The following article discusses session one in the IR Global Virtual Series on 'Fundraising via ICO: A Regulatory Perspective'
Noreen Weiss – U.S. (NW) One of the basic things that some issuers find advantageous about an ICO, as compared with traditional methods of raising money by selling equity or convertible debt, is that they are not giving up equity. There are two primary reasons to consider an ICO. One is to raise money without giving up equity, and the second is the ability to raise large sums of money to fund a developing business that is not much more than an idea.
In order to raise equity or convertible debt, typically an investor expects a business plan that’s a lot further along, with some proof of concept or prototype available. An ICO can allow a company to raise the money necessary to develop the blockchain platform before there are any service or products on the platform that is actually available for sale or use. The token itself could be a utility token, namely a way of buying and selling services on the platform, but the challenge is that, under applicable law, the token may be deemed regulated in some fashion, for instance as a security or a commodity or as a business that acts as a money transmitter. Simply having a utility does not exempt a token from these regulatory compliance issues.
Benoit Couty – France (BC) I agree with Noreen that the upside to an ICO, is not being required to dilute equity in any way, as opposed to a standard equity investment or potentially an STO.
They also allow a presale of services and goods because of the use of utility tokens. The tokens that circulate on the platform are a convenient way to fund a project, involving a community with exchanges between members. It is not only a good way to raise money, but also structure a business model. The token helps to build a new kind of business model, which some refer to as tokenization. There are, of course, downsides because of abuses. People have lost their once irrational faith in ICOs and are now looking closer at the details for fear of scams. It’s an aspect we should take into account because it is more difficult to complete a successful ICO now.
ICOs do have a credibility problem, but the good projects will emerge. It may be more difficult though because they will have to show they are good projects. Last year everything was successful because it was the new thing, and the market was rising. This craziness will make it more difficult, but the good projects will prevail.
Dunstan Magro – Malta (DM) I agree with the points raised by my previous interlocutors. From my end, I do recall a Harvard Business Review article by Jeffery Bussgang and Ramana Nanda, which commented that certain observers have pointed out that blockchain projects may have an inherent incentive and strategic reason to be more aggressive in raising capital earlier in the experimentation process. Two additional benefits of ICOs may, therefore, be summarised as follows:
- To jumpstart network effects that provide a first-mover advantage – tokens issued through an ICO are the means through which users transact between a decentralised network of participants without the need for any central organization or platform. By making the tokens issued through the ICO widely available and liquid (and by using the cash raised to finance further development of activity on the network), projects can rapidly channel developer attention towards their protocols.
- To generate publicity that allows them to solicit broad feedback on their beta product – The publicity around the upcoming launch of an ICO that plans to raise several tens or even hundreds of million dollars is a related way to drive developer interest and engagement. This focused attention from developers has the added benefit of crowdsourcing feedback on the beta version of the project.
Although ICOs do come with real benefits, they also have their disadvantages. There are very real potential downsides to large, public fundraising through an ICO. One can appreciate the disadvantages of ICOs and why they are important, by analysing why staged venture-capital financing has been so successful in the first place.
A fundamental characteristic of commercialising new ventures is the high failure rate they face. A solution to this challenge is multi-stage financing, which allows entrepreneurs and investors to learn about the ultimate viability of an idea through a sequence of investments over time. Multi-stage financing is usually seen as benefiting the investors: It allows them to commit only a fraction of the money upfront, preserving the option to abandon the investment if the idea does not pan out, but allowing them to reinvest if things continue to go well.
On the other hand, from the entrepreneur’s point of view, the earliest money invested in a venture, which is raised when uncertainty is highest, is the most expensive. By raising a small amount of money initially and de-risking the venture through a series of structured experiments, entrepreneurs who succeed, raise subsequent capital at higher prices and are able to retain a higher share of the venture they have built.
