In Part 2 of this series, we looked at the various regulations governing Initial Coin Offerings (ICOs). To give a quick recap, on one end of the spectrum there is China, which has completely banned ICOs. On the other end, we have Gibraltar which has drafted specific legislation for ICOs. The majority of the other jurisdictions have taken a more neutral position, by using existing securities regulations to govern ICOs.
In the last article of this series, we shall move away from the legal aspects and explore the technical aspects of ICOs. This article will explore the structures, objectives, elements and stakeholders in an ICO.
Structures for ICOs
An ICO may be structured in a variety of ways.
(1) Capped First-Come First-Served (CFCFS) offering
The most common structure is a CFCFS offering, where a cap is placed on the amount that is to be raised. A fixed number of tokens are sold at a fixed price, and on a first-come first-served basis until the supply of tokens are sold out.
(2) Uncapped offering
As the name suggests, an uncapped offering is a structure without a maximum limit on the amount that can be raised. Investors are able purchase as many tokens as they desire.
(3) Capped auction offering
In a capped auction, investors bid on the price they desire to pay for a token and the total amount they want to spend. The number of tokens sold varies and goes to the lowest bidder, proportional to the total amount that is pledged by each investor. The auction itself may be by way of a Dutch auction or a blind auction. In a Dutch auction, the price of the token is set after all bids have been taken to determine the price at which the token offering may be sold. In a blind auction, sealed bids are placed by bidders at the same time, and no bidder is privy to the other bids that have been placed.
(4) Uncapped auction offering
A uncapped auction offering is similar to the capped auction offering in that investors bid for tokens. The difference is that in an uncapped auction offering, a fixed number of tokens are sold to investors in a descending order beginning with the investor who placed the highest bid. The offering goes on until the available token supply has been sold. Therefore, the cap here is on the tokens available for sale and not the amount that may be raised. The amount depends on the bids placed by investors.
(5) Capped with redistribution offering
Here, investors bid on the total amount they want to spend. A fixed amount of tokens are sold at a fixed price proportional to the total amount that is pledged by an investor. Excess payments made by investors are then refunded back to them.
(6) Capped with parcel limit offering
This structure is fundamentally the same as the CFCFS offering. The main difference is that a limit is placed on the total amount of tokens that may be purchased by an investor. This is achieved by placing a ceiling on every transaction and making it difficult for investors to undertake multiple transactions.
Despite the differences articulated above, all of the structures have one commonality in that all of them tend to reserve a percentage (fixed or variable depending on the structure) of the token supply for insiders such as founders and developers.
Objectives of ICOs
An ICO’s objective helps determine the right structure an issuer should work with.
(1) Raising capital
The development of any innovation requires funding. Hence, it is undeniable that the primary objective of any ICO is to raise capital to fund innovations. Although it might be tempting for issuers to lean towards an uncapped offering due to the allure of being able to raise significant amounts of capital, issuers may want to be cautious and raise just enough capital to fund their innovation. Holding more money than what is required may place a greater burden on issuers, and is more likely to attract regulatory attention.
Further, a capped offering may be more beneficial when the token trades on the secondary market. A limited supply of tokens may translate into the token trading at premiums.
(2) Wider token distribution and increased participation
If the innovation applies to a diverse demographic, it would be beneficial for its developers to ensure their tokens are widely distributed. Developers may also desire that their tokens be available to all investors and not just to a particular group of investors. In which case, issuers may consider a capped offering with redistribution or parcel limit.
(3) Allocation of token and obtaining fair market price
Apart from the above, developers may also wish to focus on (a) the percentage of tokens they have designated for allocation to the founder and developers, and (b) obtaining a fair market value for the issued token. Compared to the former objective, the latter tends to be a trickier exercise. This is because most ICOs tend to be in support of innovations that have long development periods. This might make it difficult for investors to fairly value the token. Notwithstanding, it is not uncommon for developers to take part in the exercise of discerning a price for the token.
Elements of ICOs
We now turn to the elements of an ICO. The recent barrage of online ICO advertisements may have led some to wonder if conducting an ICO is that simple. While it may be true that there is a new ICO launching just about every other week, most of them tend to fail. This is due to a variety of factors such as poor marketing or regulatory sanctions. Hence, an entity wishing to conduct an ICO has to pay careful attention to the various elements of an ICO, some of which are as follows:
(1) Whitepaper
The whitepaper is a document that presents the entity’s project to potential investors. The purpose of a whitepaper is to provide potential investors with an opportunity to gauge the viability of a project. Items that are commonly found in a whitepaper include:
- The problem the entity is seeking to address
- The solution to the problem
- The description of the solution
- The business model of the entity (revenue streams, value, financial projects)
- Information regarding the token (supply, price, caps, utility, equity or security, deployment plan)
- The entity’s team
- Legal disclaimers (For example, TenX stated multiple times in their ICO whitepaper that citizens of the United States and Singapore should not purchase their token)
- General timeline
The importance of a whitepaper cannot be stressed enough. Apart from providing an insight into the offering, it serves as a crucial marketing tool for the ICO. A whitepaper that clearly sets out the entity’s direction and project may foster greater trust in the entity, which then translates into greater support of the respective ICO.
(2) Team
A credible team is also essential in establishing trust between the ICO issuer and potential investor. A core team usually includes a Chief Executive Officer, Chief Technology Officer, Chief Project Office, Chief Operations Officer, Chief Financial Officer, advisors, public relations, designers and a strong development team. Ideally, the team should be made up of experts in business development and the field in which the entity is intending to operate.
