, which they increasingly are, the decline would not go unnoticed.  

Those in the ecosystem legitimately realize that the Wild West aspect of ICOs can't go on. There needs to be standards, and if this form of fund raising is going to flourish, there needs to be the ICO equivalent of what you find in other capital markets: equity analysts, ratings agencies and a clearer regulatory regime.  

When I get my new token, can I immediately start to use it on the blockchain protocol the developers talked about in their white paper?

Maybe. More likely, the funds you provided by buying the token will be used to develop the application. Think of it like a book advance: the publisher gives the writer an advance, and the writer goes off to produce--hopefully--a best-seller. One difference: if the writer fails to produce, the publisher can usually claw back the advance. It is debatable whether that's possible with a token owner who bought a cryptocurrency for an application that remained nothing more than an idea.

When did this new trend start?

The generally accepted first ICO was for a company called Mastercoin, back in 2013, but the ICO to fund the Ethereum platform is considered the coming of age for this new form of fund raising. The many offerings in 2016-2017 reflect a combination of maturity and frenzy, all rolled into one.

If I wanted to use the services of Storj, or some similar blockchain-based application, would I need one of the cryptocurrencies that are behind each token?

The Storj white paper describes the system as "payment agnostic." It does add, however, that the system "assumes" the use of Storjcoin, the token offered as part of the Storj ICO. It also states that bitcoin and ether--the Ethereum platform's digital currency--can be used. It also says the "physical transfer of live goats" is acceptable also, which is not the type of verbiage you'd find in too many prospectuses. Implied then is that dollars would be just fine. But it's clear that the token ecosystem believes these applications operate best with the cryptocurrency designed for that platform.

Why wouldn't a company like Storj lay down tighter guidelines on approved payment methods?

The platform is based on distributed ledger technology, the key being "distributed." Transactions between parties on the blockchain-driven application are peer-to-peer, and the assumption is they can figure out for themselves how a seller gets paid.

Can you give me examples of some other services that are provided by recent ICOs?

There are now literally hundreds of them. Smith & Crown is a coin research and price tracking company with the added quirk of a name that sounds like an English pub. In mid-June, it listed almost 60 pending ICOs. It had almost 70 ICOs under the heading of recent ICOs. It also tracks the value of many cryptocurrencies created by ICOs. Some of the brief business plan descriptions include gaming or gambling; another is a decentralized encyclopedia, like Wikipedia with a "for-profit business model and rewards for users who create or edit content." Some descriptions can only be described as "geek speak." Various financial services are listed, such as one that describes itself as a "project aimed to create a regulated bank for cryptofinance" and one for a company called Legends Room, described as providing token owners with "VIP membership in a Las Vegas gentleman's club" (though to be fair, that one is very much an outlier). But in general, if you look over the list of the ICOs on Smith & Crown, the majority are distributed, transparent applications utilizing the capabilities of blockchain.

Are recently purchased tokens being actively used for the services provided by the company? Or is it all just speculation?

Here's an unscientific poll result: At a sold-out New York event called the Token Summit in May of this year, the conference chair early in the day asked a room of approximately 500 people how many of the attendees owned a token. The sea of hands that shot up was estimated by the chairman as constituting about 90% of the room. The question then was put to the audience: how many of you have actually used one of them for the application tied to the token? Only about 10% remained raised. What that may signify is not necessarily that they're all speculators. It probably also reflects the fact that many of the ICOs have been issued to fund applications that have not yet been developed.

Those connected to the token space will readily concede that in the first half of 2017, the (mostly) rising price of cryptocurrencies was being pushed by investors looking at hot money opportunities, buying tokens tied to business plans that in some cases were vague at best. Some high-profile scandals, and indeed Ethereum's very own flash crash of June 2017, have perhaps not helped. Yet there also are serious, long-term funds that have raised millions of dollars to invest in cryptocurrencies.

