Startup businesses usually get the financing they need through money obtained from banks, venture capital funds, or crowdfunding because many credit institutions are reluctant to provide funding. Startups are looking for new ways to raise funds and integrate new technologies (blockchain, Distributed Ledger Technology, smart contracts) into their business models.
Initial coin offerings (ICOs), also known as initial token offerings (ITOs), are becoming more and more popular because blockchain technology offers the possibility for startups to get financing through these methods.
An initial coin offering is a way of financing a company, similar to the old fashion initial public offering (IPO). When using an IPO, the company issues shares or other securities to potential investors. Through an ICO, a startup company gives digital tokens to investors.
To understand how an initial coin offering works, we need to understand the blockchain technology on which any ICO is based.
The blockchain is a decentralized peer-to-peer electronic public ledger that accurately records and keeps track of transactions. Peer-to-peer means in computer language the direct connection between two computers on the same network, sharing information without the need for a third to serve as a server. This public ledger is decentralized, and its immutable nature is the real innovation. It allows for the first time people who do not know each other to enter transactions with confidence without relying on a conventional intermediary (such as PayPal or banks).
A blockchain is open-source software that anyone can download for free, use and improve to develop new tools to manage online transactions. Thus, it has the potential to unleash countless new applications and transform a lot of things.
Initial coin offerings usually reach the public after a startup announces, through online channels, such as cryptocurrency news websites, about launching a digital token offering to raise funds to develop a product or service in the technology sector using a blockchain platform.
Within an ICO, digital tokens can have different purposes and purposes: to provide voting rights or rights to a portion of the future income of the issuing startup, or to serve to access or purchase a service; or product that the issuing startup will develop or to be traded and exchanged in fiat or virtual currencies (Ethereum, bitcoin, etc.).
The incentive for initial coin offerings is determined by the enthusiasm for the applications of the new blockchain technology, the ICOs being the way to raise funds for developing these new applications. In an ICO, issuers will offer digital tokens to be purchased with various cryptocurrencies (the most popular are Bitcoin and Ethereum). These companies will usually display a set of information in the form of a white paper, which defines the business model and purpose of digital tokens, generally containing a detailed explanation of the business concept and other helpful information. A white paper is an essential document for informing any investor and at least a minimum of research that investors must do when deciding whether or not to buy a particular digital token.
While most financial regulators and supervisors in Europe are silent on many legal issues related to initial coin offerings, the US Securities and Exchange Commission (SEC) has stated that digital tokens are securities in certain circumstances. The German Federal Financial Supervisory Authority qualified them as financial instruments, subjecting digital token trading to MiFID II requirements.
Similar to the US regulator, the Canadian regulator believes that if a person purchases a digital token that, for example, allows them to play video games on a platform, the chances of that token qualifying as security are reduced. However, suppose the rights deriving from the token are related to the profits or success. In that case, the digital token could be qualified as security (bonds, other debt securities).
Undoubtedly, investors in digital tokens will have to proceed with caution, as the line between the rights deriving from the token and, therefore, the qualification of tokens as securities is fine and differs depending on the specifics of each initial coin offering. In addition, how different European Union countries will want to regulate the tax on earnings from digital tokens could also influence the nature of the digital tokens assigned by regulators. In addition to how digital tokens are regulated, the legal aspects of consumer protection and anti-money laundering provisions must be carefully considered when dealing with an ICO.