One can consider ICOs as the wild west of fundraising, unlike an IPO which is subject to stringent regulations which are subject to onerous filing requirements which do take months to complete. An ICO is not an efficient way to secure that a project is adequately financed throughout its development until the project is actually completed. Through an ICO an investor might not be sufficiently motivated to complete the project, which highlights the problems created by systematic scammers. This, therefore, stresses the importance of adequately regulating ICOs.
Another disadvantage to consider is the following. Many early-stage ventures start off in ‘stealth mode’ to prevent their idea from being widely accessible and among the reason’s firms have taken advantage of the abundance of growth capital to remain private much longer (e.g., Uber, Airbnb, WeWork) is that it allows them to only selectively disclose confidential information that can be important for strategic reasons to not be available to competitors. An ICO exposes a start-up’s strategic roadmap and, in many cases, actual software code to the public, allowing competitors to learn and adopt elements of it into their own protocols.
Luis Santine – Dutch Caribbean (LS) While an IPO is seen as the first sale of stocks issued to the public by a firm on an international trade platform, such as a securities exchange, ICOs are considered mainly as a new fundraising mechanism for blockchain start-ups.
An ICO is typically an unregulated form of start-up crowdfunding which allows companies to raise as much capital as they wish without a central authority overlooking the entire campaign or issue.
Companies active in the field of blockchain and particularly cryptocurrencies, typically face significant challenges with the opening of bank accounts. ICOs can, therefore, serve as a convenient way to raise capital in the form of a token issuance. In some instances, the crypto exchange can simply be seen as a ‘super’ broker with token reserves. With no adequate regulation or real AML policies in place, ICOs can easily be subject to market manipulation and lack of clarity around taxation.
The major utility which an investor can enjoy through stocks is that they are entitled to receive dividends and can also enjoy voting rights during a shareholders meeting. In contrast, by an investment made into an ICO, an investor is entitled to tokens issued by the firm in exchange. However, they are not entitled to any sort of ownership of the project. Unlike with IPOs, it is therefore also common for investors to avail some of their services to the issuing company in exchange for tokens.
One of the main challenges facing ICOs is the common lack of traditional analytical logic in specific business cases. A significant number of crypto projects are merely conceptual ideas with a minimal viable product and scarce traditional financial plans, cash flow statements or balance sheets. Valuation is currently based on a combination of ideas, team reputation, advisory, token economies, continual development and upgrades, while hype also still plays a huge role in the crypto world.
Lavinia Junqueira – Brazil (LJ) I believe the biggest advantages of an ICO are the lower cost of issuance and the potential for it to be a quicker way to get funding if the project is a success, as compared to equity issuance or even international debt issuance. Another advantage is that, like a utility or commodity, the token can blend into the project and become a part of the business plan itself.
Disadvantages in Brazil are linked to anti-money laundering and anti-corruption rules. Some companies may not be able to meet with those rules if they are participating in the ICO market. This is something they need to be very aware of, because the penalties may be high if they're contributing to money laundering and corruption.
Another issue is that the market is new and may in the future involve competition. With competition and demand comes volatility in the pricing of an ICO. You may not know how much money you have to pay at the end of the day for your debt, or if you are going to be able to roll over this debt. Because of the lack of regulation or limited regulation, you may also be subject to economic bubbles and disruption risks.
U.S. – (NW) It's interesting what you say about tax implications Lavinia because that is a disadvantage and it can vary from jurisdiction to jurisdiction.
In the US, if you sell a token, then you're selling property according to the tax authorities, so the money that the company receives can be taxed, in dollars, in the year it is received.
People who are buying and selling tokens are also being taxed in fiat currency, on the value of the gain. This may be a problem, since the person transacting in the token may not have actual money to pay the tax in dollars when all transactions are denominated in Bitcoin or some other cryptocurrency.
I also note that the cost of an ICO is not always lower. Some exchanges charge $1million and up to list a token, but that can be offset by the ability to raise more money than in a traditional raise or even an IPO.
France – (BC) One of the downsides of an ICO is the lack of clarity, certainty and predictability in terms of regulation. This includes tax accounting and tax treatment.
