Définition anglaise des SECURITIES

« Financial securities are tradeable financial assets, including stocks and bonds.
Traditionally, they are divided into debt and equity securities. Debt securities include
corporate and sovereign bonds, while equity securities include common and
preferred shares. There are also hybrid securities, which share some characteristics
of debt and equity securities, including preference shares, convertible bonds and
equity warrants.

There are different official definitions of securities. In the US, where any
tradeable financial asset is a security, derivatives like futures, options and
swaps are also securities. »

Article White & Case

What is an ICO?

International Coin Offerings ("ICOs") are increasingly popular among start-up and
other companies when raising capital. Investors participate in the fundraising by
transferring fiat currencies or cryptocurrencies to the issuer in exchange for digital
tokens (“Tokens”), representing a holder’s right of benefit or performance vis-à-vis the
issuer. Tokens may also be used (exclusively) for payment to the issuing company for
its services or products. Contrary to shares offered in a traditional initial public
offering (“IPO”), Tokens typically do not represent ownership interests or dividend
rights. ICO investors seek to directly benefit from the issuing company’s future
business, while investors in IPOs tend to pursue a long-term interest in the value-
creation of the IPO entity.

The underlying technology of the Tokens is based on blockchain which is maintained

by a network of participants and computers. Utilizing cryptography to record
transactions, blockchains process, verify and track the trade of the relevant virtual
currency securely across independent network components.

Similarly to IPOs, the issuer can use the proceeds of the ICO to finance its business
operations and future growth. In the event that Tokens are exchanged for other
cryptocurrencies, the issuing company can exchange them for fiat currencies. As the
features of Tokens issued in ICOs can vary widely, every Token has to be assessed
individually. Tokens are typically tradable on virtual currency exchanges, creating a
secondary Token market, which makes them fungible in the same way as shares.

Financial Regulation of ICOs

Existing legal uncertainties in relation to cryptocurrencies extend to ICOs. The specific
crowd-lending regulation cannot be applied to ICOs, as investors in an ICO do not
grant a loan to the issuer. The purchase of Tokens issued in connection with an ICO
could be qualified as a purchase of commodities, a purchase of rights or a purchase of
securities which may ultimately subject ICOs and the relating documentation to
prospectus or other disclosure requirements.

Applicable regulations are not necessarily limited to those of the jurisdiction

governing the ICO. When marketed to investors residing or domiciled in another
jurisdiction, the laws and regulations of such jurisdiction may equally apply to the
ICO.

Documentation Requirements

To market an ICO, it is currently market practice that the issuing company publishes a
whitepaper (“Whitepaper”) on its website and certain virtual platforms. In the
Whitepaper, the issuing company describes its business operations as well as the
structure and features of the Tokens. The transaction documentation may also include
a Token purchase agreement stipulating the terms and conditions pursuant to which
investors can purchase the Tokens.

Even when Tokens are not qualified as securities, ICOs and Whitepapers have to
conform to certain anti-fraud and information requirements. Information requirements
may apply to the issuer and any other party involved in the sale and marketing of
Tokens.

Generally, transaction documentation must include all necessary information to allow

an average investor to make a reasonable investment decision. The documentation
must be accurate and not misleading, comprehensive, transparent and include potential
risk factors as well as a description of the characteristics of the Tokens and the
business of the issuer. Statements on future developments must be reasonable, and
disclosure on the use of proceeds is required. If qualified as general terms and
conditions, the terms of the sales documentation must comply with certain local
requirements.

Transparency and comprehensiveness of a Whitepaper are currently not necessarily

examined by regulatory authorities. Risk factors, if included, are frequently limited to
vaguely standardised descriptions of potential conflicts. In addition, (audited) historic
financial information may not be available to investors who might therefore not be
able to make a reasonable investment decision. However, ICOs frequently occur in the
early stages of launching a business.

