Initial Coin Offering - Explained
What is an Initial Coin Offering?
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Table of ContentsHow Does the ICO Process Work?How are Coins Sold?Why are Coins Valuable?How Do You Get PurchasersHow are Coin Offerings Regulated?What Is Required for an ICO?What are some of the benefits of an ICO?No Debt or Equity in an ICOEarlier Access to CapitalAvailability of TechnologyLower Competition for PurchasersICO RegulationAre There Companies to Help with the ICO?Where Do I Find People/Talent to Launch an ICO?Where to Find ICO TalentHow Much Does it Cost to ICO?Technology Development CostsICO WhitepaperToken Smart ContractCrowdsale Smart ICO ContractSmart Contract AuditsLegal Structure and Regulatory FilingsMarketing
How Does the ICO Process Work?
Launching an Initial Coin Offering (ICO) is a demanding procedural process. As the old saying goes, “it takes a village”. In this article we discuss the primary steps associated with launching an ICO and the individuals who can assist with the process.
An ICO is a method of raising money for technology companies. Basically, the company creates its own cryptocurrency (or virtual currency) in the form of virtual tokens. The currency exists on a platform either created by the company or on platform specializing in trading third-party tokens.
The benefit of the ICO is that early-stage technology companies are able to access the capital for development and growth long before traditional methods of funding are typically available.
ICOs are generally only available for technology companies. There are numerous reasons for this. Most notably, it generally takes a technology driven company to undertake the steps of creating and selling the digital currency.
The companies must build or intend to build a technology platform or service to issue tokens. The tokens represent value on the future platform. There is a finite number of coins (I.e., the company will not issue more coins in the future, so the value of the coins rises as the value of the company issuing (and backing) the coins rises.
Investors in ICOs are generally technology investors. They want to purchase these coins at an early stage of development in hopes of cashing in when the coins rise in value. Investing in the tokens very early in the company’s development (generally before the company has even fully created its value offering) has the potential for major gains.
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How are Coins Sold?
The issuing company uses a technology platform that it has created or is in the process of creating to initial sell, transfer, and store the offered coins. Companies carrying out the initial coin offering generally take one of two approaches to building a platform for the offering. They either contract (code) a platform from scratch or employ the technology contained in existing platforms. The software used to build a virtual currency platform, such as Bitcoin and Etherum, is often open source and available to anyone for free. A computer coder with an understanding of how the platform operates can make modifications to the system to accommodate the specifics of the coin offering.
Why are Coins Valuable?
The coin purchasers either desire to use the coins on the platform that is being constructed, or believe that others will value the coins highly in the future as the value of the services or platform rise. The company will generally authorize a fixed number of coins, so as to create a sense of scarcity. During the initial coin offering, the coins are generally sold at a set price. The coins will later be traded on a virtual currency exchange or via direct trade between coin holders accessing the initial distribution platform. Naturally, the startup maintains control of a large number of coins in hopes that the value will increase as demand increases.
How Do You Get Purchasers
The coin holder generally does not receive any equity or ownership percentage of the issuing company. There are some exceptions to this fact, but the majority of offerings do not entail an equity stake. The difficult part is convincing people to purchase the coin under the assumption that it has value and will ultimately rise in value. The company will generally sell the coins in exchange for a virtual currency. The coins have a stated value that the purchasers must pay.
How are Coin Offerings Regulated?
Some cryptocurrencies, including the currency issued in a coin offering, have been made illegal in certain countries, such as China and South Korea. In other countries, the coin offerings are heavily regulated. This is true for certain types of coin offerings within the United States. In the United States, virtual currencies are subject to regulation if they are categorized as securities. Section 2(a)(1) of the Securities Exchange Act of 1933 (“1933 Act”) provides a definition for what is a security. The long list does not include modern digital assets. The catch-all type of security is known as an “investment contract”. The question then becomes whether a cryptocurrency is considered an investment contract, and thus a security, under the securities laws. In determining whether a cryptocurrency is an investment contract, ask this question (known as “Howey Test”):
1) Is there an investment of money,
2) into a common enterprise,
3) with the expectation of profits,
4) derived solely from the efforts of others?
The central issue is whether the expectation to earn a profit from purchasing and holding a virtual currency is “derived solely from the efforts of others”.
By its nature, an initial coin offering meets all of the elements of the Howey test. It is an issuance backed by an issuing business entity. As such, coins or tokens issued in an ICO are considered securities, and their sale or exchange will be subject to securities laws. If the coins offering is centralized, but are structured more like a consumer item than a security, then it may escape securities regulations.
