ICOs - A new way of Raising Finance

Dr. Priscilla Mifsud Parker co-authored with Sarah Vassallo | 03 May 2018

Blockchain and Initial Coin Offerings ICOs

Initial Coin Offerings (ICOs) are a means by which start ups and companies can raise funds for a new distributed ledger technology asset (DLT asset), more commonly referred to as a token or digital token. Since ICOs remain vastly unregulated by most Governments around the globe, several companies have turned to ICOs as an alternative way to raise finance and bypass the rigorous processes of raising capital through banks or on the capital markets. 

Essentially, during an ICO campaign, the company who is seeking to create a new DLT-asset will offer it to the public at a discounted rate to entice initial backers of the project. Therefore, besides the technological aspect of the project, the ICO campaign can be considered as a marketing exercise since the more DLT assets it manages to sell to the public the more will the asset appreciate in value. Therefore, the popularity of the asset will not only determine whether the issuer has been successful in creating something of value, but it will also determine whether the investor will make a profit from the investment since unlike in the case of stocks, a DLT asset will not confer any ownership rights to the investor. 

Malta – Regulatory leaps

Malta is one of the few jurisdictions which have already made solid plans to regulate ICOs and technology services providers. In early 2018, the jurisdiction announced the introduction of three new Acts of law (“Act/s”) which are set to provide an apt legal framework for the blockchain and crypto-sphere. The proposed Virtual Financial Asset Act shall primarily regulate ICOs and their Virtual Financial Assets. The proposed Act is set to become law around June of this year, however, the regulator has already given the industry a taste of the proposed framework through a number of consultation documents. 
The act will only regulate digital medium recordation that are used as a: 
•    digital medium of exchange, 
•    unit of account or store of value that is not electronic money, 
•    a financial instrument that falls within the remit of MiFID or
•    a virtual token which would be any DLT asset which has no utility, value or application outside of the of the DLT platform and that cannot be exchanged for funds on such platform or with the issuer of such DLT asset.

ICOs vis-a-vis crowdfunding and IPOs 

ICOs have been likened to Initial Public Offerings (IPOs) as well as Crowdfunding since essentially all three activities aim to raise funds for undertakings. Also known as a ‘token sale’, or a ‘token generating activity’, an ICO is a fund generating activity whereby investors receive DLT-assets in return for their Investment. They can be considered as an offshoot of crowdfunding since they are ideal vehicles for start-up companies seeking to obtain capital. 
The idea behind ICOs is to enable innovation in a fast way at a lower cost than doing an IPO. Start-ups felt that the process to set up an IPO and the stringent regulatory standards were killing innovation. An ICO allows a company to obtain financing before it even launches its product or establishes itself in the market by presenting a concept to investors of the product they seek to launch in the market. Investors commit their funds and in return, they are given tokens. 

How do ICOs work?

ICOs are generally created by a start-up in need of funds to launch its products. 

The first building block towards setting up an ICO is the creation of a whitepaper. The white paper outlines the vision of the creators for their project, the governance of the ICO, a business plan and a marketing plan. It is a promise which the creators of the ICO give to investors vis-a -vis the token purchase paper. 

Any company seeking to set up a successful ICO needs to be as trustworthy and transparent as possible, since investment is wholly dependent on the investor’s belief that the concept of the product being proposed is viable and a worthwhile investment. Therefore, the whitepaper needs to prove that the concept works and expose the source code of the concept, however, it will need to do deliver this key information in non-technical language which allows the investors to make an informed assessment of the prospect of the issuer. 

From a technical perspective, the contents of the whitepaper must be reflected on the smart contract which should automatically enforce anything promised in the whitepaper between the investor and the issuer.

How do Smart Contracts work within the ambit of an ICO?

Simply put, a smart contract is a piece of code which will automatically execute itself without the intervention of any one of the contracting parties. From an ICO perspective, smart contracts allow issuers to release contracts and sell them to investors. Since unlike in the case of shares, the investor will not be acquiring part of the ownership of the company, but a token whose value is very often speculative at the infancy of the offering, the smart contract ensures that while the issuer acquires capital from the investor, the investor will receive whatever was promised in the Whitepaper in the form of tokens.