This sounds like a bubble. But there have been bubbles before, and the products at the heart of the bubbles have often stuck around, like in the dot com burst, or tulip mania in the 1600s. What's going to stick around in this case?

It is true that it can be difficult to fully understand the business plans of many of the companies issuing ICOs or why many tokens have soared in value. The issuers are not even what could really be called "companies." They've been more accurately described as "blockchain protocols," which are blockchain-based applications designed to facilitate further uses that may not yet be fully defined. Some will make it, others won't.

The recent token sale from Aragon--viewed as successful--is a case in point. In its white paper, it describes the Aragon Network as "a token-governed digital jurisdiction that focuses on creating the best conditions for true global indiscriminatory economic growth. The Aragon Network (AN) will be the first decentralized autonomous organization whose goal is to act as a digital jurisdiction that makes it extremely easy and friendly for organizations, entrepreneurs, and investors to operate. The Aragon Network will be bootstrapped with a very thin Constitution voted by its governance. New laws can be added and they can be amended by the governance of the AN."

It's tough to translate that easily. But if we had to, we'd say that Aragon is setting up a blockchain-based network that other entities can use as the base for building a business, with the token owners being called upon to provide a level of governance to the application. Precisely what that business would be is up to the entity developing it on the platform. But once it does, it would use the Aragon token to transact, and uses the consensus aspect of distributed ledgers to help settle disputes. That's not a lot of detail; you'd have to wait to see the application built on the Aragon network. 

Will the actual use of ICOs last? Has a whole new tool for raising capital been discovered, or is this a passing trend that will run out of steam?

ICOs are addressing an issue unique to the nature of blockchain applications: the difficulty in making money from developing open-source software. As noted, many of the entities behind the ICOs consider themselves more as internet protocols rather than traditional companies. But even if monetizing those protocols through traditional channels is extremely difficult, no one knows these networks better than the original developers. Once the open-source software is released and adopted, it will go through numerous iterations; it will presumably never sit still. Who better to provide support to companies using it than the original developers?

One analogy that has been drawn is to Red Hat. (Kudos to the folks at Coin Center who pointed this out.) The Linux operating system is open source; nobody owns it. But Red Hat has carved out a $2 billion business by supporting applications built for Linux. Or as its CEO James Whitehurst said in the company's annual report for 2016: "Red Hat's breadth of open-source technologies spanning infrastructure, application development, middleware, and management layers, combined with award-winning support, training, and consulting services, help transform an organization's data center to meet those customer demands and gain competitive advantage." That's the sort of business that could be sold in an IPO. A group of developers with an open-source blockchain application that is still under development wouldn't have much attraction to traditional venture capital companies or investment bankers who take companies public. Again, quoting Coin Center in a paper from last year: “Open platforms have proved difficult to create because it has been historically difficult to monetize them even if they become successful—by nature they are public goods.”

How many tokens do the initial entrepreneurs retain in the ICO?

There is no hard-and-fast rule. But you can find numerous references to an 85-15 split, with the developers retaining 85%. There are other applications though where the developers held as little as 5%; the Gnosis ICO is an example. Long-range plans require further sales to fund the necessary investment to produce the product promised in the white paper. It's not just to fill the pockets of the principals.

Can I "mine" new tokens?

Mining is the process in the bitcoin protocol where, via an electricity-intensive complex application, new bitcoins are yielded from the original stash of 21 million bitcoins; the number of bitcoins is capped at 21 million, though each bitcoin is divisible into a smaller unit with up to eight decimal points beyond the number 1. The ether token on the Ethereum network is also mined. But most of the recent ICOs, those tied to a specific use case, offer what has been referred to as "pre-mined" tokens where further mining is not possible. Whether the total is capped varies among the ICOs.

If I bought a token as a speculator, or simply don't want to use the application anymore, how can I turn it into real money?

First things first: in this community, never use the term "real money" unless you want to be mocked mercilessly. The term the "ecosystem" uses for dollars, euros, yen, etc. is "fiat currency." It is not a compliment.