(3) Security
The DAO hack in 2016 is a famous example of the importance of cyber security in ICOs. At that time, the DAO ICO was the largest ICO and raised over $150 million. Unfortunately, just a month after the ICO, a hacker exploited a bug in the code of the DAO and stole approximately $50 million worth of ether. This sent massive ripples in the crypto market and led to the fall of DAO.
(4) Legal Framework
Given the spotlight on ICOs in the recent months, there has been much regulatory interest in the topic. As discussed in Part 2 of this series, ICOs are increasingly being scrutinized by the relevant financial authorities. Entities that wish to conduct an ICO should educate themselves on applicable regulations and ensure compliance to prevent potential investigations and delays. They should also include a detailed legal framework of the offering jurisdiction and indicate the manner in which they will be in compliance with the applicable laws.
(5) Marketing
The last element is marketing the ICO. Often, where an entity desires to raise funds for its projects, its actual product has yet to be built and the entity tends to market the potential of the technology to investors. In this instance, the entity may wish to leverage on the reputation and credentials of its founders and developers to gain the trust of potential investors.
Another marketing strategy may be to focus on specific segments of potential investors. For example, a token such as Golem that gives its holders access to computing power may attract a particular group of investors, whereas a token like Filecoin that gives its holders access to a cloud storage may attract another group of investors. Understanding the space in which the token operates and marketing accordingly to the respective audience is a great way to attract the right investors.
Stakeholders in ICOs
There are various stakeholders in an ICO. These include the team which conducts the ICO, the investors and the exchanges upon which the digital tokens are traded.
(1) The team behind the ICO
As outlined under “Elements of ICOs”, the team behind an ICO consists of various members, each of whom contribute their respective expertise to the project.
The core team usually consists of the founder, developers and public relations personnel, though is not uncommon for one member to wear various hats in the team.
- Founder: Unsurprisingly, the founder of the project is often the CEO. This is normally the case where the founder wishes to have greater control over the direction of the project.
- Developers: Developers form the backbone of an ICO. Therefore, having reliable and experienced developers focusing on coding and testing the quality of the product or service is absolutely crucial.
- Public Relations Personnel: As explained above, marketing is imperative to an ICO. It would be pointless to have a great product or service if it does not capture the attention of prospective investors. An ICO that has poor public relations is inevitably bound to fail.
Along with the core team, a project would also have an advisory team. The members of an advisory team would vary depending on the requirements of the project and the members of the core team. For example, if the core team has security experts, they may not require the assistance of external security experts for the ICO. On the other hand, if the core team lacks public relations personnel, they may seek the assistance of consultants who have extensive connections with different pools of investors.
(2) Investors
Investors are undoubtedly the most important stakeholders in an ICO. Without their funds, projects will be unable to progress and move forward.
There are various groups of investors such as retail investors, private/accredited investors and institutional investors. Retail investors are day-to-day individual investors. Private/accredited investors are individual investors who are recognised as being sophisticated or well versed in making investments. Institutional investors manage and invest funds of a group or an institution.
The type of investor an ICO is targeting is crucial because the choice would affect the level of disclosure required and the attention of the authorities. The most common offering requirement in any securities legislation is the requirement of a prospectus. The prospectus informs investors of the various aspects of the project and more importantly, material and/or key disclosures that would influence the decision of investors. The objective of such an offering requirement is the protection of investors, especially retail investors who are recognised as being more vulnerable than accredited or professional investors.
In the event that an issuer desires to target all investors (including retail investors), its offering may face greater scrutiny from the authorities than an issuer that is raising funds from private or institutional investors. For example, Telegram focused on private investors during its presale and cancelled its public ICO. In doing so, Telegram excluded retail investors from participated and avoided being subject to conventional securities registration requirement.
(3) Crypto Exchanges
Crypto exchanges are platforms on which tokens are traded. Famous examples of such platforms include Coinbase, Poloniex, Binance, Kraken, Bitstamp, Gemini, Bittrex and Bitfinex. Post ICO, issuers often aim to get their respective token listed on exchanges like these. This makes the buying and selling of the token much easier. More importantly, the listing of a token also confers greater legitimacy.
Every exchange has its own position with regards to the listing of a token. Poloniex, one of the bigger exchanges, states on their website as follows, “We don’t have a definitive set of criteria as each project is unique. We listen to the community and select projects that we believe are unique, innovative, and that our users would be interested in trading. We also look for products that have strong (organic) market demand”. In addition, Poloniex also expressly states that it shall not list any token that resembles a security. This position reflects the increasing spotlight on ICOs and the regulatory clampdowns as discussed in the previous article.
Another such platform, Bittrex, has two stages before a token may be listed. The first is a preliminary review where a determination is made as to whether the token should proceed through a full listing process. The second is a full listing review, where the documentation submitted by the issuer is scrutinized by Bittrex’s employees, before a decision is made on whether the token will be listed.
Overview
We have discussed various aspects and factors to consider and grasp with regards to ICOs in this series of articles. The different jurisdictions and regulatory framework were outlined in Part 1 and 2, as well as the type of token pertinent to the ICO. These should be the first points to consider when embarking on the conduct of an ICO. Following which, one would also have to ascertain the objectives of the offering, and understand the various technical aspects as set out above, all of which have to work in unison for an ICO to be successful.
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This article is written by Yeong WanHsi of Arrowgates LLC and edited by Seah Ern Xu of Asia Law Network
This article does not constitute legal advice or a legal opinion on any matter discussed and, accordingly, it should not be relied upon. It should not be regarded as a comprehensive statement of the law and practice in this area. If you require any advice or information, please speak to a practicing lawyer in your jurisdiction. No individual who is a member, partner, shareholder or consultant of, in or to any constituent part of Interstellar Group Pte. Ltd. accepts or assumes responsibility, or has any liability, to any person in respect of this article.