Howard Marks


The ICO Is Dead. Long Live the ICO 2.0

The entire cryptocurrency industry is full of debates about regulation and which victims the SEC will go after next. However, these debates are misguided. In reality, debate ought to be focused on how to best use existing regulation to raise capital for a new blockchain company. The belief system of industry pundits is that regulation is unfair, unnecessary, and only applies to bad actors who are hurting the marketplace. It is time to make the transition and accept reality: rules and regulations exist, and they apply to Initial Coin Offerings (ICOs).

A Little History On Making the ICO specie

It turns out the first ever ICO was Mastercoin (now called Omni), which raised 5,000 Bitcoin at a total value of $500,000 in 2013. Mastercoin organized a foundation called the Mastercoin Foundation to receive the Bitcoin and manage the project. Then came the DAO ICO, which is famous because it raised close to $50M or 5% of all existing Ether on May 2016 and then was hacked, causing the investors to lose all of their money. On July 2017, the SEC issued a Bulletin saying the DAO was a security but decided not to prosecute the virtual organizers.

After the DAO came the ICO Big Bang in 2017. That year, ICOs raised close to $4B, and ICOs became the most disruptive way to raise capital for a blockchain company. Say goodbye to VCs, and hello to the crowd, who were salivating to invest in the next big ICO.

Act I: Ethereum ICO

The first ICOs were structured with non-profit foundations, and it is important to understand why many ICOs copied or slightly altered the first ICO formats for their own offerings. After Mastercoin, the most important event for ICOs was the creation of Ethereum, which was proposed by Vitalik Buterin in late 2013, and in July 2014, Ethereum organized an ICO, or crowdsale, and raised over $18M.

At that time blockchain projects mostly created foundations to raise the capital needed to build the technology and make it open source and decentralized. This structure seemed to make sense because these international collaborators did not see themselves as a corporation and a foundation seemed to have the right governance structure to keep the project alive through completion and avoid any form of taxation as foundations are not-for-profit entities and thus not taxable.

Ethereum created their foundation in Zug, a small town in Switzerland, because of its favorable foundation regulations. Other ICOs decided to structure themselves as offshore corporations in the Cayman Islands, Gibraltar, Malta, and Singapore, among others. The main motivation of this structuring was to escape any form of taxation on the token sale because the tokens were issued as utility tokens. Thus, selling them is a form of revenue and taxable. Luckily in the Cayman Islands, they are not taxed at all, and thus all of the proceeds from the ICOs remained intact with the company and none with the tax authorities.

The one great innovation Ethereum offered were the programmable smart contracts, and the most widely used one is the ERC-20, which is used to raise capital. ERC-20, it turns out, is a smart contract that only does one thing: create a new cryptocurrency token and move it from one person to another. There is absolutely no utility other than that.

Act II: The Great Tezos Greek Tragedy

Some notable events happened in 2017 that turned heads and created doubt in ICO structures. Tezos launched their ICO with another Zug foundation and raised over $230M. This seemed all well and good until pundits started to peel the onion and realized that the Tezos founders were getting an 8.5% commission on the raise as well as 10% of all of the tokens. Tezos was one of the first uncapped ICOs, which means they had no goal and sold as much as they could within the timeline they proposed. This extra greed factor shocked the ICO ecosystem, and then the trouble started.

The head of the Tezos foundation, Johann Gevers, and the founders started a dispute which is still unresolved as of today. DLS, the company founded by Kathleen and Arthur Breitman, did not get the money they were promised. Some of the Tezos investors filed lawsuits, and the entire project seemed to unravel. Why can’t we all get along?

Act III: The SEC strikes back

The SEC entered the playground with some notable bulletins accusing some of the ICOs as fraud schemes. In August last year, the SEC contacted a company called Protostarr, who were conducting an ICO, and shortly after, Protostarr cancelled its ICO and refunded the money it had raised so far. The next month the SEC exposed two more ICOs for defrauding investors. This was only the beginning.

