Claudia Teo of Eversheds Harry Elias, notes that the dynamics of initial coin offerings (ICOs) will continue to evolve, with investors deriving comfort from regulated entities, and more likely to back token generation event.
The emergence of ICOs as a tool of entrepreneurial finance has seen it being used by both startup ventures and venture capital funds to raise capital.
Since the beginning of 2017, over 70 cryptocurrency funds have sprung up, many with venture funds as investors. Firms like TaaS Fund, Finshi Capital, Blockchain Capital, Pantera Capital and Starta Capital have engaged in ICOs, issuing digital tokens to raise funds.
These digital tokens are essentially crowdfunding units, sold by projects in order to develop products, support expansion or accumulate tokens for other goals and represent different types of rights. In most cases, they represent pre-payment of goods and services in the style of platforms like Kickstarter and Indiegogo and represent access to those goods or services in the future.
In certain cases (i.e. equity tokens), they can represent rights for dividends or other underlying assets. ICO tokens can be sold for fiat currencies (e.g. USD, EUR) or for more liquid tokens from mature digital currencies such as Bitcoins and Ethereum.
In an exchange with DEALSTREETASIA, Teo discussed the contours and complexities of using the ICO to raise a fund, particularly in Singapore.
What’re the dynamics for PE/VC players looking to raise a fund via ICO using an equity token vs a utility token?
A core issue for PE/VC players to consider is the rationale for the ICO when compared to other, more traditional methods of raising funds, such as IPOs or bank loans, or more recent variants such as crowdfunding. The rationale for the ICO will help inform views as to its credibility. The decision to structure the ICO as an equity token versus a utility token should reflect this core purpose.
If for example, an ICO is structured as a utility token, then this sits with the core feature of the ICO as a flexible vehicle for investing in a concept. Potential investors should consider the feasibility of the concept, and whether the utility aspect of the token means there is a cap on the number of tokens that could be produced.
On the other hand, an equity token may be more suited to finance a decentralised autonomous organisation (DAO), and, in these scenarios, an investor may wish to look at issues such as the viability of the organisation together with the governance and dispute resolution procedures.
Can you highlight some of the legal complexities of raising a fund via an ICO that’s a securities product in Singapore?
This depends on the nature of the token. One common issue is to determine the regulatory classification of the token that is being issued. An interesting point here is that structuring a token so that it falls outside a regulatory framework may not always be the best option, as investors generally derive comfort if an ICO is being driven by a regulated entity.
Another issue to consider is whether the regulatory system performs not only a restrictive role in limiting what cannot be done but also a protective function, as compliance with the regulatory framework reduces the scope for criticism. As such, even if a token is outside a regulatory system, voluntary compliance, in a proportionate manner, with standards analogous to that under the regulatory system generally makes sounds commercial sense.
In August 2017, the Monetary Authority of Singapore (MAS) stated that ICOs may constitute a debenture under the Securities and Futures Act and thus a security falling within the regulatory framework.
In November 2017, the MAS published A Guide to Digital Token Offerings (“November Guidelines”) in which it clarified that ICOs may be regulated by MAS if they are constitute capital markets products. A digital token may constitute a share, a debenture or a unit in a collective investment scheme. In which case, the offer, if involving a security, will need to comply with the prospectus requirements under the Singapore Securities and Futures Act, unless they fall within the safe harbour exemptions. MAS again emphasized the availability of the regulatory sandbox to digital tokens.
Therefore, investors should note that an ICO may constitute a security and thus subject to the regulatory framework. A platform operator that involves ICOs as security is subsequently subject to licensing requirements.
ICOs require that a foundation is formed to issue tokens and subsequently hold the cash, and Tezos has run into problems with this. In a Singapore context, how can an ICO be structured to avoid these governance issues?
We would suggest that the key here is not to “avoid” the use of an entity to issue the tokens and hold the cash, but rather to ensure that this is done in an appropriate manner. For example, a bank could be used to hold the cash during the fund-raising, and to release that cash on behalf of investors in exchange for tokens once the fundraising is completed and the tokens created. Another example is to have the ICO operate under the regulatory sandbox once the regulator conclusively states its position.
In the November Guidelines, MAS also highlighted that it intends to establish a new payments services framework that will include rules to address money laundering and terrorism financing risks relating to the dealing or exchange of virtual currencies for fiat or other virtual currencies and intermediaries will be required to put in place procedures to address such risks.
We look toward to this framework for further guidance on the measures that will need to be implemented.
Venture capital firms are increasingly interested in the ICO space due to the liquidity and returns available to them through liquidating the tokens while preserving equity. For limited partners (LPs) backing an ICO, what’re the liquidity options and legal aspects surrounding the investment?
The LP will want to ensure that they have considered the white paper and that this is a true reflection of the proof of concept behind the ICO. They should also ensure that they understand the legal nature of the ICO and the rights and obligations they have incurred.
It would be interesting to have rights embedded where the rights of redemption can be divorced from rights of ownership. But we must still bear in mind, as clarified in the November Guidelines, the issuance of digital tokens may constitute a security, depending on how it is structured.
If the token is in the form of units in a collective investment scheme, the constituent documents of the scheme will determine the liquidity options and such divorce features, if possible.
How does conducting an ICO impact the viability of a firm in terms of M&A, given that it’s issued its own digital currency whose value it doesn’t directly control? Does it create complexities in an M&A deal or an IPO, particularly with regard to equity tokens being issued?
Yes, it does if the equity tokens are treated as security under the SFA. Complexity may also arise depending on the rights embedded within the token produced as a result of the ICO. Usually, tokens do not provide ownership rights in a company – and in this respect, they obviously differ from shares – and so will not usually affect the ability to buy a company.
If the ICO is for a DAO (distributed autonomous organisation), the intrinsic nature of this entity means it does not have shares, and so cannot usually IPO or be acquired through an M&A transaction. The closest option may be to acquire a majority of the relevant tokens, but this is likely to undermine the purpose of the DAO, and in any event is not really analogous to an equity interest.