It is not clear today in most of the jurisdictions, how you can roll over the profit from the amounts that you raise. The starting point is that you are immediately subject to tax on the full amount that you raise. Alongside this exposure, is also VAT exposure, and obviously, when you exchange crypto assets you are taxed on the capital gain, without a fiat currency gain to pay for the tax.
In France, we have identified those issues and are working towards some solutions accounting-wise and tax-wise to fix those things. It's not yet perfect, but we are moving in the right direction.
Diego Benz – Switzerland (DB) A distinction should be made between coins and tokens. Tokens are not coins, since not all ICOs aim to have own coins, and rely on other cryptocurrencies as a method of value transfer.
With regard to tokens, one of the advantages is that no bank account is required, however, clients may want to collect FIAT currency, which would require a normal bank account.>
Some jurisdictions that are more favourable for ICO's, such as Switzerland, which ranks highly from an ICO perspective and a regulatory perspective.
There are jurisdictions, including the US, that allows clients to use an investment contract called a SAFT (Simple Agreement for Future Tokens), which is regulated as security. It is a useful instrument if the issuer does not want to put in the effort to make their token issuance comply with mandatory securities regulations, or if they are simply not ready to issue tokens. The SAFT contract allows the purchaser who holds the SAFT to convert it to tokens in the future when the tokens are finally sold to the public, at an exchange rate that is converted at a discount to the ICO price.
However, instead of using a typical SAFT, it can be favourable to use documents which allow tokens to be offered to private purchasers in the form of token purchase agreements drafted under Swiss law. One of the reasons for that is to make it as difficult as possible for foreign regulators to qualify this purchase agreement as a security offering. Nevertheless, careful advice must be taken around which jurisdictions require a SAFT.
With respect to the valuation of coins traded by banks, the Swiss Financial Markets Supervisory Authority (FINMA) sent a letter in October to EXPERTsuisse, the association for audit, tax, and fiduciary professionals, stating that;
“FINMA has recently received an increasing number of enquiries from banks and securities dealers holding positions in crypto-assets and subject to capital adequacy requirements, risk distribution regulations and regulations for the calculation of short-term liquidity ratios”.
According to the reports the 800 per cent risk weight applies to crypto assets both in the banking and the trading book. A risk-weight of 800 per cent means that, for purposes of calculating capital requirements, the market value of crypto-assets is multiplied eight times. The bank has to support 8 per cent of this risk-weight with capital, i.e. 64 cents for each franc of market value. Under the Basle III bank capital framework, risk-weights are somewhere between 0 per cent for highly-rated sovereign debt and 150 per cent for non-investment grade corporate debt, high-volatility real estate or past due exposures. Secured real-estate credit carries a risk-weight of 35 per cent, while the highest risk weight under the current regime is 1,250 per cent for positive replacement values from failed derivatives and securities transactions or payments.
Taking into account the rationale for the calibration of risk weights under the Basle III capital framework, it is clear that it is the extreme volatility of cryptocurrency that warrants such a high-risk weight. On the other hand, it seems equally clear that this rationale is valid only for cryptocurrencies that have no intrinsic value and do not represent any sort of claim against an issuer, but not for crypto-assets in general.
The fact that auditors requested advice from FINMA on how to calculate the capital charge for crypto assets is another clear sign that this new asset class is quickly making inroads into the banking system.
France – (BC) ICOs do apply more readily than more traditional fundraising to certain industries, products or ideas. Any project that is based on blockchain technology will have an interest in doing an ICO, because they issue tokens and plan that the token issued will be exchanged on their platform. It is possible I suppose for regular projects with no blockchain involvement to also use this form of fundraising, but not with the same upside as for truly blockchain-based projects.
U.S. – (NW) An issuer should also question whether its product is actually appropriate for an ICO on the blockchain since not everything fits this model. “What is the use case?” The other issue, even if you have an idea that works really well on the blockchain and has the functionality for a token, is whether it will attract the kind of investor who typically invests in ICOs.
