ICO in Legal Terms: An Introduction

The last two years have shown that an ICO is a relatively efficient and affordable way to raise funds for product development. According to CoinDesk's ICO Tracker, by the end of November 2017, projects have attracted almost $3.8 billion via an ICO. Yet, it’s more likely that the amount is even higher.

In this series of articles, lawless.tech describes the legal peculiarities of the ICO phenomenon. However, before going into details, it is best to explain an ICO in general.

What Is an ICO and How is It Regulated?

ICO (Initial Coin Offering) is a relatively new way for a project to raise funds for its development. The project issues digital tokens and distributes them among interested enthusiasts in exchange for cryptocurrency or fiat money.

Apart from the term “ICO,” there are several others frequently used, such as “crowdsale,” “token sale,” “contribution campaign,” “ITO” (Initial Token Offering), “TGE” (Token Generation Event), “token launch,” and so on.

Although the first ICO was held in 2013, significant attempts to regulate ICOs took place in 2017:

• In July 2017, the United States Securities and Exchange Commission reported that some digital tokens can be qualified as securities. The Howey Test, Family Resemblance Test, and Capital Risk Test, to name a few, are applicable to determine whether certain tokens are securities.
• In August 2017, the Monetary Authority of Singapore said that digital tokens are not similar to virtual currency. Additionally, in November 2017, the regulator has defined cases of an ICO in which securities regulation is applicable.
• In September 2017, the Financial Conduct Authority of the United Kingdom stated that ICOs are subject to current UK legislation.
• Also in September 2017, the People's Bank of China forbids Chinese citizens from undertaking an ICO.

However, cryptocurrency and digital tokens, along with ICOs and other crypto activities, still lack regulation in many jurisdictions.

General Traits of an ICO

Each particular ICO is tailored to a specific case along a set of key parameters, such as the number of stages, pricing and token distribution specifics, time frames, etc.

In terms of structure, a typical ICO splits into:

• Presale (also pre-sale). It is generally conducted to test the project’s idea (proof-of-concept). The project distributes some part of its tokens among the enthusiasts in advance and gets much needed feedback about its product early on.
• Main sale. The main round is held to collect the bulk of funds necessary to develop the project according to its roadmap.

Within both the presale and main sale stages, a project may offer bonus tokens or discounts under desired conditions (e.g., 20% extra tokens for early participants or a 20% early-bird discount).  

Fundraising models may also vary in terms of the limits imposed on token issuance, pricing mechanics, distribution, and other details.

In terms of token issuance limits, a project may run:

• A sale with limited token emission. A company explicitly sets the number of tokens to be minted. With such an approach, contributors have a desire to buy tokens as fast as possible because of their limited quantity.  
• A sale with unlimited token emission. Using this model, a company doesn’t limit the quantity of issued tokens.

In terms of pricing mechanics, there are options, including:

• Fixed token price pegged to a certain crypto or fiat currency (Ethereum, USD, etc.).
• Deterministic mechanism that forms token price based on certain criteria, such as the current stage of the sale or the current amount of sold tokens.
• An auction, where the participants bid their prices, and the total amount of tokens offered is distributed among the bidders in descending price order.
• A reverse Dutch auction (second-price Dutch auction), where the stake of each participant’s tokens depends on the moment when the hard cap is reached or all tokens are distributed. For instance, if an ICO ended on the first day, its participants will receive only a certain part of all tokens (for example, two percent), on the second day investors will receive four percent and so on.

In terms of token distribution during the ICO, a project can:

• Set a limit on the amount of tokens available to a single participant, allowing more people to get tokens.
• Set conditions for equal or proportional redistribution of all sold tokens depending on each participant’s individual contribution.

Apart from an ICO, some projects choose to conduct a Secondary Coin Offering (SCO). As the name implies, a SCO is the subsequent fundraiser held after an ICO if the project needs additional funding.

ICO Legal Models

From the legal perspective, any ICO falls into one of three general categories:

A sale of utility tokens (app tokens). Utility tokens give their holders a right to use certain products or services. A business model with app tokens is more attractive to contributors and potential users, since the token will be useful within a product and will remain in circulation (otherwise users won’t be able to use a platform or network). As one of the key features, a utility token is easier to sell to a wider audience. A sale of utility tokens (app tokens) is the one of the most popular ICO legal models. Enigma, Storj, Tierion, and many other projects used this model.

An offering of security tokens (tokens that have characteristics of securities). Securities tokens seem to be a more attractive investment than utility tokens, since they give token holders some specific rights regarding the issuer company (e.g. voting rights, profit sharing rights). However, this model entails additional risks related to securities legislation. For example, a company running an ICO may be fined for violations of an emission prospectus or for offering securities tokens without observing the legislative rules. Thereby, it’s important to observe all statutory rules concerning securities legislation or use specific exemptions that make a legitimate offering of securities possible. An offering of security tokens as an ICO legal model was used by such projects as Blockchain Capital, The DAO, etc.

A donation campaign. Participants of a donation campaign are voluntarily supporting the team and its idea, receiving no profit for their contribution. Over the sale of utility tokens, all funds are collected by an LLC or another type of company. In the case of a donation campaign, all funds go to a non-profit foundation. This model implies using a different corporate structure. Tezos is one of the projects that used this model.

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