An initial coin offering, or ICO, is a way for startups to raise funds on the blockchain. In many ways, it’s an easier process than an initial public offering, or IPO, on the stock market.
The explosion of initial coin offerings from 2014 to 2018 saw countless projects—both startups and existing businesses—raise millions of dollars through the sale of digital tokens. Many people mistakenly believe that ICOs are unregulated, but the SEC has been cracking down on companies that sell unregistered securities or defraud investors through ICOs.
Not all initial coin offerings involve securities, and not all of them are conducted unlawfully—but with the SEC keeping a close watch, it’s important to understand the regulations and risks.
Considering launching an ICO campaign? Here’s what you should know.
What Is an ICO?
An initial coin offering (ICO) is the cryptocurrency industry’s version of an initial public offering (IPO). Unlike IPOs, initial coin offerings operate on the blockchain instead of the stock market. Cryptocurrency ICOs can also be referred to as token sales or token funding.
The purpose of the ICO is to raise money for a business venture by selling digital tokens to investors. Often, the token gives investors access to features of the project. It could also increase in value over time, allowing early investors to make a profit.
During the Ethereum ICO, investors received Ether (ETH) in exchange for Bitcoin. The company sold more than 7 million ETH in the first 12 hours, worth more than $2.2 million at the time.
Risks of Initial Coin Offerings
While investing in an initial coin offering can produce gains for investors, on the other hand, there is always the risk that the company doesn’t take off. Even worse, the team behind an ICO could “rug pull” the project, taking investors’ funds without developing anything. It is crucial to research each ICO before making an investment.
Here are a few things you should know before investing in an ICO:
- Information about the company and their ICO whitepaper
- The type of tokens being used and their functions
- How the tokens will be traded
How Do Initial Coin Offerings (ICOs) Work?
So, you have an excellent idea for a cryptocurrency project but no money to support it. If you think an ICO would help you meet your financial goal, your first step would be to determine the structure of your initial coin offering.
The 3 different ICO structures include:
- Static Supply/Static Price: Each token in this structure has a set price, with a fixed supply, due to the company’s specific financial goal for the project
- Static Supply/Dynamic Price: The price of each token is determined by the number of funds the ICO receives.
- Dynamic Supply/Static Price: The amount of money received through investors determines the number of tokens supplied
Once you’ve decided which structure works best for your project, it’s time to create an ICO whitepaper. This document is made accessible through the company’s website and provides investors with necessary information regarding the ICO, such as:
- The goal of the project and the need it fulfills
- The financial goals of the project
- What type of currency is being accepted (USD, BTC, ETH)
- The length of the campaign
It’s essential to be as detailed and transparent as possible when releasing the ICO’s whitepaper to the public. The purpose is to encourage like-minded individuals to invest in your project and help reach your funding goal. If the project meets its funding goal, you’re one step closer to bringing your project to life.
While the whitepaper is extremely important, it’s only one part of the process! In order to cover all of your tracks and avoid dealing with penalties from the SEC, consult with an experienced SEC attorney before moving forward with your ICO.
Are ICOs Regulated by the SEC?
With more companies and individuals using initial coin offerings to raise money, the SEC monitors these campaigns to ensure investors are not at risk of fraud and manipulation.
On the one hand, ICO campaigns can provide the boost needed to get an idea off the ground, with a lower barrier to entry than traditional fundraising methods. On the other hand, because ICOs are relatively easy to launch and often don’t follow regulations, they could be fraudulent and leave investors at risk of being scammed.
The U.S. Securities and Exchange Commission considers many of the tokens sold in ICOs securities, which means they either need to be registered or exempt from registration, and the companies involved must comply with federal securities laws.
It’s important to be aware of whether your ICO falls under SEC jurisdiction and to remember the following:
• Contact an experienced SEC attorney before launching any ICO
• Determine whether security laws apply to your tokens before promoting or selling them
• If your token is considered a security, comply with all SEC regulations
Failure to follow SEC law could result in steep financial penalties, or even being forced to shut down your entire company.
Utility Tokens and Security Token Offerings
In some cases, startup founders have promoted the use of utility tokens in order to skirt SEC regulations. Utility tokens give investors access to features within a specific network.
Binance (BNB) is one example of a utility token ICO. It began in 2017 as a utility token offering discounted trading fees on the Binance cryptocurrency exchange. By launching an initial coin offering of BNB, the company was able to raise funds while also encouraging users to trade on Binance versus other exchanges.
However, utility tokens can still be considered securities depending on the specific situation, so calling your ICO a utility token is not a free pass to skirt SEC regulations.
Increasingly, companies that want to be extra safe have gravitated toward a new buzzword: security token offerings, or STOs. Security tokens represent a stake in the underlying business and are subject to SEC rules and regulations. Creators are more transparent with investors by actively calling the token a “security” and laying out a detailed SEC compliance plan.
Whether your token sale uses a utility or security token, it’s always best to contact an attorney as early in the project as possible.
The SEC vs. ICOs
In December 2020, the SEC filed a lawsuit against Ripple Labs, claiming the company illegally raised $1.3 billion through sales of the XRP token. The company never registered XRP as a security. This highly publicized case will set an important precedent for other token funding projects.
Ripple isn’t the only company under the microscope. SEC Chairman Gary Gensler has remarked that many unregistered securities exist in the crypto industry.
As a result, more lawsuits are being filed against companies that conduct allegedly improper ICOs.
At the start of 2022, the SEC brought charges against Craig Sproule, founder of Crowd Machine Inc. and Metavine Inc., for selling unregistered digital assets through an ICO and misleading investors. According to the SEC, Sproule raised funds by selling the Crowd Machine Compute Tokens (CMCT); investors believed proceeds would go toward enhancing an existing software application for a decentralized computer network.
Instead, Sproule sent over $5.8 million of the ICO’s proceeds to South African gold mining entities—a use that was never disclosed to investors. The SEC ordered him to pay $195,047 in civil penalties and restricted him from holding a position as an officer or director of a company.
Other companies that are facing heat for ICOs include messaging app Kik, which was sued by the SEC and ended up paying $5 million in penalties; Ukirn Esports, which agreed to pay $6.1 million in penalties for conducting an illegal ICO; and the FLiK token that was created by film producer Ryan Felton and promoted by rapper T.I.
Initial coin offerings continue to provide entrepreneurs with the chance to raise capital for their projects. ICOs can be a huge asset for creators, but it’s important not to gamble with the law—especially when all the money raised through your ICO could be snatched away if the funds were raised illegally.
Before launching your ICO campaign, call the team of attorneys at Gordon Law Group for help!