What Is Required for an ICO?
Launching an ICO requires numerous steps. The major components are as follows:
Technology Platform - The company must be able to develop the company’s core value proposition. This normally requires a software developer, programmers, and (in some instances) computer scientists.
Whitepaper - The company must disclose information to prospective investors. An ICO is generally considered issuing securities. A disclosure document, known as “whitepaper, informs potential investors of the nature of the company, the token being sold, and the terms of the sale. This must be drafted to meet the requirements of applicable securities laws.
Token Smart Contract - The company must develop the actual token that will be sold. This requires creating a form of computer file that can be created, transferred, and stored. Further, the token must be compliant with the system on which it will be sold. If sold on an internal system, then the internal system must be developed. If sold on existing systems, it must meet specific requirements — known as “ERC20-Compliant”. Creating a token smart contract generally requires the services of an expert in this type of software development and programming.
Crowdsale Smart ICO Contract - The company must create a method of transferring or distributing the points. In many cases, the company will contract with an established exchange. The exchange will handle the ICO sale and delivery process. This process is very similar to an underwriting agreement in traditional equity offerings. Most companies contract with a platform that specializes in the storage and sale of cryptocurrency.
Smart Contract Audits - Maintaining the security and integrity of the token and the token system is paramount. The company will need individuals who can maintain the ICO platform. These are called audits. Failure to conduct routine audits subjects a company to risks of the tokens being stolen, deleted, or corrupted.
Legal Structure and Regulatory Filings - Most ICOs are considered securities. This is true if they are backed by the issuing company, as most tokens are. This means that the coins are subject to regulation by the Securities Exchange Commission and state regulatory authorities. The company must hire a law firm that can navigate these legal requirements.
Marketing - This entails making people aware of the offering. There are numerous companies that specialize in getting the word out about the coin offering.
What are some of the benefits of an ICO?
An initial coin offering (ICO) is a method for companies to raise money to fund the venture. Basically, the company creates its own digital or virtual currency. In doing so, the company creates its own digital platform. The platform allows for the transfer and storage of the virtual currency. The company creates a coin that represents future value on the company’s platform. The company distributes the currency to individuals interested in owning the currency. The currency is not able to be used immediately to purchase services; but, it is believed the currency will be used in the future on the company’s virtual platform. There is generally a fixed number of coins to create a sense of scarcity among holders. The coin has a current value (or is sold at a set price) that is less than what it represents on the platform, thus investors wish to hold it. Basically, the company is selling an asset indirectly. The coin is a speculative asset (it has a perceived value) that may ultimately represent actual value on the company’s platform. If the company’s platform never fully develops, the coins will have little or no value.
No Debt or Equity in an ICO
The ICO allows the startup company to raise money without selling equity or taking out debt. Incurring debt burdens the company to repay the debt and make interest payments. This can stifle the company’s ability to use revenue for growth and development. Selling equity in the company diminishes the founders’ ownership interest and ultimately surrenders a level of control to the investors. Further, unlike debt and equity, selling coins does not entitle the purchaser to anything. If the platform is never completed and the coins ultimately lose or have no value, there is no recourse for the coin issuer.
Earlier Access to Capital
The ICO generally allows the issuing company to raise capital before it would otherwise be able to through venture capitalists or lenders. Venture capitalists generally require the company to have stable operations and signs of dependable growth. Lenders look for company assets to secure repayment of the loaned funds. The ICO generally takes place before the company’s platform is fully developed. Whatever product or service is being offered by the company (generally some form of software as a service) is generally not fully developed. As such, there is not dependable source of growth or assets to meet the requirements of investors or lenders.
Availability of Technology
The mechanics of the offering are generally far less daunting than it appears to non-technologists. Companies do not have to entirely construct their own platform for issuing and storing coins. The software used to build a virtual currency platform, such as Bitcoin and Etherum, is generally available for free as an open-source platform. As such, the company is able to employment this structure and make modifications to the system to accommodate the specifics of the coin offering. This makes the coin offering process less burdensome and available to a greater range of companies.
Lower Competition for Purchasers
In today’s investment environment, managers of money funds seek to be a part of the newest trend with the greatest potential for return. Traditional securities are part of an established market. The depth of knowledge of these securities makes pricing more accurate and reduces the potential for major gains from buying and selling them. ICOs are still the new kid on the block. There are less tokens or coins from ICOs than other forms of securities (such as stocks or bonds). Investors don’t want to miss out on the offering’s potential upside, so they are more will to purchase the asset with less knowledge or insight about its current value.