The kind of people who invest in tokens is a demographic that is super tech-savvy and wants interesting technology products. When you have ICOs that are in more traditional, non-tech real world sectors, it can be more difficult to raise money. Shipping is an example of great use of blockchain technology, but we are assisting a shipping client with an ICO that is having trouble getting traction because it is not the kind of sexy tech product that tech-oriented investors recognise or appreciate. This kind of weird market dynamic happening right now is interesting.
Robert Lewandowski – Poland (RL) Within the Polish market, the downsides of ICOs currently prevail over the benefits resulting from using cryptocurrency, however, recent statements made by the Polish Financial Supervisory Authority, Komisja Nadzoru Finansowego (KNF) and the Polish Government, suggest there is a potential market for the cryptocurrency.
An advantage of cryptocurrencies is that they are decentralised, unregulated and have no government or state-related institution as yet determining their value. This enables users to set up their own system of valuing the currency and make crypto deals faster, gaining larger profits within a shorter period of time.
Most cryptocurrencies introduced here in Poland do not require any form of personal information disclosure, so the process of making cryptocurrency deals is more or less anonymous. The parties to such transactions also do not have to worry about crimes such as identity theft, which are common within traditional payment transactions.
Additionally, crypto transactions are in the public domain, with all these transactions available on the network. This differentiates the cryptocurrency from traditional digital transactions, within which the access to transfer of money can only be accessed by approved entities such as banks or public prosecutors.
With regard to disadvantages, there is no existing regulatory body or (government) institution in Poland dedicated to monitoring cryptocurrencies and transactions subject to this currency, at the moment. The value of cryptocurrencies is not determined by established and reputable institutions in Poland, and there is currently no legal framework backing cryptocurrency in Poland in the form of decrees, laws or/ directives.
Cryptocurrencies are, instead, regulated by the individuals/entities offering the currency in question. This makes the currency fickle and dependant on the private vested interests of third parties. It is unknown how the rights and interests of the parties involved could be sufficiently protected and enforced by legal means.
In Poland, the attitude to this currency by highly ranked Polish authorities such as KNF has been negative. KNF started a smear campaign to scare users against cryptocurrencies, and the campaign had a negative impact on ICOs in Poland.
Using cryptocurrencies in Poland does not require any form of identification and disclosure of personal data such as full name, billing address, phone number or tax identification number etc. This phenomenon makes cryptocurrency transactions, such as ICOs, difficult to trace, and they may, therefore, be used for illicit activities as well.
U.S. – (NW) Robert touched on a very important point about digital assets – the fact that ownership is anonymous – which creates issues for KYC and AML (anti-money laundering) compliance laws, that are designed to prevent the funding of terrorist and criminal activities. Governments have a legitimate interest in preventing crime and terrorism and are grappling with how to apply those regulations in the crypto context. Also, institutional and professional investors such as investment funds and advisors and pension funds, are bound by strict KYC and AML regulations that will prevent them from investing in tokens if the chain of ownership cannot be vetted.
Andrea Vasilova – Slovakia ICOs offer lots of opportunities because they allow investors to gain exposure to an asset which may be of great value in the future. On the other hand, investment in ICOs is also connected with a potentially high risk. There are no guarantees that a particular project will be successful, or that the value of the cryptocurrency will grow at all. A good instrument for risk limitation is to use diversification and to invest the capital among more than one ICO.
When comparing ICOs with fundraising via IPO, I see a real cost advantage. IPOs are strictly regulated in most countries and subject to very strict and costly rules. ICOs are not regulated, so are cheaper to issue. This low level of regulation may be considered as an advantage or a disadvantage since investors do not get any shares or voting rights when investing in an ICO.
Within the framework of the Slovak legislation, the question of legal regulation of cryptocurrencies is currently focused on the question of the method of taxation of income from the sale of cryptocurrencies. The Slovak Ministry of Finance has issued a document entitled; ‘Methodological guidelines on the process of taxation of virtual currencies,’ which defines the virtual currency as a digital bearer of value, which is neither issued nor guaranteed by the central bank or the public authorities, and is not necessarily linked to legal money. It does not have legal status but is accepted by some natural persons or legal entities as a means of payment which may be transferred, stored or electronically traded.
