Following the media attention given to cryptocurrencies during their price rise in late 2017, interest in Initial Coin Offerings (“ICOs”) is greater than ever. However, these offerings are still a relatively new method of raising capital and lack a unified regulatory system. CMS has used its experience in assisting companies to launch its cryptocurrencies to put together our top tips for launching an ICO successfully.
With nearly USD 4bn having been raised by tech start-ups through ICOs during 2017, the overall appetite for issuers to launch, and for investors to participate in, these offerings remains strong. At the same time, ICOs are under increased scrutiny from regulators globally. Some jurisdictions are in the process of developing specific frameworks for the regulation of ICOs (e.g. Gibraltar, Malta, Bermuda). However, in the vast majority of jurisdictions, it is a matter of assessing on a case-by-case basis whether a particular ICO will be regulated under existing regulatory regimes. This can be a complex exercise, especially where the ICO is marketed and available to participants from a number of jurisdictions.
In this article, we set out seven points for consideration by issuers planning to conduct an ICO.
1. Is an ICO the best option to fund raise?
Whilst ICOs are increasingly viewed as an attractive way to raise capital to fund the development of blockchain-based products, issuers should consider whether an ICO is in fact the best way to raise funds or whether other, more traditional forms of capital raising might be more suitable.
Generally speaking, where the product in question is at an advanced and reasonably mature stage of development and there is a clearly identified market which meets the potential investor’s expectations on likely return and timing (supported by a healthy amount of evidence), then other funding methods might well be more suitable. Venture capital, share sales and bank loans are all established methods of generating capital for new businesses that may offer the right opportunities without the complexities, risks and degree of legal uncertainty surrounding ICOs.
2. What nature of token best suits the ICO?
Broadly, there are three main types of token that can be offered in an ICO:
- Utility tokens – these are tokens that are intended to allow digital access to an application or service.
- Payment tokens – this kind of token gives no rise to claims on the issuer, but is intended to be used, either now or in the future, as a means of payment for acquiring goods or services or as a means of value transfer.
- Security tokens – these tokens represent assets such as a debt or an equity claim on the issuer. For example, the tokens might give their holder a share in the future capital flows or earnings of the company. This makes them broadly similar to traditional securities.
Issuers will need to consider carefully what type of token meets their requirements and the regulatory implications that flow from that. This requires a thorough legal and regulatory analysis of all aspects of the proposed token and its functionality, typically on a multi-jurisdictional basis. Generally speaking, tokens that are deemed to be security tokens are, for regulatory purposes, treated like any other security and will be subject to securities regulation (as applicable). This may, among other things, trigger licensing requirements for ICO issuers and intermediaries.
3. Where will the ICO be launched?
Once it has been determined that an ICO is the appropriate means to raise funds, ICO issuers will need to consider from which jurisdiction they wish to launch the ICO, i.e. where to establish the issuing company. This decision will likely be informed by a combination of commercial and regulatory considerations. The reasons why an issuer may want to choose one jurisdiction over another include, for example:
- tax implications – e.g. some jurisdictions such as the Netherlands, Belgium, France and Luxembourg subject revenue from token sales to corporate tax, while others do not;
- the nature of the intended target audience – e.g. there might be a desire to restrict participation in the ICO to investors from a limited number of jurisdictions;
- the local regulatory framework – e.g. some issuers may prefer to operate from jurisdictions considered to have a more financially sophisticated regulatory framework or, conversely, from jurisdictions which they consider more “ICO friendly” given their lack or limitation of financial regulation. Going forward, the market may see a move towards jurisdictions that are in the process of introducing ICO specific legislation as they might be seen to provide more legal certainty around the regulatory treatment of ICOs.
4. Which jurisdictions will the ICO be marketed in?
Launching an ICO from one jurisdiction does not mean that it will be limited solely to investors based in that jurisdiction. On the contrary, ICOs are typically open to investors from a number of jurisdictions in order to secure the maximum amount of funding possible. However, the regulatory treatment of ICOs, as well as the rules and regulations relating to their marketing, differ significantly between jurisdictions. Generally, the nature of a token as a security or non-security token (see point 2 above) will be critical in determining what restrictions (if any) apply.
For example, China and South Korea have effectively banned ICOs. In the United States, ICOs are potentially subject to numerous and wide-ranging laws and regulations, whilst in the EU, given the absence of any harmonised approach to ICO regulation, the regulatory treatment of ICOs largely remains a matter for the local regulator.
On the marketing side, tokens that are deemed to constitute securities may require the publication of a formal prospectus; equally, there may be a requirement to limit participation in the ICO to certain types of investors only (e.g. investment professionals, self-certified high net worth investors) to avoid a breach of applicable marketing restrictions. Importantly, to the extent that investors in a particular jurisdiction have access to the ICO, the marketing rules of that jurisdiction are likely to be engaged. The regulatory sanctions for breach of local laws and regulations are wide-ranging and potentially severe.
Finally, depending on the jurisdictional analysis/preference, issuers will need to consider what procedures, systems and controls they wish to put in place to ensure that the ICO is only open to eligible investors.
5. What documentation is required?
Several important documents must be produced before the launch of an ICO. The suite of key documents includes (but is not limited to):
- the white paper describing the (blockchain based) project for the development of which the funds are being raised. The white paper should also set out the key parameters of the ICO (e.g. amount raised, price per token, ICO period), describe the utility/characteristics of the tokens and include information on, among other things, token allocation, milestones (i.e. the roadmap for development and implementation), risk factors and the project team. The white paper should include:
- relevant disclaimers;
- terms and conditions governing the pre-sale and/or token sale, including eligibility criteria and risk factors; and
- token purchase agreement/OTC contract for the pre-sale.
All of the above need to be prepared in line with applicable rules and regulations. The white paper should be drafted in plain language, giving due consideration to the information needs of potential token purchasers.
ICO issuers should also consider the need for additional documentation such as incorporation documents, agreements with third party service providers (e.g. payment services firms), applications for listing on crypto currency exchanges and communications with local regulator(s).
6. Have all appropriate AML and KYC checks been carried out?
Whether or not ICO issuers will formally be required to comply with anti-money laundering regulations (“AML legislation”) is likely to depend on the ICO in question and the nature of the tokens.
Even where ICO issuers are not by law subject to AML legislation, they may want to consider very carefully the benefits of undertaking AML and know-your-customer checks as a matter of good practice.
ICO issuers may become subject to regulatory scrutiny if there is a risk, or perception of risk, that the ICO might be used by some investors as a means to further financial crime, e.g. for the purposes of laundering the proceeds of any illegal activity.
7. What legal uncertainties exist around ICOs?
Whilst regulators around the world are debating whether/how to regulate ICOs, the current regulatory environment for ICOs in the vast majority of jurisdictions remains unclear. Some regulators have issued statements or guidance commenting on the legal and regulatory implications of ICOs.
However, ICOs continue to offer advantages to companies whose traditional capital raising activities may not been entirely suitable. Even with ICO regulation constantly being updated, the potential benefits that ICOs can offer the financial markets cannot be ignored.