By: Ali N. Habhab

Much has been made of the “blockchain” revolution in recent years – the development of a secure digital ledger has spurred numerous applications in everything from tradeable cryptocurrencies to smart contracts. Perhaps the most eye-catching aspect has been the speculative trading of bitcoin and other cryptocurrencies. Before a precipitous decline in 2018, bitcoin peaked at a market cap of nearly $830 billion.[1] Investors in cryptocurrencies ran the gambit from crypto-focused hedge funds to retail investors armed only with internet access and a Coinbase account. The decentralized, distributed, and immutable nature of the blockchain sparked excitement for its potential to displace the need for trusted intermediaries in everyday transactions. Given the increasing amount of money flowing into the crypto-space, many in the start-up community began considering ways to tap into blockchain markets as a relatively cost-efficient means of raising capital.

Enter the initial coin offering or ICO. The appeal to early-stage growth companies was quite clear: ICOs offered a quick way of tapping into capital markets without ceding equity as is the case with the issuance of stock. At the outset, ICOs were seemingly unregulated; many companies raised money without the onerous disclosure requirements and sale restrictions associated with traditional IPOs, private placements, or Regulation D offerings, greatly reducing the cost of raising capital. The traditional public offering process is usually reserved for later-stage growth companies that can afford the reputational signals sold by underwriters and the legal legwork needed to comply with the Securities Act’s Section 5 registration requirements. The requirements include developing and furnishing investors with a statutory prospectus and complying with the complex “gun-jumping” rules that prohibit offers before filing a registration statement with the SEC. Many, correctly or incorrectly, viewed the ICO as an end around to the SEC’s restrictions on public capital raises: start-ups offered digital tokens to just about any interested party on the web – a public market without the watchful gaze of an expensive gatekeeper, be they on Wall Street or K Street. In 2017, the heyday of the ICO, over $6 billion was raised, driving the value of bitcoin to even greater heights.[2]

Despite the obvious benefits to blockchain start-ups, this “wild-west” like atmosphere posed similarly obvious risks to investors, ultimately raising the ire of an alphabet soup of regulators from the SEC to the CFTC. Allegations of wide-spread fraud in the ICO space in 2018 scared off retail investors and sharpened the focus of the SEC.[3] The Commission has applied the traditional investment contract test[4] to require registering most ICOs as securities offerings and has since launched numerous enforcement actions.[5] In this new, more highly regulated environment, the calculus for deciding to launch an ICO has changed – ICO activity declined an astonishing 90% since January 2018.[6]

This has led many to ponder whether the ICO is, in practical terms, dead. But before assessing its present prospects for entrepreneurs, it is important to understand the basic structure.

The Mechanics of an ICO

To the extent the ICO moniker is envisioned to elicit comparisons to an IPO, it is a bit of a misnomer. In an ICO, a start-up wanting to raise money to develop its business offers digital tokens in return for fiat money or cryptocurrencies like bitcoin or Ethereum.[7] However, the start-up’s digital tokens typically do not provide an equity stake in the company (see utility tokens below), and as such, the investors do not develop legal rights of ownership and control over the entity. The obvious benefit is that founder control is not diluted during the capital raise, as is often the case in an IPO or private placement. And what do investors get in return? Investors typically look for two ways to earn a return on their investment:

1. Enjoying the use and appreciation of value of the digital tokens in the company’s native ecosystem (a so-called utility token). For example, an artisan marketplace app might develop a digital token with which customers may purchase art pieces; investors would receive the tokens in exchange for their investment and be able to transact in the marketplace. The idea is that the token has a utility and competitive advantage value for use in the marketplace beyond just a store of value.

2. Capital appreciation through an asset-based security coin. These tokens most resemble traditional equity securities – they do offer some ownership rights and are primarily designed for the investor to enjoy dividends and capital appreciation.

Many companies offering ICOs argued that they were issuing “utility” tokens and that this should exempt them from being treated as a security requiring registration, but the SEC has decidedly pierced through formal distinctions: even tokens that resemble some element of “utility” still often derive their value from the success of the underlying company’s efforts, a condition consistent with the SEC’s definition of a security.[8] The result is to capture most ICOs within the definition of a securities offering, triggering the expensive and onerous registration requirements under Section 5 of the Securities Act. Of course, start-ups could try to fit their ICOs under a § 4(a)(2) private placement, wherein if they limit the scope of the offering and their target net of potential offerees, they could exchange tokens for capital without registration. The same is true for fitting under one of the Regulation D exemptions from registration. However, restrictions on resales might lead investors wanting of an equity stake, reducing the entity-side benefits of a utility token offering.

Rethinking the ICO

So what does this all mean for start-ups considering tokenizing for a capital raise? For starters, the early promise of the ICO as a cost-efficient capital raising instrument is likely obsolete – companies selling digital tokens will typically have to register their offerings or fit within some exemption, like a private placement or Regulation D. That said, their value isn’t completely diminished; companies seeking to tap public markets can still elect to do so through an ICO, provided they meet regulatory requirements. Pure utility tokens can have significant second-order benefits beyond merely as a tool to raise money – they get more people interacting within the company’s native ecosystem and as a corporate governance tool, can be a powerful incentive for investors to monitor the company’s activities. While private placements might still be a better first option, tokenization can still play a similar role in those markets as well. Repurposing the ICO as a value-add for investors, rather than as an end-around from government regulation, could expand the potential pool of interested investors, all while enhancing investor engagement with the company’s underlying technologies and products.


[1] https://www.telegraph.co.uk/technology/2018/09/06/bitcoin-hit-183bn-fall-market-value-since-january-amid-growing/

[2] https://www.nytimes.com/2018/02/05/technology/virtual-currency-regulation.html

[3] https://www.wsj.com/articles/buyer-beware-hundreds-of-bitcoin-wannabes-show-hallmarks-of-fraud-1526573115

[4] link to Han Zhu’s article on cryptocurrency and the Howey Test: http://www.wolverine-startuplaw.com/2019/01/07/cryptocurrency-and-the-howey-test/

[5] https://www.cnbc.com/2018/11/16/in-crackdown-of-crypto-sec-goes-after-unregistered-coin-offerings.html

[6] https://www.bloomberg.com/news/articles/2018-10-08/crypto-ico-funding-dropped-in-september-to-lowest-in-17-months

[7] https://www.investopedia.com/news/what-ico/

[8] https://medium.com/altcoin-magazine/how-is-a-security-token-different-from-a-utility-token-1eea0e4523cc. (SEC Chairman Jay Clayton: “I believe every ICO I’ve seen is a security.”)