The sale of virtual currency is defined by the ministry, for the purpose of taxation, as an exchange of the virtual currency for another asset, or the exchange of the virtual currency for the provision of a service, or exchange for another virtual currency.
José María Dutilh – Spain ICOs are still rarely used in Spain, despite continuously gaining global relevance. Compared to a figure of 60 million euros in 2016, ICOs raised 2.8 billion euros globally in 2017.
Spanish authorities hold a reluctant position regarding the trustworthiness and maturity of ICOs and the cryptocurrency sector, despite ICOs offering emerging technology companies ways to finance themselves independently, without the need for large-scale investors and venture capital firms or private equity funds. With the flexibility ICOs provide, entrepreneurs gain more freedom in the planning and execution of their vision, which fosters innovation. Moreover, the democratisation of investment may nurture competition and thus deter the formation of oligopolies.
The Comisión Nacional del Mercado de Valores (CNMV) is the Spanish government agency responsible for the financial regulation of the securities markets in Spain. The agency warns investors that, to date, no issue of cryptocurrency or any ICO has been registered, authorised or verified by any supervisory body within Spanish jurisdiction, although there have been private closed ICOs.
Cryptocurrencies are not supported by the Spanish Central Bank or other public authorities in Spain since they have different features to FIAT currency. It is not obligatory to accept cryptos as a mean of payment of debts or other obligations, the circulation is limited, and its value fluctuates strongly, so it cannot be considered either as a good deposit of value or a stable account unit.
Currently, Spanish legislation does not expressly regulate ICOs, rather it considers the tokens as negotiable securities.
As such, investors lack the special protection offered by Spanish and EU legislation for regulated investments. ICOs are therefore vulnerable to fraud, price manipulation or other illicit activities.
Taking IPOs as a counterpoint, the EU Prospectus Directive introduces capital thresholds for traditional IPOs. These thresholds trigger prospectus requirements and detailed reporting requirements. Comparable transparency provisions do not yet exist for ICOs, which causes substantial legal insecurity regarding the promised performance of projects. Like most projects, at the time of the ICO, only exist on paper, investor protection is an urgent issue. This is exacerbated by the fact that the current ICO craze causes many entrepreneurs to issue tokens haphazardly. Lastly, there have been various scam incidents and growing speculation may create a financial bubble.
For entities that participate in ICOs, the European Securities and Markets Authority (ESMA) says that they must be clear about whether they are carrying out regulated investment activities because they must comply with the corresponding legislation in each case if so. The agency mentions four European directives that may be relevant to these products: Brochures Directive, Financial Instruments Markets Directive (MiFID), Alternative Investment Fund Managers Directive (AIFMD) and the Fourth Anti-Money Laundering Directive.
Noreen Weiss (NW) MacDonald Weiss PLLC – U.S. – New York www.irglobal.com/advisor/noreen-weiss
Lavinia Junqueira (LJ) Tudisco, Rodrigues & Junqueira – Brazil www.irglobal.com/advisor/lavinia-junqueira
Diego Benz (DB) Zwicky Windlin & Partner – Switzerland www.irglobal.com/advisor/diego-benz
Andrea Vasilova (AV) VASIL & Partners –Slovakia www.irglobal.com/advisor/andrea-vasilova
Luis Santine (LS) InfoCapital N.V – Dutch Caribbean www.irglobal.com/advisor/luis-santine-jr
José María Dutilh (JSM) LeQuid, Social Enterprise and Business Law Firm – Spain www.irglobal.com/advisor/jose-dutilh
Dunstan Magro (DM) WDM International – Malta www.irglobal.com/advisor/dunstan-magro
Dr. Robert Lewandowski (RL) DMP Derra, Meyer & Partners – Poland www.irglobal.com/advisor/robert-lewandowski
Benoît Couty (BC) Pichard & Associés – France www.irglobal.com/advisor/benoit-couty