The icy road to ICO

courtsey Autolook image

Previously, I had written a cautionary article in Bostinno for retail investors who want to buy tokens through ICO. This article is for incumbents and startups that are planning to take the ICO road. Here in this article, ‘you’ is referred to a startup or company unless otherwise stated.

I had been advising many blockchain companies lately. Many of them want to do an ICO and a few of them want to go the equity route (they have my utmost respect). Initial Coin Offering, a.k.a. ICO, is one of the best things that has happened to founders since the IPO. It makes entrepreneurs’ lives easier compared to thousands of rejections and meetings with potential investors, who may take major chunk of their companies. Founders can now focus on product development and market traction. But the road to an ICO is icy.

The very first piece of advice that I give to any company/startup interested to do an ICO is to consult a good ICO lawyer. It is better to be safe than sorry to your stakeholders and consumers by bringing legal worries and a bad name to your company. The regulations are murky and it is easy to slip into the SEC or non-US govt. regulators’ prying eyes. In this article, I try to explain in simpler terms the checklist that you need to follow before, during and after your ICO.

TYPES

There are four kinds of companies who are taking the ICO route.

The Incumbents

These are already established companies who have mentionable revenues and 20~50 employees. They want to go the ICO route because for them its lucrative to bring a blockchain and crowd sourcing funding layer on top of their existing business model. They are in a position where they can raise money from banks or venture capital or private equity firms, but they want to jump on the ICO route. They think an ICO will help them in future funding, revenue increase and customer engagement.

The Blockchain Startups

These are the blockchain companies whose entire business model is integrated in the blockchain protocol and ICO is the natural route for them to raise initial funding. Some of them are venture-backed during the pre-sale of their tokens. This is the kind of company whose ICO’s are in high demand and they know what they are doing. They are the reason why everyone wants to do an ICO and they are also the reason why the SEC has started raising red flags. I’ll discuss that in detail later in the article.

The Startups whose funding stalled

These are the startups who have raised couple of millions in seed rounds but having difficulty in raising the next rounds due to many different reasons. Instead of addressing those reasons they think the ICO route will help them in the future to secure their product development funding and customer traction through the token’s network effects.

The ‘Happy Go lucky’ Startups

These are the ones who love everything that is ‘current or happening’. So do most of us. They decided to do an ICO because every company they know is doing an ICO and blockchain is the flavor of the funding that everyone is loving. They have an idea which they want to put into a blockchain protocol and smart contracts and want to take the ICO route for their initial funding. They don’t care what the SEC, their mother or their advisors are saying. They love ICO.

Last year, when I wrote how crazy it is that over $3.7B was collectively raised in 250+ ICOs in 2017, which surpassed the amount raised in early stage VC funding in Q2 2017, I was half right. According to CB Insights, it was over $5B raised collectively through ICO, which is 5x more than the equity financing. This year Telegram Messenger just announced they are raising $1.2B in ICO.

Image courtesy CBInsight

ICO- 25 lines of code

Yes, an ICO is almost 25 lines of code on Ethereum. Ethereum is a second-generation blockchain by Vitalik Buterin which utilizes smart contracts to enable this new way of crowdsourced funding. Anyone can learn how to create an ICO in days if they know how to code. There are online courses, some even for $12 in Udemy — How to Build a Crowd Sale (ICO) App in Ethereum Blockchain.

Smart Contract is Iron Clad, Literally

A contractual agreement encoded into a common law has always been the binding chain of a free market economy. That is what Nick Szabo envisioned in 1996. A Turing complete program with a Byzantine fault tolerant code enabled the decentralized security in cryptocurrency protocols. In lay man terms, smart contracts are self executing and self enforcing immutable piece of code that binds contractual states between two or multiple parties encoded on a blockchain. The idea to decentralize and automate a contractual agreement without the human element (the expensive lawyers) has excited us. The common law of contractual design should be enforced (as stated by Nick Szabo, 96') through

‘Enforceability,

Observability (the ability of the principals to observe each others’ performance of the contract, or to prove their performance to other principals),

Verifiability (the ability of a principal to prove to an arbitrator that a contract has been performed or breached, or the ability of the arbitrator to find this out by other means)

Privity -the principle that knowledge and control over the contents and performance of a contract should be distributed among parties only as much as is necessary for the performance of that contract.’