There are a number of considerations which an ICO issuer will need to consider:

1.    Drafting the smart contract -although the industry is growing at a staggeringly large pace, specialists in this area are few and far in between, and this means that finding a reputable person who is qualified to draft a smart contract will not be an easy, not particularly cost-effective feat. Alternatively, an issuer may opt to use a special platform to hold their ICOs at a fee. Such ready-made tools would be ideal for projects which would only require the smart contracts once for their ICO, and the product itself can function without the need of smart contracts. Alternatively, one may take a longer route and draft the smart contract themselves which will require the drafter to become familiar with the necessary language, syntax and examples. 

2.    Inflexibility of released smart contracts – once set in motion, smart contract cannot be changed and this permanence makes them strong tools, but also very dangerous tools in cases where there is a bug in the code which can have tragic consequences as seen in the Parity case where about $150 million was frozen due to a critical error in the code. To avoid such incidents thorough testing must be carried out under various conditions and cases, and the smart contract should be audited by an external auditor.

In the light of the above, the Malta Digital Innovation Authority is being set up with the aim to certify such technology. The new Authority shall be manned by technical experts who shall ensure the soundness of such platforms. 

For more information on how Smart Contracts work, we encourage you to read this publication.

What do tokens from an ICO represent? 

Investors will be given tokens in return for their investment, however, the value of the token is highly dependent on each respective ICO and what intends to offer. Essentially, tokens are cryptographically secured digital representations of a set of rights. Depending on how the ICO will work, a token could confer the right to access or use of a network or software application, the right to redeem the token for a unit of currency or a good, the right to receive a share of future earnings, the right to vote on decisions made by the organization or more.

Basic considerations when setting up an ICO

First and foremost, a start-up should consider whether its business plan can accommodate the DLT asset model since a this may not be necessary for every kind of company and equity funding would be a more viable option. 

The current situation with respect to ICOs takes us back to the dot.com bubble, where several companies failed, but those which succeeded are now billion-dollar companies. Although there is no denying that the hype surrounding blockchain technology will definitely attract investors, it is important to understand what this technology can truly do, its limitations, and whether it suits one’s business model. 

Secondly, it needs to establish a solid framework by establishing a whitepaper that gives a transparent overview of the concept, its feasibility and which evokes trust in prospective investors. 

The next step is to set out a solid marketing plan for the ICO. An ICO is as much of a marketing event as it is a tech and financing event since the success of an ICO is directly affected by how popular an ICO is among investors. Thus, the creators of an ICO will need to generate interest and a hype for the token and create a sense of community prior to launching the actual token generation event. Thus, setting up a good public-relation strategy is crucial, and this could even be done through social media, posting videos, hosting AMAs etc. 

Project Team for an ICO Campaign 

From an investor’s stance, a great team behind an ICO project is one of the most important factors when deciding on contributing to an ICO. On the other hand, an unproven or anonymous team is likely to serve as a major red flag and stop people from investing in an ICO. As such, it is considered as a good practice to have a list of all major team members, along with their biography, openly available to any potential investor. 

In most cases, an ICO project will have the following team members:

a)    ICO Advisor 
It is important that an ICO project has an advisor that is well respected and known in the industry, without any vested interest in that company.

b)    Legal Advisor
This role is important to ensure that the ICO project is compliant with all applicable laws. 

c)    Business Analyst
This person is responsible to conduct research on crypto assets/token research (business model, value drivers, market trends etc.).

d)    Project Manager
A person who monitors the ICO project as a whole and ensures that all the work is being done in a qualitatively manner.

e)    Community Manager
This person is responsible to respond to all the questions raised by the prospective investors during the offer period of the ICO. 

f)    Public Relations and Communications Specialist 
A mass media manager who builds and maintains a positive public image for the ICO venture. This person is responsible to develop the ICO website. Furthermore, such specialist is needed to narrow the marketing campaign entirely at the audience interested in cryptocurrencies.

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Dr Priscilla Mifsud Parker

Senior Partner, Corporate, Tax & Immigration

+356 22056122

Mr Steve Muscat Azzopardi

Director, Trust & Corporate Services, CCA Interserv Ltd

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