The wild world of ICOs
By Chris Burniske and Jack Tatar
A new cryptoasset can be announced any number of ways: at conference; or on Twitter, Reddit, Medium, or Bitcointalk. It is important that the announcement is followed by a white paper containing details about the founders and advisory board, and that it clearly outlines the structure of the initial crowd-sale. It should be easy to contact the founding team, whether through one of the aforementioned social media channels or a dedicated Slack or Telegram channel. If an ICO is scant on information, that is an immediate red flag.
Structuring and timing of the ICO
ICOs have a fixed start and end date, and often there is a bonus structure involved with investing earlier. For instance, investing at an early stage may get an investor 10 to 20 percent more of a cryptoasset. The bonus structure is meant to incentivize people to buy in early, which helps to assure that the ICO will hit its target offering. There’s nothing like bonuses followed by scarcity to drive people to buy.
It’s best practice that an ICO also have a minimum and maximum amount that it plans to raise. The minimum is to ensure the development team will have enough to make a viable product, and the maximum is to keep the speculation of crowds in check. For example, the infamous DAO ICO didn’t set a maximum limit on the fundraising amount, which led to rampant speculation.
The Howey test for discerning if an ICO Is a security
The Howey Test is the result of the 1946 U.S. Supreme Court case, SEC vs. Howey Co., which investigated whether a convoluted scheme to sell and then lease tracts of land qualified as an “investment contract,” also known as a security. The Howey Test determines whether something should be classified as a security, even if it is referred to differently in an offering to avoid regulatory action. If something classifies as a security, SEC oversight requires a long list of requirements to be met, which would likely dampen all but the most well- capitalized innovations in the exciting new world of cryptoasset offerings.
If an asset meets the following criteria, it will likely be considered a security:
- It is an investment of money.
- There is an expectation of profits from the investment.
- The investment of money is in a common enterprise.
For the most part, the teams behind ICOs want to avoid classification as a security because it will demand hefty legal fees, delay innovation, and require restructuring of the current cryptoasset landscape.
A joint effort by Coinbase, Coin Center, ConsenSys, and Union Square Ventures, with the legal assistance of Debevoise & Plimpton LLP, produced a document based on the Howey Test called, “A Securities Law Framework for Blockchain Tokens.” It is especially important for the team behind an ICO to utilize this document in conjunction with a lawyer to determine if a crypto- asset sale falls under SEC jurisdiction.
Innovative investors may also want to evaluate these criteria on their own in line with what they know about the ICO: if there’s a belief by the investor that the offering should be considered an investment contract and the offering team is moving forward without that assumption, that could be a red flag about the legitimacy of an ICO.
The framework document is also helpful because it includes best practices for a ICO, which provides a good checklist for innovative investors. They are paraphrased below to provide context for what an investor should consider for any potential ICO investment (much of this overlaps with what has been stated already, but with ICOs, it’s best to be doubly sure.) Note that in this context, cryptoasset is synonymous with token:
- Is there a published white paper?
- Is there a detailed development road map that includes a breakdown of all appropriate financials along the way?
- Does it use an open, public blockchain, and is the code published?
- Is there clear, logical, and fair pricing in the token sale?
- Is it clear how much of the token has been assigned for the development team and how those tokens will be released? Releasing them over time keeps the developers engaged and protects against centralized control of the token.
- Does the token sale tout itself as an investment? It should instead be promoted for its functionality and use case and include appropriate disclaimers that identify it as a product, not an investment.
Chris Burniske and Jack Tatar are authors of the new book from McGraw-Hill, Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond. This article is excerpted from the book.