As smart contracts can not interact with other contracts in the blockchain, there are other vulnerabilities. There can be legal doctrinal as well as practical issues.

i) One cannot put an illegal contract even if it is self enforcing and self binding. Eg: I can not put a smart contract to sell my country USA to China though how much ever trackable and irreversible that code is. Because that is illegal and absurd.

ii) Smart contracts can not be re-negotiated if you change your mind and may pose confusion between who stands as a plaintiff and who is a challenger.

iii) Security code flaw — When DAO got hacked someone created a child DAO(child smart contract of the parent DAO) and siphoned $50M. The smart contract code was the ultimate arbiter not subjected to any jurisdictions. So the heist became a legal transaction due to the flaw in the security code. You can read details here.

SINGLE @Address

I can not emphasize this enough. DO NOT put all your MONEY in a SINGLE Ethereum address. Most of the heists in exchanges and DAOs had been due to such a lackadaisical approach to security. It is very important to maintain multiple addresses for your digital wallets to keep your money safe. Also learn about multi signature wallet here.

Blockchain CODE

The blockchain programming security model is unlike client-server web development, where you can roll back the bad code. Most of today’s programmers have become used to such freedom. But Blockchain smart contracts are intrinsically irreversible. A bad written smart contract can easily fall prey to hacks and can remain hacked forever unless an intelligent smart security code can shut down your servers to fix it or do a hot fix. That’s not an easy possibility in a decentralized distributed network where everyone is part of the world server. So companies encouraging smart contract should keep in mind that all your codes are accessible to everyone in the blockchain and everyone can have access to your currency. The blockchain ecosystem has not reached its mature equilibrium and will go through many versions of development to make it more secure. So it is very important to know those vulnerabilities before doing an ICO.

Difference between coin and token — It is explained very well here.

Security token vs Utility token

This has been the biggest debate for everyone in the cryptocurrency market. The murky line between security and utility tokens has kept many entrepreneurs out of ICO funding. Though I have explained this in my previous Bostinno article, I will try to revisit this again.

Security token — They offer dividends, interests, and profit. Tokens that are issued in compliance with SAFT (Simple Agreement for Future Tokens) are securities. Most tokens are sold only to accredited investors and are exempted from SEC registration, but one can qualify under Regulation A+, a section of the JOBS Act that “allows companies that want to raise between $3 million and $50 million to do so from anyone.”

Utility Token —They are issued to customers to finance future services rendered by startups on a fully developed commercial platform. But these services are not fully developed yet and treating the token as a unit of service now is a speculative investment. There are two types of utility tokens,

i) Utility token that is used in an ICO — If you are raising money through utility tokens then you have a fiduciary responsibility towards your consumers and token holders. For such utility token ICOs startups should consult an ICO lawyer and understand what exempts the tokens if the SEC contests them as security token.

ii) Utility token that is not used in an ICO — If you are not raising money through an ICO but are using utility tokens to provide non-monetary services, then you should also check with an ICO lawyer what fiduciary responsibility you have towards your consumers and token holders who are holding a trade-able asset.

If you are not seeking SEC registration of your tokens, then you must fall under these categories:

·Rule 506(c): the token sale can be broadly solicited to an unlimited number of purchasers so long as the Company meets two conditions (1) All token purchasers in the offering must qualify as Accredited Investors; and (2) The Company must have undertaken reasonable steps to verify that all purchasers are Accredited Investors.

·Regulation S: should the Company choose to exclude US token purchasers they may do so under Regulation S of the Securities Act. Among other requirements, (i) the Company must verify that the token sale is made outside of the US to non-US persons (ii) there are no direct selling efforts made in the US and (iii) the securities or tokens will not be transferred to investors or token purchasers in the US or to US persons for at least one year following the original token sale.

CAP your total token supply- It’s important to cap your total token supply without causing confusion to your potential token holders. Issuing tokens after the ICO may devalue or dilute the existing token value. Eg: You can read the details here.

White Paper and clear communication in your ICO page

It is significant and highly advisable that a company should maintain proper communication of their work in progress to the consumers and token holders:

i) The product or service development roadmap that you have laid out in your white paper should show updates of the work in an ICO landing page that your hard working employees are doing in the company.

ii) A Github repository page where the code work can be reviewed by other developers. This shows transparency and your startup’s interest in building the ecosystem.

iii) All your company’s public policy related announcements whether monetary, fiscal, audit, legal should be maintained and updated in the website. The company’s audited financial statements, if available, should be shared.

iv) The company/startup leadership background should be stated in your website with basic company information. Details of the company’s entity type and location.

v)The details of the type of ICO offering token — is it a security token or utility token. Do they comply with securities law? If not, why and how are they exempted from securities law?

vi) In the event of fraud/hack/heist/downturn of your business, what legal protection or rights do the token holders have?

v) Details of how you are spending your ICO funding in product and business development should be laid out.