Now, it looks like the SEC is gearing up to crack down on ICOs in a serious way. Last December, SEC Chairman Jay Clayton wrote a public letter stating that all token offerings are securities, and on February 6th, he testified before Congress again confirming that most ICOs constitute the sale of securities. This means that all ICOs must be regulated and registered with the SEC. Last month, Arisebank’s ICO was shut down by the SEC, who claimed the company is “an outright scam.” The SEC’s actions sent shockwaves into the investor and ICO community.

Mom, ERC-20 is a Security!

Most ICOs in 2017 used the famous ERC-20 smart contract to raise capital from investors. These ICOs issued utility tokens, which are used to operate their blockchain application. Fair enough, but instead of issuing the token that will operate their application, they issued an ERC-20 token, which has only one utility: to raise money. It is clear and without any doubt that selling an ERC-20 is an option to receiving another token when the blockchain application is completed. Guess what: an option is a security.

So if all these ERC-20 utility tokens are securities, then what happens to those who structured them, promoted them, and finally sold them to US persons without registering with the SEC or using approved exemptions? What are they supposed to do now?

Is the Rescission a Get Out of Jail Card?

Enter the Munchee ICO, which attempted to raise $15M selling utility tokens to investors. The SEC politely called them up and asked Munchee to immediately interrupt their party and give back to investors all of the money they raised in an operation called the great rescission. Yes, 2017 was the year of the utility token ICO, and now 2018 is going to be the year of the ICO rescission.

The SEC made it clear: sometimes sins can be washed out by committing an act of kindness and refunding all of the investors. However, the company can also start a brand new ICO that uses one of the beautiful SEC exemptions and offer to their investors the ability to reinvest with new terms. This is a great opportunity for these CEOs and officers who care to avoid trouble with potential securities fraud and suffering some irreparable damages, which include becoming a felon.

Enter ICO 2.0, and the Party Goes On

The ICO is clearly one of the great innovations to come out of the blockchain industry. It offers freedom to those who innovate from harsh treatment by Venture Capitalists. This is clearly an alternative important to those who are shut out from receiving expensive VC capital with more strings attached than one can count. The ICO 2.0 solves all of the issues ICOs are confronted with and offers a way forward in which investors are able to make an informed decision, and CEOs get to achieve their dreams while living in freedom. Amen.

To explain further what an ICO 2.0 is, we need to learn about the JOBS Act, which was signed into law on April 2012, way before anyone knew what a Bitcoin was. This new legislation is one of the greatest achievements in modern capital innovations. For the first time in 80 years, ordinary investors can now invest in startups and innovative blockchain companies.

The act is divided into three main parts:

  • Regulation D 506(c), where accredited investors can invest with no limits. Investors need to be verified and pass the Bank Secrecy and USA Patriot Acts test also called AML/KYC/CIP (love those acronyms).
  • Regulation Crowdfunding, where anyone can invest and the company can raise up to $1.07M per year. This is rad.
  • Regulation A+, where anyone can invest and the company raise up to $50M per year after the SEC has qualified the offering. While more expensive, it is the future of ICOs.

An ICO 2.0 can offer to investors several different structures. Keep in mind these structures will require the help of an attorney:

  • Simple Agreement for Future Token (SAFT) is a derivative securities instrument. It is simple to put in place and offers investors the ability to invest before the token is ready.
  • Real Agreement for Tokens and Equity (RATE) is a two token offering. One of them is equity in the company and the other the delivery of another token as a perk.
  • Simple Agreement for Future Equity (SAFE) is an equity-only offering. The token can be a preferred or common equity investment. If it is a preferred offering, it can offer a non-convertible security with a dividend similar to a revenue share.
  • Straight equity offering by issuing a token. This is simple because the company offers a new class of equity, be it common with or without voting rights. The token can also be preferred and offer dividends.

Important: the terms of the token must be clear if you choose a public offerings such as Regulation Crowdfunding or Regulation A+.

Next is the biggest question of all. Where do you trade these securities tokens, and how are investors going to make money? Turns out the SEC was kind enough to allow broker dealers to use Alternative Trading Systems (ATS) to sell securities that are not offered on national marketplaces. These systems are coming soon to the token market, and it will allow the ICO 2.0 marketplace to flourish and forget about the good old days when investors were in the dark and at risk of being defrauded.

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