What you should know before participating or launching an ICO
Today I want to tell you about the Initial Coin Offering ( ICO ) madness.
What is an ICO
Traditionally, technological startups went to banks and venture capital to obtain financing in exchange for stock in the company or a high interest rate loan/bonds to the company.
To obtain financing startups should have a highly qualified team with a strong business background, a solid project and, usually, a product already marketed.
This changed in 2015 when Ethereum and later Waves brought a new financing model to raise funds from the public: An ICO .
ICO’s are a non-regulated means by which a blockchain startup sells its native token or cryptocurrency to the public in exchange for bitcoin or ether to raise funds to develop its decentralized application.
Normally this cryptocurrency or token will serve as use or license rights for the software that the company is building or as a payment unit in its decentralized app.
This new model of crypto financing exploded in 2017 with more than 400 successful ICOs raising collectively more than $5.6 billion, with some projects raising over $200 million.
Compare it with the traditional ways to obtain financing, a company with a solid business and product may struggle to get just one million dollars via venture capital normally in exchange for stock and close oversight from investors.
ICOs represent a breakthrough in the way that tech-startups are financed, democratizing access to financing and allowing entrepreneurs to find resources to develop their projects.
However, whether you are or plan to be an “investor” or an entrepreneur planning to launch your ICO you have to be aware of the risks and consider several factors if you don’t want to run into trouble.
First, I want to point out that the word investment may not be the most accurate way to define these transactions.
At the end of the day, when you buy a token in an Initial Coin Offering, you are buying access rights or credits to use in a software. Commonly called utility tokens, these have utility solely within a given app.
You are not buying any physical asset, or stock, nor any financial product that entitles you to claim dividends or voting rights in the company, so to call it an investment might not be accurate.
If the ICO claims that its tokens provide profits and voting rights, I would recommend being far away from them. The company is running a securities offering and if they are not properly registered in the jurisdictions where their buyers are located, which most likely they will not, they may be breaking securities and other laws and government agencies can and will prosecute them.
Participating in an ICO with speculative reasons to obtain profits selling your tokens in a secondary market is risky and you must be aware that you can earn a lot of money, but you can also lose everything. If someone denies this be extremely leary as there are a lot of ICO scams out there.
Never risk what you cannot afford to lose. The risks and limitations of the cryptocurrencies and the blockchain that we discussed in the previous letter are even more valid for ICOs.
As a purchaser you must do your own analysis and never make hype-driven decisions. ICOs are over marketed and hype is not a strong fundamental and may disappear in a matter of days.
The first rule is that you should make sure you understand their white paper, do not put money into something you do not understand.
Check out if the project is really solving an existing problem and if there is a need to use blockchain.
Blockchain is trending and, yes, it is a technological breakthrough that may be a game changer for many industries but it is not the solution of everything.
Blockchain is a public ledger, decentralized and distributed and replicated among several nodes. Not everything should or is ideal to be recorded in the blockchain.
You must also look at the team that will develop the project, which is what you are mostly buying now.
Investigate if the team has a business background, preferably in the same industry.
Make sure that the team has experience, knowledge and business connections necessary to turn the project into a reality.
Ideally, the project must already have an MVP or a related marketed product.
Look at the maximum amount they are trying to raise. Does their project justify it? If they raise too much money, incentives to work on the project may be lower.
Are the tokens distributed to founders vetted for a period of time through a smart contract or escrow company? If this is not the case, there may be a risk that they will take quick profits and abandon the project.
What is the communication policy of the ICO? If they are promising quick profits or use a too salesy language, you might want to pass on it as it is usually a bad sign. If they are not honest in their communications, they might not be with their project promise either.
Make sure they have a strong legal team. Although ICOs are not currently regulated, their activities are subject to several laws. A poor legally structured ICO may not last long in business.
For instance, KYC & AML/CTF. Make sure that the ICO conducts the proper due diligence by identifying and screening its participants.
Read the Terms and Conditions and be fully aware of what you are buying. This is the most important document and governs your relationship with the ICO.
And finally, one of the most important: Will there be demand for this token?
The price of a product or asset is driven by supply and demand. Make sure that they are really solving a current problem and that there will be demand for their product, in which the token makes sense and plays a fundamental role, and that the token economy is feasible in the long term.
With a comprehensive analysis, research and making informed decisions, you may avoid falling into an ICO scam trap.
Although most projects are legit, there are many ICO scams out there to take advantage of clueless investors and make quick profits. Beware.
That being said, failed business ratio in any sector is high. Considering that this is a totally new space and technology, risks increase exponentially.
It is likely that only a small percentage of projects that are being financed through ICOs will succeed.
You want to participate in this small percentage of projects that are going to survive and be successful, so do the proper research and due diligence before giving any money.
And above all, own your decisions. Following influencers’ opinion may not be a good idea, you never know if they have charged for it.