The SEC has explained the concerns and considerations for ICO here.

Network effect vs exchange listing

As a startup issuing an ICO, the main ideas behind issuing coins and tokens are to raise money and to create network effects. But one should realize most of these ICO token holders are not hodlers. They want to take a liquid position in the exchange market as soon as possible. Most of the potential token holders are here not to use your service or build network effects but to make money. The exchanges list tokens that are ERC20 compatible and are highly talked about in the market. They cannot list every token because of currently high token traffic. You can get more technical details here.

Strong TEAM with cybersecurity and blockchain skill

I have met multiple startups and companies who want to join the ICO bandwagon, but do not have any blockchain talent and cyber security skilled team member. Either they outsource or ask their existing developer to learn the smart contract coding. It is very important to have the industry knowledge and talents. But many such startups were able to raise huge funds through an ICO.

As venture capitalist/investors bet on founders/teams who execute the idea and business model presentation into an actionable million dollar product. Expect your potential token holders to bet on blockchain experts who know what they are doing. It is very important to have in-house blockchain developers and crypto security experts to make sure you are not recklessly irresponsible towards your token holders. Get a security auditor to inspect your smart contract.

What problem are you solving?

Do not do an ICO because it is the easier path to raise money or get a market hype for your current product, but instead try to solve a problem. This is the statement every VC, investor, advisor for your company will make. I’ll go back to my four types of ICO startups to discuss this further.

Incumbents + Startups whose funding stalled- If you think an ICO can keep your boat afloat, you are wrong. You are overlooking the real problems that your startup is facing. It can be the business model or the product or the market sales or the team leadership or an amalgamation of all. If you think you can win over a competitor with an ICO then you have not heard Peter Thiel statement — “Competition is for losers”. Your focus should be to fix the intrinsic problem with your company instead of introducing a new crypto protocol to your business model. There are some great articles by Founder Collective on product development, product challenges, investor update, sales, diligence, funding etc and see how you can attribute that to your own company’s development.

If an ICO is the pivot that your business needs then the introduction of the token economy should become a coherent part of your business. Every cryptoassets within its native protocol serve as a mean of exchange like a store of value within their protocol economy. That means your token economy should act as a financial stakeholder in your business model. Get a good ICO consulting team comprised of technical, functional, legal and security audit talents.

Blockchain Startups- They are the most envious startups now, just like internet companies in the early 90s. They not only hold the key to the future infrastructure development but also the key to the development of the crypto economy market. They have championed ICO fundraising and their company’s token conduct has a lot to do with how the SEC will introduce regulations. Though the first token sale was done in 2013, it became more popular in 2017 after the ICOs of Filecoin, Tezos, Brave, Kik etc.

Startups that are building the third generation blockchain technology, Bitcoin being first and Ethereum being second, some of them are trying to solve the scalability issue. One of the major issue in a decentralized platform is how to improve the protocol infrastructure along with interoperability. Such research oriented product development can lessen the industry specific risks if there is an overall reduction in the valuation level of coins or equities. They can survive market correction. These startups/companies also bear the responsibility to set up a precedent of how to handle the token market, how to carry on with innovation and handle market regulations. Their actions are prompting other new startups to follow suit and encouraging retail investors to put their money in the blockchain industry. Stories like Tezos, Munchee, “REcoin” and “DRC,” and many more have different set of struggles and setbacks. Their irresponsible actions are adversaries of good market behavior and should be lessons for new ICOs.

The Future

90% of token may not survive market correction, key is to have a controlled risk profile as each crypto market has unique characteristics that can be exploited to effectively manage the market inherent risks.

Currently the blockchain industry is at a nascent stage and there are lot of debate about decentralization, scalability, interoperability that amount to vulnerabilities in the code, where some of these syndicates treat the industry as a zero sum game. To sustain decentralization, we need consensus to thrive and analyze the optimal strategies by which we can enforce agreements among the crypto groups. I have mentioned this in my twitter account last year that we can see equity token offerings from the Fortune companies in the near future if the ICO market stays lucrative and productive for a future gold rush. The future lies not just “In cryptography we trust” but in its ‘social scalability’ as we build the ecosystem of responsible crypto economic behavior.

Disclaimer: There are further technical checklists which are beyond the scope of this article. But you can contact me if you want to know further details.

This is my small contribution to create a checklist for companies interested in ICO, please feel free to add or edit this checklist. Suggestions are welcome!