ICOs are becoming increasingly accepted as an alternative means to generate capital for a variety of projects. How do ICOs compare to other financing options and how are they treated by regulators?

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INITIAL COIN OFFERINGS
A legal perspective for project financing
Andreas Gunst, Kenneth Wallace-Mueller

2. 1 Initial Coin Offerings

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 Initial Coin Offerings (ICO), also known as Initial Token Offerings (ITO) are an
innovative project finance tool.
 ICOs are similar to IPOs, in that virtual “coins” or “tokens” are created and publicly
issued to investors in return for project capital.
 An increasing number of ICOs have appeared over the last year, with approx.
USD 6.3 billion having been raised in Q1 of 2018 (Coindesk.com).
 Whilst some ICOs are legitimate, a number have turned out to be fraudulent, with
culprits increasingly adopting professional approaches.
 ICOs currently occupy a legal vacuum, with many countries holding back on
actively regulating ICOs and the underlying tokens.
 The ICO investment community however increasingly self-regulates ICOs, which
requires an active approach to seeking investment.
Background

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 Blockchain technology has received a lot of media attention in the last few
months, with promises made that it will revolutionise many sectors.
 Blockchain is the backbone technology the cryptocurrency Bitcoin, and it has
quickly been developed into different structures, such as Ethereum.
 Also known as Distributed Ledger Technology (DLT), it acts as a chronological
record of transactions, tracking the movement of value, such as bitcoins,
between participants.
 The USP of blockchain is that the record is not stored on a central server or by
a single entity. Instead the entire record is stored on the computers of all
participants on the blockchain network.
 Transaction details are encoded, meaning that the parties to a transaction
cannot easily be identified, and the nature of the record prevents the
retroactive amendment of transaction details.
 This creates a robust peer-to-peer transaction system, potentially eliminating
any third parties from the transaction and reducing errors and transaction fees.
What is blockchain?

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 The mechanism of blockchain technology is best summarised by its name.
The record is ultimately a chain of blocks, whereby each block contains the details
of a number of transactions.
 Each time a transaction is made, the details are added to a block of other
transactions made. After a set period of time, the block is completed and attached
to the last block, creating a new link in the chain.
 The network verifies the authenticity of the new block, and if confirmed by
consensus of the other computers in the network, it is attached to the previous
block. Each block contains a unique "hash" which references the previous link in
the chain.
 The updated record is then synchronised with all of the computers on the
blockchain network.
 If any block in the chain were to be altered, the hash would no longer align with
that of the previous block. All of the computers on the network continuously verify
the state of the blockchain, so that any such alteration would be noticed and red
flagged.
How does blockchain work?

6. 2 How an ICO works

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How an ICO works
 An ICO can be performed in six general steps:
– The organisers announce the ICO to generate interest;
– A white paper is published, providing details on the organisers,
the project, the ICO process and the nature of the tokens;
– A fixed number of tokens are created, the number of which
determines the ICO token starting price;
– A date and duration for the ICO is set, as well as the token price
(which may be flat or increase in phases during the duration) and
a cap on the amount of money to be raised;
– A platform to advertise the ICO is selected; and
– The ICO proper is then performed.

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Nature and types of tokens (1)
 In return for capital, investors are issued a number of “tokens”. These can
take a variety of forms, depending on their intended purpose.
 The exact nature of the tokens needs to be considered. These may
otherwise fall under the definition of:
– equity (e.g. ownership of a company or project); or
– financial instruments (e.g. derivatives or swaps),
and therefore fall under extensive state regulation.
 There are several general options for tokens or token-alternatives:
– Usage tokens;
– Work tokens;
– Simple Agreements for Future Token (SAFT); and
– Simple Agreement for Future Token or Equity (SAFTE).

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Nature and types of tokens (2)
 Usage tokens (e.g. Ether, part of Ethereum)
– These are in a literal sense cryptocurrencies, which carry value and can
be exchanged with other tokens (such as Bitcoin with Ether), fiat
currencies, or goods and services.
 Work tokens (e.g. ClimateCoin)
– These grant certain rights within the framework of their issuance. These
can be varied, such as ownership rights, voting rights, or a tracking
system for certain goods, or even simple proof of investment.
– These can be sub-divided into:
– tokens mimicking equity instruments or debt instruments;
– tokens serving as types of vouchers, the use of which is determined
by the organiser (utility tokens); and
– utility tokens, which are locked on issue and are unlocked once the
system is built.

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Nature and types of tokens (3)
 Simple Agreements for Future Token (SAFT)
– A right to acquire tokens in the future following the launch of the system.
– SAFTs may be sold as securities, however after launch the tokens
themselves become Utility Tokens.
 Simple Agreement for Future Token or Equity (SAFTE)
– A SAFT with an equity conversion feature if a priced equity round occurs
prior to the network launch.
 A SAFT or SAFTE is designed to avoid the ICO being considered an ICO
as such, but instead through a token presale it seeks to raise funds to
develop the token before an ICO.
 These are just general types of tokens, however these can be tailored for
the specificities of the project and the desired rights of token holders.