There is currently no established case law available regarding inaccurate, incomplete

or misleading ICO documentation. But this may change soon.
Conclusion

ICOs are an innovative and appealing method for companies to raise capital. Although
there is currently no specific ICO regulation in place, a diligent analysis of the
regulatory framework is necessary to identify and ensure legal compliance with all
applicable laws and regulations prior to launching an ICO. Legal challenges arise
especially if an ICO targets investors globally. Regardless of the Token structure, the
issuing company needs to provide investors with sufficient and accurate information
and disclose such information comprehensively and transparently to permit average
investors to make a reasonable investment decision.

This post comes to us from White & Case LLP, and has been authored by Karsten
Wöckener, Carsten Lösing, Thilo Diehl and Annekatrin Kutzbach.

FLADGATE article

International companies continue to treat London as a key destination for raising institutional
finance. Furthermore, of the firm offers announced in 2012 for companies subject to the UK
Takeover Code (being, principally, UK corporations listed on the United Kingdom Listing
Authority’s Official List and traded on the London Stock Exchange Main Market or listed on the
AIM market of the London Stock Exchange), over half were made by non-UK bidders (including
nine US and four Canadian bidders). More recently, on 1 March 2013 AIM and TSX-listed Ithaca
Energy announced a $309 million cash and shares offer for Valiant Petroleum plc. Other
corporate transactions may involve UK securities law considerations, such as a rights issue
where an issuer has UK shareholders on its register.

Hence, there are a number of scenarios where an understanding of applicable UK securities laws
will be important to an overseas issuer and its investment bankers or other brokers. This note is a
high-level review of the common English law points to be considered.

UK prospectus requirements

A UK prospectus, which must be vetted and approved by the UK Financial Conduct Authority
(FCA), is required for an “offer of transferable securities to the public” in the UK. Exemptions are
available for an offer of securities to “qualified investors”, which covers most institutional
investors, and/or an offer to fewer than 150 persons (excluding qualified investors) in the UK
(which would include the underlying clients individually if a fund manager or stockbroker is not
acting on a fully discretionary basis). Marketing a placing to institutional investors in the UK would
therefore typically not require a UK prospectus.

Other transactions with a UK element may require a prospectus. A takeover offer by way of a
securities offer or a mix and match cash/shares offer would require a prospectus. Similarly, a
rights issue or open offer is likely to require a prospectus. Certain other prospectus exemptions
(such as, offers with a minimum consideration per investor or a minimum denomination) may be
available.

Other UK regulations on the communication of investment opportunities

In addition to the prospectus regime, which is a function of European law, the UK has an
additional “financial promotion” regime which regulates the communication in, or into, the UK, in
the course of business, of any invitation or inducement to engage in “investment activity”.

Such communications are prohibited unless a person authorised by the FCA, such as a UK-
based investment bank or broker, makes the communication or approves its contents, or unless
an exemption is available. Included within the financial promotion ambit would be presentations
and materials, investor calls, preliminary prospectuses and the like filed in non-UK jurisdictions
that are used on a financing roadshow, plus placing or subscription letters; other transactional
documents (such as takeover offer documents and related public announcements) are also likely
to comprise financial promotions.

In the context of an institutional placing, exemptions similar to the prospectus exemptions exist.
Issuers and banks commonly approach only “investment professionals” and “high net worth
companies, unincorporated associations, etc”. Communication with individual “high net worth” or
“sophisticated” investors is possible but is more cumbersome as there is a greater burden of
paperwork which must be exchanged and checked before the individual can be contacted.
Accordingly, an institutional private placement in the UK can typically be done without the
documentation requiring formal approval by a UK bank or broker.

Certain alternative exemptions are available for other types of transaction. Communication
between an issuer and its shareholders or creditors in relation to the issuer’s securities is exempt,
which allows, for example, an issuer to communicate a rights issue to its shareholders without the
circular requiring approval by an FCA-authorised person (although the circular may also comprise
a prospectus or require approval under listing rules).

Communications in relation to the sale of certain bodies corporate are exempt; this exemption is
often relied upon in connection with public takeovers (again, the offer document may also be a
prospectus if securities are offered). Communications included in a prospectus are exempt, but
this exemption does not cover ancillary communications, such as press releases, which may
need to be approved by an FCA-authorised person.

