Are ICO’s a safe class of investment?
ICO’s have taken in over one billion dollars in investment (or “donations”) this year alone. Their popularity is likely based on two primary factors:
1.Decentralization of opportunity to invest in start-ups (something that has primarily been available to venture capitalists or “accredited investors”);
2.”Gold Rush” fever spiked by new and innovative ideas that are generating outsized investment returns market-wide.
Neither of those factors are difficult to understand or improper. Providing opportunities to the general public to be involved in an exciting industry and to share in the profit potential is arguably a very good thing. In that sense the idea of an ICO is intriguing and fits very well with the crypto-currency model.
However, not all of the ico’s are providing what many would consider to be fair protections for the investors and many investors probably do not even really know what they are getting in return for their money – many investors may well be under the misapprehension that they are receiving something equivalent to equity in the company, which they are not receiving.
In this article, I argue that the ICO model requires standardization of investor protection and a considerable increase in transparency. As part of this analysis, it is important to understand what a company is, what people are receiving in these ICO’s, and how the two may potentially interact.
In my view, there are two distinct categories of companies involved in ICO’s:
(a)Those that give up their ownership of the equity of the company and essentially transfer the equity into the token/coin; and
(b)Those that keep the equity of the company and issue “use tokens”.
(a)
Past ICO’s such as those for Ethereum, EOS and Tezos provide examples of the first category (to the best of my understanding). In the most recent example, Tezos, the ico was structured so that the company that had ownership rights sold it to a newly created foundation that issues tokens to its users. The code and the crypto-currency system is thus purchased from the company and the company no longer has ownership. The direction of the currency and the major decisions for it are thereafter decided by the token holders and the token holders reallize any increases in the value of the system/token.
This first category of ICO’s can offer its investors something of value and that can appreciate as the value of the system increases. There is no guarantee that the value of the system will increase, but the token is directly tied to the value of the system or product.
Many people, including Meltem Demirors (Digital Currency Group’s director of development) have expressed concerns about the motivation of “founders” of these ICO’s to actually complete the product once they are holding many millions of dollars. This is a very valid concern that needs to be dealt with by ico's. One of the ways that Tezos dealt with that concern from the marketplace was to include a clause that prohibited payment to the founders until the network was running as intended for a defined period of time. Beware that not all of the projects offer these types of clauses.
(b)
The second category of token/coin is very different. These are the “use” tokens such as Civic or TenX – which could certainly be very good and profitable ideas. However, Civic and TenX are not divesting their equity into the token/coin or foundation. Instead, they are issuing “use tokens” – tokens that can be used on their system, but the companies are maintaining the equity/ownership of the system itself separately.
To discuss this in a more general way, without referencing the complex details of any company’s individual structure, “Coin Incorporated” can create a system for tokenizing government ID’s that it calls “Coin net”. Coin Incorporated can maintain the ownership of the software, the goodwill, the equipment, and all other aspects of the business in the Coin Incorporated company. Coin net can then issue tokens that people can use on its system and sell those in an ICO. While investors may own the tokens, they have no control over the Coin Incorporated company and the decisions that it makes or its assets or profits.
The easiest example of how a token holder may lose out is if Coin Incorporated simply decided to issue more tokens at some point in the future. Depending on the promises made in the ICO offering, that might meet with legal action by the token holders. However, imagine that the company instead decides to issue a different class of tokens (ie: akin to steem power versus steem versus steem dollars, or tokens that provide additional/platinum benefits etc) or to provide alternatives to the tokens themselves, or to simply “fork” the network system/tokens. The enforceability of any initial promises not to issue further tokens is questionable as I understand it, and creative minds can often find ways around promises (ie: imagine that the company decides to set an expiry date on some of the use tokens, the examples of creative ideas are infinite).
Imagine further that the company decides to sell the rights to the system to a competitor who has a different vision, or that the company itself decides to create a different version of the system. Imagine that the company’s equity holders decide to take out all of the profits or to bankrupt the company for one reason or another. There are many potential ways in which a token holder may have the value of their token reduced considerably based on actions from the company that they do not own any part of.
One might argue that anything that these companies did to prejudice the token holder of the system could be met with a lawsuit. However, many of the companies have went to great lengths to ensure that they could argue that the tokens are not investments. Instead, they have made it very clear in their offering memoranda that they are simply “use tokens” and have explicitly said that they are not investments. An appropriate analogy would be if you had a gift certificate for one month free at a local fitness facility (or, an even better analogy, would be a groupon for one month free that you had purchased). You would own the right to use the fitness facility for one month. However, the gym may well offer "new gift certificates" that provide access to the "executive lockers" or to extra classes or access at particular times.
When stocks are issued to investors, there are protections in place for the shareholders and there is, generally, a duty upon the company’s directors to use the company’s assets in the interests of the shareholders. There is very little detail and control for how the token holders are advantaged or protected in these ICO’s and how the funds are required to be used.
The reason that many reputable companies have likely decided to issue a “use token”, is because of regulatory concerns and the potential imprisonment that could follow if the tokens were deemed to be securities. U.S. Securities law will, generally, examine these sorts of offerings according to the tenets of the Howey test. Without getting too far into the details, Courts will consider whether something should be deemed to be a security and should thus be subject to regulation as a security (even certain golf course memberships and orange grove ownership/profit structures have been the subject of inquiry). Company’s involved in these ICO’s have went to great lengths to avoid that – they offer “use tokens”, they restrict any purchase from the United States to avoid the SEC, they rename these offerings as TGE’s (token generating events) – perhaps because ICO sounds too much like IPO (an initial public offering in a securities context). A regulator’s decision on whether or not this is a security, may not only target those offering the ICO, the purchaser could end up with a significant investment loss as well. If it walks like a duck and quacks like a duck, the regulatory authorities may well eventually call it a duck.
While the decentralization of opportunity and the exciting profit potential of this market in general is arguably a very good thing, there are some very real concerns. The SEC does not impose regulation simply to be a party pooper or as part of some grand conspiracy – the reason for the regulation is to protect individual investors. Arguably, the regulation is over-complicated and difficult to navigate and ends up restricting opportunities, perhaps more than it should, but the regulation is there because there is a real risk of individual investors being taken advantage of. While the “crypto-forest” may be very beautiful and promising in general, there are wolves roaming in all forests, and there is a very real need for some regulation to protect individual consumers.
My suggestion is that companies that truly want to offer a decentralized form of investment follow the likes of ethereum and tezos and establish a foundation, which purchases the network/system and all assets from the company using the funds from the token generating event. There should be a "model ico term sheet" developed by the crypto community that provides clarity and protection to users. This would truly provide something to the individuals who are investing their money.
While I have great respect for some of the individuals in the companies going the "use token" route, I think that they may face the argument in the future that they failed to provide sufficient clarity and failed to appropriately provide particulars and details to the individuals investing.
Tokenization of value is a very new and intriguing concept, but (using the previous example) the public needs to know that purchasing a one month free fitness pass is not the same as purchasing part of the fitness club. The fitness pass may go up in value if the price of access to the club increases, but the club maintains control over all of the terms and details and uses.
(The information set out in this article is simply the author’s belief and opinion, and is not a statement of fact and should in no way be interpreted as investment advice or information on which you should rely. The author is not an investment manager or advisor and offers no representations or warranties about the correctness of the information contained in this article).