If you want to convert your digital currency into fiat currency, many exchanges exist to do so. Coinbase, probably the most well-known, is a popular exchange for bitcoin, ether, and litecoin conversions. Exchanges are being created or expanded to provide liquidity for a range of new tokens created through recent ICOs, while existing services like ShapeShift can convert more obscure tokens into liquid options like bitcoin or ether.

I've just read a whole Q&A on ICOs and now I'm starting to hear that the term is being frowned on. Why is that?

Because of a question that was asked earlier in a roundabout way: what is the difference between an ICO and an IPO? Those in the token community are starting to push back against the ICO term precisely because of the comparison with IPOs. The concern is that they will fall under the same sort of regulatory structures as IPOs, and that is something they would very much like to avoid. Step one is to avoid calling them something so similar to IPO.

Has that regulatory oversight been avoided so far?

Yes, but it's an ongoing debate within the industry how long this freedom will endure. A joint paper published this year attempted to address the issue. Part of the paper was from a consortium that included Coinbase and CoinCenter as sponsors; the other half of the paper was from the law firm of Debevoise & Plimpton. The Coinbase/CoinCenter portion laid out best practices for an ICO. It starts by discussing the so-called "Howey test," determining whether a financial instrument is subject to SEC regulation. Three elements are spelled out: an investment of money, a common enterprise, and "an expectation of profits predominantly from the efforts of others." Later, in the Debevoise & Plimpton section, the law firm says a cryptocurrency token wouldn’t meet the definition of a security--with an eye toward the Howey test--if it has several rights, such as the right to use a system and its outputs and the right to contribute "labor or effort" to that system. But it would be a security if it involved equity or ownership, something that is clearly not part of a token holder's rights.

There are those in the token ecosystem who believe ICOs should be offered only to accredited investors, making them more like a private securities offering instead of an IPO. CoinList, for example, is restricted to accredited investors. It also created a specific instrument for ICOs called a SAFT: Simple Agreement for Future Tokens.

Is the industry largely in agreement that it is not a security?

(Soon after this report was first published, the U.S. Securities & Exchange Commission issued a report stating that it believed tokens in an ICO are securities and are subject to the same laws and regulations as other securities governed by the SEC. The agency’s ruling came in a case involving an ICO known as “The DAO,” notable in part because some of the tokens in that offering were stolen in a hack. The SEC statement said sales of “digital assets” are subject to securities law, but whether any particular sale is subject to those laws “will depend on the facts and circumstances.” The July 25 statement is seen as the first step toward an uncertain regulatory future. We have left the Q&A on regulation below intact from its first publication.)

It's keeping a wary eye on the SEC. At the big blockchain-themed Consensus meeting in New York in May, Valerie Szczepanik was quoted in a Reuters story as saying, "Whether a token is a security or not is a fact or circumstance-based thing and you have to really pick it apart," leaving enough ambiguity that the issue clearly is not viewed as settled.  Szcaepanik's formal title is assistant regional director, Division of Enforcement for the SEC, but she was described in the Reuters story as the head of the agency's distributed ledger team. "Whether or not you are regulated by the SEC, you still have fiduciary duties to your investors," she said, according to the Reuters story. "If you want this industry to flourish, protection of investors should be at the forefront."

Watch the full Q&A here >

Photo of Thomas Zakrzewski, Head of Architecture and Digital Design, Distinguished Engineer, S&P Global Market Intelligence; James Rilett, Global Director of Innovation, S&P Global Platts; Eric Turner, Research Analyst - Financial Technology, S&P Global Market Intelligence; John Kingston, Director of Global Market Insights, S&P Global and lead author.

(Left to Right):Thomas Zakrzewski, Head of Architecture and Digital Design, Distinguished Engineer, S&P Global Market Intelligence; James Rilett, Global Director of Innovation, S&P Global Platts; Eric Turner, Research Analyst - Financial Technology, S&P Global Market Intelligence; John Kingston, Director of Global Market Insights, S&P Global and lead author.