With over $8.8B raised via Initial Coin Offerings (ICOs) since 2014, and over 1,200 tokens in circulation with a combined market capitalization of over $300B, it’s not surprising that ICOs are an increasingly popular fundraising tool. In this post, we discuss eight key items to consider before staging an ICO.
1. Security v. Utility. Tokens are not a homogeneous asset class –– they may feature characteristics of securities, commodities, currency units, or a combination thereof. As a result, the legal analysis relating to a particular token may involve multiple regulatory regimes. Irrespective of whether a token has a consumptive purpose and may be characterized as a “utility token” by its issuer, the SEC repeatedly stated that “Whether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction,” and confirmed that ICOs would be analyzed under the facts-and-circumstances test outlined in SEC v. W.J. Howey Co.
2. The Howey Test. The U.S. Supreme Court in Howey developed a four-pronged test for evaluating whether a particular instrument constitutes an “investment contract.” An instrument is an “investment contract” under the Howey test where there exists: (a) an investment of money; (b) in a common enterprise; (c) with an expectation of profits; and (d) to be derived solely from the efforts of others.
It is worth noting that the concept of “investment contract” embodies a flexible principle that is capable of adaptation to meet the countless and variable constructs developed by contractual arrangements over time.
3. U.S. Federal Securities Laws. The Securities Act requires that securities be offered and sold only (i) if registered with the SEC or (ii) in transactions exempt from, or not subject to, registration under the Securities Act. Several ICOs have been conducted in reliance on Rule 506(c) or Tier 2 of Regulation A+. Each exemption features characteristics and imposes certain limitations on an ICO; therefore issuers should take care in determining which exemption is best suited for their needs. For a summary comparison of the main features of these two exempt offering alternatives, see “Do You Want to Launch an ICO? Please, Listen to the SEC” (February 8, 2018), available at https://www.mofo.com/resources/publications/180131-ico-sec.html#_ftn14.
4. The Regulators are Watching. The level of attention paid to ICOs at the SEC has dramatically increased in the last six months, as reflected by a number of enforcement actions and guidance provided to market participants. Conducting an ICO within the United States without complying with the U.S. federal securities laws or relying on an applicable exemption could expose an issuer to rescission rights and a variety of remedies in enforcement actions brought by the SEC (including disgorgement of any profits, and civil and criminal penalties).
5. Timeline. Depending on the securities offering exemption chosen by an issuer and a variety of other factors that are unique to each transaction, the timeline to conduct an ICO may range from 4-8 weeks for an ICO conducted in reliance on Rule 506(c), to about 12-16 weeks for an ICO conducted in reliance on Tier 2 of Regulation A+.
6. The White Paper. The process for undertaking an ICO typically originates with the preparation of a whitepaper. Drafting a whitepaper is, in and of itself, a time consuming endeavor. The question of what exactly should be included in a whitepaper merits a separate discussion, but generally speaking a well-developed white paper should include, at a minimum (a) a thorough description of a problem, (b) a detailed explanation of how the blockchain project is expected to provide a solution, (c) a technical description of the architecture (mathematical formulas and computer code), (d) development plans, (e) use of funds, (f) tokens economics, (g) information on the team, including (ideally) their experience with blockchain and crypto assets, (h) risk factors, and (i) legal notices.
7. Online Presence. Assuming general solicitation and advertisement are permitted, the vast majority of marketing for ICOs takes place online, via website landing pages and social media profiles. For this reason, it is important to establish and maintain a uniform online presence from a project’s inception. Securing the domain name for a website and building cohesive profiles on multiple social media platforms is critical, as these are the nodes through which potential investors and members of the blockchain community will stay abreast of the project’s progress. In addition, a consistent name across all media platforms will reduce the risk of imposters deceiving investors into sending their investments to their wallets rather than to the issuer’s wallet. On a similar note, it is important to engage with community channels and forums (i.e., BitcoinTalk, Discord, Slack, Telegram, etc.).
8. Token Generation. Choosing a blockchain platform is a topic that deserves its own discussion, but for purposes of this blog, it is worth noting that depending on the complexity of the programming capabilities required for a given token, many ICOs have taken place on the Ethereum network using ERC20 tokens, or on the Stellar network.
A special thanks to corporate paralegal Camille Houle for her contributions to this post.