Regulators have been slow to respond to the emergence of ICOs. The current regulation regime is poorly constructed to deal with these offerings. The result is that ICOs have been made illegal in certain countries, such as China and South Korea. In the United States, ICOs fall under the regulatory control of the Securities Exchange Commission and state regulators as a “security”. Section 2(a)(1) of the Securities Exchange Act of 1933 (“1933 Act”) provides a definition for what is a security. The long list does not include modern digital assets. The catch-all type of security is known as an “investment contract”. The question then becomes whether a cryptocurrency is considered an investment contract, and thus a security, under the securities laws. In determining whether a cryptocurrency is an investment contract, ask this question (known as “Howey Test”):
1) Is there an investment of money,
2) into a common enterprise,
3) with the expectation of profits,
4) derived solely from the efforts of others?
The primary determination is whether the expectation to earn a profit from purchasing and holding a virtual currency is “derived solely from the efforts of others”. Many coin offerings meet this defection if the coin is ultimately backed by the issuing business. In some cases, however, the coin is issued on an independent or open-sourced platform. The coin is decentralized and not directly backed by the company. The issuer simply represents that the independent value of the coin will be respected by the company, along with other forms of currency. These types of issuances are difficult to construct, by can fall outside of standard securities regulation. In such a case, this makes the issuance outside of the current securities regulatory regime.
For these reasons, company founders strongly prefer the coin offering to the these traditional methods of raising capital.
Are There Companies to Help with the ICO?
There are numerous companies that can help with each stage of the ICO process. First, you will need to find the technologists who can develop the token smart contract and platform. You will also need to make certain these individuals are available to run audits on the system. You will, of course, need internal individuals to manage the system. Then, you will need a legal firm to help draft the whitepaper and complete the securities filings. Lastly, you will need a marketing firm to help you get the word out to investors about the ICO.
Begin searching for companies on the internet that profess some level of expertise in the ICO process. If you familiarize yourself with what is required for each step of the process, you can look for service providers who offer those services. You can also look for independent contractors on sites such as UpWork.com. You will of course need to seek references for any company or service provider. They should be able to produce references and proof of prior work. The marketing and legal firm should have an industry presence and proof of prior work as well.
Where Do I Find People/Talent to Launch an ICO?
In the last five years, the number of initial coin offerings (ICOs) in the United States has skyrocketed. The reason behind this growth concerns the many benefits associated with a coin offering. Early-stage technology companies are able to access the capital for development and growth long before traditional methods of funding are typically available.
ICOs are generally only available for technology companies. Companies that have built or intend to build a technology platform or service issue tokens, a form of cryptocurrency, that represents value on the future platform. There is a finite number of coins, so their value rises as the value of the company issuing (and backing) the coins rises. Investors want to purchase these coins at an early stage of development in hopes of cashing in when the coins rise in value.
The interesting part of ICOs is that investors often buy these tokens before the company has developed its service or platform. This is generally far earlier than an angel investor of venture capitalist is willing to purchase an equity interest. Also, the founders of the company retain complete ownership.
Where to Find ICO Talent
In this instance, you best friend is Google. You can do an internet search for companies holding themselves out as offering ICO services. Of course, you should be familiar with the services you will need prior to searching for these companies. This is a new space, and it is easy for unwitting companies to be taken advantage of.
Another option is to reach out to companies that have successfully undertaking an ICO. Ask them about who they hired for their ICO. It is possible that the companies will not be very helpful. They may want to keep their talent locked down for continued audit and token maintenance services.
Join affinity groups. If you get involved in technology forums, reddit groups, and other information websites, you will undoubtedly come into contact with individuals who have the skill and knowledge to carry out the technical aspects of the ICO.
Also, don’t forget that you will still need to meet regulatory requirements. This means hiring legal professionals to undertake the securities filings and disclosures necessary to comply with federal and state securities laws. Failing to comply with these regulations can result in all purchasers being able to reclaim their capital from the company.
How Much Does it Cost to ICO?
Initial Coin Offerings (ICO) are growing increasingly popular as a method of funding emergent technology companies. Basically, the ICO allows these tech companies earlier access to funding than is available through debt lending or equity investment channels.