Conduct of regulated activities in the UK

The commentary above relates to an offer of securities and the communication of that offer.
Additional regulations cover the conduct of investment activities in the UK. Under the “general
prohibition” set out in the UK Financial Services and Markets Act 2000, no person may carry on,
or purport to carry on, a “regulated activity”, by way of business, in the UK unless it is an
authorised person or an exemption applies. Regulated activities include dealing (buying, selling,
subscribing for or underwriting) in securities, as principal or agent, and arranging deals in
securities. If a regulated activity is being carried on in the UK, and no exemption is available, an
FCA-authorised person must be engaged.

The first step is to establish whether a regulated activity is carried on “by way of business” (by
considering factors such as whether the transaction is a one-off or more continuous in nature,
and the scale of the activity relative to the rest of the party’s business) and in the UK (by
considering factors relating to the mechanics of the transaction such as where communication of
the acceptance is made). These threshold matters will need to be considered on a case by case
basis, and the analysis would need to be undertaken for the activities of the issuer and the
investment bank or broker separately. Whilst an issuer may consider that it is not conducting a
transaction “by way of business”, on the basis that a placing or takeover offer is a one-off event, it
may be difficult to establish definitively whether the investment activity will fall outside the UK
regulations, so it is necessary to consider the exemptions.

Issuers commonly benefit from exemptions relating to dealing in their own securities or making
arrangements to which the issuer will be a party. The position of overseas investment banks or
brokers is more complicated, but certain exemptions are available. In the context of a placing, a
prerequisite is that the bank is an “overseas person”; that is, the bank does not carry on
investment activities, or offer to do so, from a permanent place of business maintained by it in the
UK. An overseas bank will not require FCA authorisation to effect transactions with investment
professionals or other persons within the scope of the exemption from the UK’s financial
promotion regime (see previous section).

Advising on a UK takeover or a transaction where a UK prospectus must be produced will

generally require the engagement of a UK bank or broker. Whilst exemptions are available in
respect of regulated activities carried on in connection with the sale of a body corporate, and
under the UK Takeover Code a bidder is not obliged to retain a financial adviser, a bidder would
typically appoint a UK financial adviser. A target is obliged under the UK Takeover Code to
appoint a UK financial adviser, whose advice is made public.

Breach of UK regulations

Breach of the UK regimes on financial promotion, prospectuses and the conduct of financial
services business carry both civil and criminal sanctions. Additionally, it should be noted that any
agreement made pursuant to an unlawful financial promotion or by a person lacking the
necessary FCA authorisation may be unenforceable.

Conclusions

It can be seen that overseas issuers and financial advisers may be able to raise institutional
finance in the UK in compliance with UK securities laws without needing to navigate onerous UK
regulations or incur significant cost. Placing securities with UK high net worth or sophisticated
individuals is similarly possible, but requires more careful planning. In all cases, the marketing
materials and investment documentation must be drawn up to the highest standards of accuracy
(in compliance with general English law), and should be reviewed to ensure that appropriate
disclaimers and representations are included and that proper procedures are established to
ensure the UK roadshow excludes ineligible persons.

It is likely that UK advisers will need to be engaged on other corporate transactions which have a
UK element.

Paul Airley, Partner, Fladgate LLP ([email protected])

Initial Coin Offerings

Initial Coin Offerings (ICOs) provide unprecedented efficiency for capital formation in startups. ICO offer liquidity

enhancement of startup finance needs through crypto investors, overcoming fundraising challenges for

entrepreneurial initiatives. ICOs allow crypto startups, Fintech startups, and increasingly legacy system

innovators, and the Ethereum developer community, among others, to fundraise directly in the crypto community
for their activities and projects, bypassing both banking and non-banking entities (i.e. VCs) as well as their

services.

