Why ICOs won’t moon anytime soon
Initial Coin Offerings (ICO) have become a very useful capital raising tool for start-up ventures. All over the world new companies and eager entrepreneurs have raised billions of dollars of much needed (and sometimes unwarranted) working capital to fund their idea to fruition.
With the recent rise in mainstream popularity of cryptocurrencies and the ever-present swirl of exit-scams, cybertheft and allegations of market manipulation, governments everywhere, are making financial crypto-regulation and compliance a top priority.
The main focus for Regulators has been to ensure the safety and security of the average investor.
The very nature of blockchain is one of anonymity, trustless-ness and decentralisation, Investors are often times left with no recourse against rouge Founders/Operators.
In the wild west of Crypto they are afforded very little protection and no one to hold accountable.
This is something that needs to be addressed and everyone acknowledges this. However, what we don’t want is for regulation to stifle our young crypto industry by Governments being rushing into making poor decisions that turn into bad regulations.
You can’t hide behind a Utility
Even though, earlier this month, investors and hodlers alike breathed a sigh of relief after news broke that the US Securities and Exchange Commission (SEC) ruled that Ethereum was not a security; you only had to read past the headlines to see that it wasn’t an actual ruling.
It was in fact, prepared remarks made by the SEC Director of Corporate Finance, William Hinman at a crypto finance summit put on by Yahoo Finance. In his statement at the summit, Hinman stated,
“Putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions,”
While Hinman provided clarity on Ethereum, he also reiterated the SEC’s views on ICOs and shared further guidelines to assess whether a token is a security.
“As to whether any group or entity has maintained a large stake in a token such that the group’s efforts could lead to an increase in the asset’s price.”
With these statements, all that has been said thus far is simply commentary, lacking in any form of official guidance on how to develop and release a Utility-based token model.
As recent developments have shown, just because a project says they are selling a utility token, does not mean they will be treated as such by the Regulators.
The Tale of Munchee
One of the most prominent ICO’s to feel the brunt of the SEC was a California-based project called Munchee, who successfully raised $15 million at their ICO. They were shut down by the SEC and forced to refund all funds raised back to investors.
What is concerning is that Munchee (MUN) is an example of an ICO that was shut down having very similar qualities to many Utility projects that have been launched and ones that are being currently offered.
The SEC’s cease and desist letter clearly shows that even projects that tout “Utility” possess security-like factors that will not be overlooked by the Commission.
In its order the SEC wrote:
“Even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security. Determining whether a transaction involves a security does not turn on labelling — such as characterizing an ICO as involving a ‘utility token’ — but instead requires an assessment of ‘the economic realities underlying a transaction…”
The SEC further detailed that:
· MUN token purchasers had a reasonable expectation of profits from their investment in the Munchee venture;
· Investor’s profits were to be derived from the significant entrepreneurial and managerial efforts of others; specifically, Munchee and its agents;
· Even if MUN tokens had a practical use at the time of the Offering, this would not preclude the token from being a Security.
Therefore, SUBSTANCE over FORM.
What does this mean for new Token Projects?
It will become more incumbent for Founders to consider taking the route of compliance to avoid a fate similar to Munchee. However, taking this route may introduce significant constraints in a project’s ability to execute and eventual viability.
Let’s look at the process.
In order for a Token to be registered as a Security in the US, appropriate disclosures and fillings under Reg. D, Reg. A+ or Red. S would be required.
Putting aside time and cost factors, these requirements are extremely stringent and onerous. It places emphasis around the prospective purchasers’ qualifications and holding periods for tokens.
Additionally, the ongoing reporting requirements of registered Securities may ultimately restrict the free flow and trade of tokens.
Therefore, it would be very advantageous for a project to classify themselves as a “Utility Token” and remain so or be forced to conduct their ICO in a much friendlier jurisdiction; but be satisfied with locking out all US based investors, where perhaps the bulk of funding could be raised from.
Unfortunately, as previously stated, there is no regulatory guidance for the release of an “Utility” token.
All that Founders and their teams have right now to steer them away from “Securities” classification is the outdated “Howey Test” from 1946 relating to a Supreme Court decision; concerning some people who made leaseback agreements with a citrus grove in Florida.
The Howey Test determines whether and under what conditions you are permitted to use your money in investments of your own choosing.
By classifying securities by the rule of Substance over Form, the SEC has created a fundamental misalignment between the pre-purchasers/Investors of the token, the Token project itself and its practical use.
Unless the token project can engineer a means to incentivise Investors participation in the utility of token from Day 1; the project could run the risk of SEC scrutiny and shut down.
So, no more Moon?
It has been an interesting year for ICO’s in 2018.
As at June, ICO’s have already raised over $11.75 billion; which has eclipsed the total amount raised in the whole of 2017 ($6.3 billion).
Although these figures appear at a cursory glance promising, it paints a different picture when you look at profitability of investing into ICO’s and how it has changed over the past 15 months.
The above chart by the Aragon Group, shows us that the average monthly return on ICO investments is markedly lower in 2018 when compared against the previous year.
This data demonstrates that it is becoming increasingly unprofitable for investors to invest in new ICOs.
Combine this with the fact that approx. 46% of 2017’s ICOs have failed, Investor fatigue at the sheer number of ICO projects and greater Regulatory scrutiny; shows us that there is a significant shift in Investor sentiment.
This shift will only be more pronounced as investors become more astute and focus on proper due diligence and arm themselves with foundational knowledge to avoid loss of funds due to fraudulent or speculative ICO’s.
The Takeaway
We find ourselves in an age of technological financial breakthrough, where the concept of money, contracting and fundraising is being disrupted by a combination of decentralised networks, cryptography and other innovations.
Founders must now become more aware of and be comfortable with the possible personal liability and blurred legal risks that they and their team must face towards delivering on the promised utility of their token.
Compounding this is that Investors are tired of the ICO hype. They have also become more cautious and discerning, heightened by the constant regulatory conundrums and volatility of the market.
There will come a time in the future, in which projects will be able to release their token, move forward and succeed in both achieving their goals whilst delivering lambo-sized returns.
However, this is unlikely to happen anytime soon. The age of the ICO has changed and where it is headed, unfortunately, is up to our elected officials.
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