In this article, we discuss the various costs associated with undertaking an ICO.
Technology Development Costs
Most (if not all) companies undertaking an ICO are technology companies. They develop some sort of software or virtual service or platform for future clients or end users. The intrinsic value of the token or coin being sold is that it represents future value on this platform. Of course, most companies undertake the ICO before the underlying value proposition is fully developed. They intend to use the ICO funds to pay for the continued development. This role may belong to a company co-founder. If no, you can expect an employee (market-rate) salary from $100 - 200K per year. Of course, you would compensate that individual with either company equity or tokens.
You need to make investors aware of the nature of your company’s value proposition. This is done through a document known as a “white paper”. You are trying to explain to the investor why the company’s value proposition will be valued and accepted in the market. It will explain in detail how your technology solves some customer need or want. It should also be apparent how or why the offering will be accepted at large. This is your company’s first impression with investors. If you want to have a successful ICO, you need to make certain the explanation is well developed and thorough. Developing this document will take hours of diligent work. Normally, it will be done by a company founder and will not costs any (or very little) money to complete.
Token Smart Contract
The company must create a coin or token to be sold in the ICO. This is known as a “Token Smart Contract”. There are generally two categories of token. One is a cryptographic token that native to a blockchain that you developed for your own software system. Basically, you develop the blockchain system that allows for self-verification of the coins. The downside of this type of coin is that it can generally only be transferred within the company’s existing system. This is a very detailed computer science and programing project. Completing this task requires the skills of someone who can command a $100-200 per hour for work.
The second type of token is an ERC20 (or ERC20-compliant) token. This token meets the structural characteristics — it contains as transfer () function — to make it transferable on established exchanges (move from one address to another. Again, completing this task requires the skills of someone who can command a $100-200 per hour (if you can find that person at all).
In either event, it would take a talented coin developer anywhere from 100-200 hours to develop a cryptographic token along with a company’s block chain. It will likely take approximately 100 hours to develop an ERC20-compliant token.
Crowdsale Smart ICO Contract
Because the ICO is generally not generally carried out through an existing exchange, the distribution must be carried out by a system developed and controlled by the issuing company. In this way, the issuing company is the counter-party in the exchange with the individual purchasing the coins. The technology system used to control and distribute the coins in exchange for another cryptocurrency (such as Ether) is known as a Crowdsale Smart ICO Contract. A smart coin developer would be able to piggy back off of the work of existing ICOs, but it would still take 50-100 hours to develop the Smart ICO contract — at a rate of $100-200 per hour. Recently, companies have begun to avoid developing the Smart ICO contract and have employed the services of an existing coin exchange. Basically, the company creates and transfers the ERC20-compliant coins to an existing exchange. This exchange then handles the distribution (sale) process. The terms for handling this process is generally a pre-determined percentage of the coins being offered.
Smart Contract Audits
The most important aspect for maintaining investor confidence in the coins being offered is security. You must make certain that the coins remained safe against unauthorized transfer. Unauthorized transfer generally happens when individuals hack into an individual’s holding account or hack into the transfer system (or block chain verification system). As such, it is important to run continuous smart contract- audits for vulnerabilities. A complete audit can take from 50-200 hours. Expect a cost from $10 - 20K or larger companies from $20-50K.
Legal Structure and Regulatory Filings
The coin offering should be done as a legal business entity. This will require forming an appropriate entity structure (generally a corporation) with governance documents adequately defining the roll or rights of coin holders, shareholders, directors, and officers.
Most ICOs issue coins or tokens are backed by the company issuing the token. This generally means that the coin only has value because it represents the value or productivity of the underlying company. This qualifies as an “investment contract” — a “security” under the traditional securities law regime. The issuing company will need to either register with the SEC (a long and expensive process) or perfect an exemption from registration through an exemption. This generally means perfecting an exemption under Regulation D (of the federal securities laws). Also, it means perfecting the same exemption under state law. Both require the development of an extensive and thorough disclosure document. Much of this will piggy back off of the white paper. Hiring an attorney to handle the securities law portion will generally costs from $10 - 25K.
Making the public aware of the ICO is incredibly important for a successful ICO. You going to need investors and investors will want to see that there is some buzz around your company (as well as its ICO). You will need to use traditional and non-traditional channels, such as tech magazine advertisements, direct emails to fund managers, social media posts (Reddit, Facebook, LinkedIn), etc.
This type of marketing can be anywhere from free to thousands of dollars.