For entrepreneurs looking to launch an ICO
If you are an entrepreneur looking to launch your Initial Coin Offering be transparent.
First make sure you have a valid business idea, mature it, assemble a strong team and build a minimum viable product. Take that experience in to the blockchain space.
Do not try to ride the ICO wave only to get quick money. This is not a good idea, in addition to being morally dubious, you may end up having serious legal issues.
Second, surround yourself with a strong legal team to advise you in each phase and asset of the project, from the Terms and Conditions and whitepaper to your public communications policy. You need to overcome all the legal hurdles and not get into potential issues that issuing a token may entail.
There is a lot of regulatory uncertainty in the sector and you will want to do things impeccably to be covered and in line with existing laws.
Set up a proper corporate structure and declare a jurisdiction for dispute resolution. If you don’t, you risk being deemed as a general partnership which will expose all your personal assets to any liability that may arise.
ICOs are totally new and there is not much experience and jurisprudence to support your decisions, so you must make sure that you have a powerful corporate structure to minimize risks and reduce your corporate and personal liability.
For instance, foundations are a commonly used vehicle to conduct an ICO or manage its proceeds.
Foundations do not have owners or shareholders, is a non-profit organization established for a purpose and not for the benefit of persons and provides for perpetuity of purpose, make it suitable for managing ICO proceeds.
However, it might be advisable to establish a company solely for the issuance and another company for the day-to-day operations since Foundations are not ideal to engage in commercial transactions.
You can even combine the issuing entity with a Trust for more protection.
It is also essential to make the right decision when choosing jurisdictions to set up your corporate structure.
For instance, its reputation, political and economic stability, transparency, justice, market and individuals’ freedom, and its incorporation time, costs and bureaucratic procedures required are adjusted to your needs and priorities.
Although you collect proceeds in cryptocurrencies you will need to exchange it for fiat to pay your suppliers or employees so you have to consider the ease to open bank accounts with a given company setup.
In addition, add the factor that many banks do not want to work with ICO projects or cryptocurrencies because of the associated risks. Setting up the proper structure and be compliant with KYC/AML & CTF laws is critical to open bank accounts.
There are jurisdictions where the transfer of assets or donations or income earned by foundations are taxable and some not. Corporations raising funds, even in cryptocurrencies, may be subject to income tax or V.A.T. as well.
You should pick a jurisdiction where your proceeds won’t be taxed and that you are not breaking any tax residency laws.
You may also want to consider ICO and blockchain-friendly jurisdictions to reduce regulatory uncertainty, for instance, jurisdictions with a regulatory sandbox with enough flexibility for your blockchain project to be regulated.
Whether your token will be considered a security or not will be determined by the jurisdiction where token purchasers are located. However, it is relevant that the securities laws of the country where the issuer is incorporated has a clear and delimited definition of a security so that you can determine whether your ICO has a security token or a utility token.
Above all do not operate or sell tokens in jurisdictions where the meaning of security is very broad and can be determined by factors that are not under your control or where cryptocurrencies use is illegal.
Do not promise profits to your token purchasers, in addition to being dishonest, you may face legal issues.
Use the proper tools to conduct a KYC process with the highest compliance standards. If you are selling tokens to sanctioned individuals or entities, you are committing a crime.
Keep in mind that depending on your token nature you might be subject to different laws, including, but not limited to, commodities laws (e.g. if your token represents an underlying asset), money transmitter laws (e.g. if you provide brokerage services between buyers and sellers) or crowdfunding laws.
Also, do not call your token a ‘coin’ or ‘cryptocurrency’, especially if you are offering an ERC-20 token via the Ethereum platform.
As a conclusion, if you are a participant, be cautious, do not skimp on investigating and analyzing the project you intend to participate in, make your own informed decisions and be aware of the risks that ICOs entail. Never put more money than you can’t afford to lose.
If you are an entrepreneur, be honest, build a solid business with a viable product and then do your ICO. Make sure you that you have a powerful corporate structure, banking and you are not breaking any existing laws that could lead you into trouble.
If you want to know more about ICOs, we have written more extensively about it in our blog:
- How to do a successful initial coin offering and not get sued
- Corporate Structuring for initial coin offerings
- Where to Set Up a Foundation for ICOs (a comparative analysis)
If you are planning an ICO, we can help you, we design and implement your most suitable corporate structure and assemble teams to take care of all of the legal, tax, compliance and banking issues you need to be aware of for both your company and its officers. Contact us and schedule a free consultation call, we will be happy to help you.
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NOTICE: The contents of this article are not to be considered as a legal opinion or investment or financial or tax advice and should not be relied upon as such. Far Horizon Capital Inc does not hold itself out as a legal or tax or financial advisor. If you wish to receive a legal opinion or financial or tax advice on the matter(s) in this article please contact our offices and we will refer you to an appropriate practitioner. Use of our website FlagTheory.com is subject to our terms and conditions.