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ICO community self-regulation
 The ICO investment community has increasingly become wary of scams,
and as such has become to a degree “self-regulating”.
 This is not set in stone, but examples of common practice are:
– White paper – the project, team, performance of the ICO, and nature of
tokens are described both clearly and in detail. These generally look and
are written like an academic paper;
– Website – as the white paper, but this needs to look professional, but
explain the concepts simply and clearly;
– Team – the team needs to be well presented, showing their relevant
experience. Often technical and legal team members are included; and
– Investor relations – any questions about the project, project team, and
nature of the tokens should be answered and quickly. This should
convey legitimacy and trust to the investors. This needs to be done prior
to and during the ICO, and for the life of the project.

12. 3 Considerations before
starting an ICO

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Why an ICO?
 The advantages of an ICO are:
– it is (generally) unregulated;
– it provides access to a large group of investors;
– it has the potential to raise significant capital;
– it is relatively low cost; and
– it is still a good time to benefit from the “hype”.
 It however requires attention to:
– ensure transparency, legitimacy and trustworthiness of the project;
– ensure that the technical aspects of the ICO and tokens are in order;
– ensure that the ICO does not unintentionally fall under a regulated
regime; and
– ensure that the proper contractual framework is in place for investors.

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Alternatives to ICOs (1)
 ICOs is a new and much discussed means of project finance. It is therefore
interesting and useful to consider how an ICO compares to other available
financing options. These may include:
– Crowd-funding;
– Venture capital;
– Initial public offering (IPO);
– Bond issue; and
– Bank loan.
 These examples are compared in the next slide. These are however not
exhaustive and the answers are generalised (i.e. not taking specific
jurisdictions into account), but serves to highlight comparisons of an ICO
with other common financing options.

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Alternatives to ICOs (2)
Mechanism ICO Crowd Funding Venture Capital Bonds IPO Loan
Source of
finance
Multiple online
investors
Multiple online
investors
Directly through
investors
Exchange Exchange Bank, other
financial
institution
Regulation Currently
generally
unregulated
Varied,
depending on
jurisdiction
Highly regulated Highly regulated Highly regulated Highly regulated
Rights of
investors
Diverse,
depending on
nature of token
Generally none,
often comparable
to donation
Ownership rights Depends on
jurisdiction and
agreed terms
Ownership rights Generally none,
possible security
required
Repayment
structure
Diverse,
depending on
organiser
Generally none,
often comparable
to donation
Through sale of
shares
Payment on
maturity, possibly
interest
payments
(coupon)
Through sale of
shares
Principal and
interest to be
repaid over time
Relative direct
costs of finance
Low Low Medium Medium High High
Comments in
comparison to
ICO
N/A Similar, but less
flexible than ICO
as no tokens or
similar tracking
system involved
Equity given
away, but
investors may
contribute
business advice
and network
Limited control by
bondholder,
however highly
regulated, and
principal to be
repaid with
coupon and/or
discount,
prospectus?
Equity given
away, but
investors may
contribute
business advice
and network,
prospectus?
Secure source of
funding and
formal legal
relationship with
bank with
negotiable terms,
however
expensive

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Legal considerations
 The legal and regulatory environment for tokens and ICOs is currently
highly variable and poses a number of risks to ICO organisers.
 Legal advice should be sought to better understand the nature of the
offering and possible risks, both nationally and internationally.
 Technical advice should be sought to ensure technical soundness of the
blockchain, tokens and ICO.
 An ICO should be supported by a clear and comprehensive agreement
between the organisers and investor. This should:
– clearly assign rights/obligations between the parties;
– be drafted so that it doesn´t trigger consumer protection measures;
– be robust against legislative and regulatory changes; and
– be targeted to an international audience, using appropriate language,
governing law and court jurisdiction.

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 With regard to the UK regulatory regime, the Financial Conduct Authority
(FCA) has updated its position in April 2018.
 It confirmed that: “Cryptocurrency derivatives are […] capable of being
financial instruments under [MIFID II], although we do not consider
cryptocurrencies to be currencies or commodities for regulatory purposes
under MiFID II.”
 Regarding ICO-issued tokens, the following may require FCA authorisation:
– cryptocurrency futures – derivative contract where cryptocurrency to be
exchanged at a future date and price;
– cryptocurrency CFD – cash settled derivative contract designed to hedge
against cryptocurrency price fluctuations; and
– cryptocurrency options – contract granting a beneficiary the right to
acquire/dispose of cryptocurrencies.
 We would be happy to advise on regulatory positions in other jurisdictions.
Position of the FCA

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Any questions?
Andreas Gunst
London / Vienna
M +44 780 271 9480
M +43 676 8888 1232
andreas.gunst@dlapiper.com
Kenneth Wallace-Mueller
Vienna
T +43 1 531 78 1113
M +43 676 8888 1844
kenneth.wallace-mueller@dlapiper.com

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