ICOs Are the Next Stage in the Evolution of Startup Funding

Nearly a decade ago, in November 2008, an anonymous person or group known as Satoshi Nakamoto published a research paper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System,” describing the design for a new cryptocurrency called Bitcoin, the first application of the distributed ledger technology known as  the blockchain. The first documented purchase of goods with Bitcoin took place on May 22, 2010, when a programmer bought two pizzas for 10,000 Bitcoins. At the time, the transaction was valued at roughly $41. Today, 10,000 Bitcoins add up to more than $110 million.

For daily updates, subscribe to our newsletter by clicking here.

Since then, and especially from 2013 onwards, the cryptocurrency industry saw a sharp rise in the value of these currencies, which became widely distributed among the general public. For example, it was recently reported that Japan’s Mitsubishi UFJ Financial Group, the world’s fourth-largest bank, plans to launch its own cryptocurrency in 2018. It was also reported that the Israeli Ministry of Finance and the Bank of Israel are considering issuing a digital currency. As we write this, there are about 1,485 different types of cryptocurrencies, with a total market capitalization of approximately $550 billion.

The swiftness and ease with which a new cryptocurrency can be created at any time for different uses and applications has generated a global phenomenon called Initial Coin Offerings.

An Initial Coin Offering, frequently referred to as an ICO, is an innovative crowdfunding model, first pioneered by Ethereum in 2014, in which new projects offer to sell investors units of their underlying crypto tokens – representing a new technology or application – in exchange for existing cryptocurrencies like Bitcoin or Ethereum.

The crypto tokens themselves do not offer the holders any actual equity or particular rights in the project that they have invested in , unlike in Initial Public Offerings, or IPOs. In some cases, the crypto tokens are “equity tokens,” so-called because their only purpose is to appreciate in value, in which case they may be classified as financial securities. Such tokens are subject in various jurisdictions to strict regulations as “securities.” In other cases, the crypto tokens are solely “utility tokens,” providing the owner with access to a specific product or service, and are therefore less likely to be classified as financial securities.

In order to better understand the impact of ICOs, and why they are so successful – a blockchain-based data storage network called Filecoin raised over $253 million during its token offering in September 2017, making it the largest token sale ever – as well as the innovation they bring to international business and global economy, we should focus on the process in which capital has been raised for technology initiatives, especially young startups.

Before the ICO era, startups were able to raise significant capital only from large venture capital funds and “major investors.” Therefore, from the perspective of an average investor, investing in disruptive technologies in the very early stages was almost impossible. In the world of crypto tokens, the ICO mechanism allows startups to bypass traditional early seed investment and other technical obstacles. In other words, certain startups, even in a very early stage, are able to raise significant capital in a very short period of time.

Unlike the traditional raising of capital on a stock exchange, ICOs are not limited to a local market and are generally open to the entire world. However, it is essential that a company have a White Paper and a roadmap prepared prior the launch of an ICO and a functioning platform for the token to be used. The White Paper details everything potential investors must know concerning the new crypto token. This includes technological, commercial and financial information about the crypto token in language understandable to laymen. The roadmap specifies the company’s clearly defined, achievable and realistic objectives and their timeframes. In the current environment, it is important that ICO makers work closely with respected legal counsel as to the application of existing securities laws to the ICO. Whilst there are those who consider that there is no direct regulation of ICOs, this is not the case. Each jurisdiction has its own securities laws which must be carefully considered and complied with.

One of the reasons that ICOs concern regulators in various countries around the world is that, practically, they represent a regulatory workaround. Therefore, several regulators have taken an aggressive position in warning and protecting prospective investors from the accompanying risks. Some countries, such as China and South Korea, have even banned ICOs. Some of the risks the regulators mention include the high volatility of crypto tokens – and cryptocurrencies in general, the lack of regulation for most ICOs and their being based overseas, and the possibility for fraud, as some issuers might not intend to use the funds in accordance with the manner prescribed by the company as marketed. Hence, there is no doubt that sooner or later, ICOs will be regulated. The Israel Tax Authority published last week a draft circular for public comment concerning the taxation of specific aspects of ICOs.

The ICOs market has matured significantly in 2017. Several ICO scams exposed last year led to growing skepticism on the part of investors. As a result of that skepticism, ICO projects had to legitimize themselves and began hiring bankers, experienced lawyers, and other professionals. And finally, the statistics speak for themselves; the total amount of funds raised via ICOs has skyrocketed above $4 billion for the first time, and the number of ICOs has grown to several hundred globally.

In the coming year, we expect the crypto market to remain active and continue to grow (though, adoption of new regulations may have a major effect), as well as institutional money beginning to flow into cryptocurrency and ICO markets at a much faster pace. We also expect to see an increasing number of startups from more diverse industries attempting to raise money through ICOs.

Yair Geva and Gil White are Partners at Israeli law firm Herzog, Fox & Neeman.

Ofer Toledano is an Associate at Israeli law firm Herzog, Fox & Neeman.