The wild, wild world of ICOs
by Chris Burniske and Jack Tatar
A new cryptoasset can be announced in any number of ways: at a conference, or on Twitter, Reddit, Medium, or Bitcointalk.
It is important that announcement be followed by a white paper that includes details about the founders and advisory board, and that clearly outlines the structure of the initial crowdsale.
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.
Structure and timing
An ICO has a fixed start and end date, and often has a bonus structure in place for early investors. For instance, investing at an early stage might get an investor 10 to 20 percent more of a cryptoasset.
The bonus structure is meant to encourage people to buy in early, which helps to ensure that the ICO will hit its target offering. There's nothing like a bonus followed by scarcity to drive people to buy.
It's also best practice that an ICO should have a minimum and maximum amount that it intends to raise. The minimum is to ensure the development team will have enough to make a viable product, and the maximum is to keep speculation in check. The infamous DAO ICO didn't set a maximum limit on fundraising, which led to rampant speculation.
The Howey test
The Howey Test is the result of the 1946 U.S. Supreme Court case, SEC v. Howey Co., which decided 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 is a security, even if it is referred to in other terms in order to avoid regulation. If something classifies as a security, SEC oversight requires that a long list of requirements 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 (use of the word "money" should not cause an investor to dismiss applicability to cryptoassets, as later cases have expanded the meaning of the term).
- There is an expectation of profit from the investment.
- The investment of money is in a common enterprise.
For the most part, development teams want to avoid classification of ICOs as securities because this results in hefty legal fees, innovation delays, and the restructuring of the current cryptoasset landscape.
A joint effort by Coinbase, Coin Center, ConsenSys, and Union Square Ventures — with legal assistance from Debevoise & Plimpton LLP — produced a document based on the Howey Test, "A Securities Law Framework for Blockchain Tokens."
It is especially important for the team behind an ICO to utilize this document in conjunction with legal advice to determine whether a cryptoasset sale falls under SEC jurisdiction.
Innovative investors might also want to apply the Howey criteria on their own in line with what they know about the ICO: If the investor believes the offering should be considered an investment contract and the offering team is moving forward without that assumption, this could be a red flag about the legitimacy of an ICO.
ICO best practices
The framework document is also helpful because it outlines best practices for an ICO, which can be a useful checklist for innovative investors. These practices are summarized below — 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 financials along the way?
- Does the asset use an open, public blockchain, and is the code published?
- Is the token sale pricing clear, logical and fair?
- Is it clear how much of the token has been assigned for the development team and how these 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 be promoted for the functionality and use case of the product — which should be identified as such, rather than as an investment.
Chris Burniske and Jack Tatar are authors of the new book, "Cryptoassets: The Innovative Investor's Guide to Bitcoin and Beyond," published by McGraw-Hill. This article is excerpted from the book.