ICOs can be distinguished from initial public offerings (IPOs). ICOs enable the sale of a stake in a crypto project

that aims to raise funds at an early stage of development. Unlike IPOs, where companies sell stocks via regulated

exchange platforms, ICOs sell digital coupons, so-called presale tokens that do not generally confer ownership

rights, to early investors via unregulated or exempt exchange platforms. Risks and Rewards of tokens differ from

those of equity. Unlike token ownership, equity typically conveys a right to dividends. In the case of bankruptcy,

equity owners have some claims on the assets of the company. Moreover, unlike IPOs, successful ICOs do not

require the support of a reputable banking institution as underwriters and remove the associated fees for the

issuer. ICO fundraising is substantially less expensive than traditional IPO fundraising because of the relative

absence of regulatory constraints and procedures in the ICO space, in addition to simpler reporting requirements,

coupled with a systematic adoption of digital identity-based processes instead of paperwork in all the phases of

the process.

ICOs can also be distinguished from crowdfunding. Unlike crowdfunding, ICOs involve a financial stake in the

company including, as the case may be, the right to vote on future decisions. Therefore, ICOs cannot be qualified

as a donation. Unlike any campaigns conducted on crowdfunding sites such as Kickstarter, ICOs have often an

element of a speculative purpose or a particular infrastructure use case developed on platforms and

cryptocurrencies. ICOs are evolving rapidly. After Satoshi Nakamoto established the use of blockchain

technology for cryptocurrencies in 2008, it took until 2012 for the first ICO. However, the exponential growth of

ICOs since 2015 culminated in ICO fundraising outperforming venture capital financing of crypto startups in the

second quarter of 2017. Several prominent ICOs help illustrate the rapid evolution of the ICO market. In April

2016, the startup Gnosis, a decentralized prediction platform, raised about $12.5 million in 12 minutes, skipping

any venture capital firm or wealthy investor network. In May 2016, the startup Blood raised $5.5 million in 2

minutes. Brave, a start-up developing a web browser via the so-called Basic Attention Tokens, raised $35.5

million in 30 seconds. In June 2016, the Bancor Foundation collected $153 million in three hours.

Ethereum enabled a uniform protocol for the overwhelming majority of ICOs. the most significant transformation

in the ICOs market to date. Ethereum’s decentralized platform incorporating smart contracts allows developers to

build applications on the Ethereum blockchain. Given these advantages, the majority of developers opted for

writing smart contracts on the Ethereum Virtual Machine rather than creating their own blockchain technology.

Smart contracts automatically generate tokens when receiving Ether (ETH).

1. Roadmap

ICOs are a recent phenomenon that is constantly evolving. Standard market practices for ICOs change on

average every quarter. Yet, a structural pattern seems to emerge. ICOs vary but often follow a timeline sequence

of structural elements. Such elements are explored below:

– Before the launch of an ICO, the underlying **project is announced on cryptocurrency fora** (such as Bitcoin

Talk, Cryptocointalk, Reddit).

– The announcement is followed by an **executive summary** to present the project to investors, thereby

obtaining specific comments of the project.

– **Comments on the project** are considered by the management team / promoter when drafting a so-called

whitepaper

– The **whitepaper** is the equivalent of an offering memorandum that provides more detailed information about

the project with the purpose to support potential investors in their assessment of the project.

o Most important for the whitepaper are the key terms and the investment approach, including the investment

strategy, criteria, restrictions, processes, and return so Whitepapers are not audited by any authority. Therefore

these preliminary steps are crucial in order to build a general market credibility and investors’ trust in the

soundness of the project

-The draft of a **yellowpaper** provides the technical specifications to support the project at this preliminary

phase.

– In a first stage, in a so-called **pre-ICO **a preliminary offer is made to selected investors.

– After the signing of the offer, the **launch of the ICO is announced** and a PR campaign addressed to a

broader segment of investors (typically including small investors) begins.

– After this preliminary phase, the **ICO is launched **

o The new venture sells its own cryptocurrency to be used with their software before the software itself is even

written The better ICO companies may have a proof of concept or an alpha version before starting the token sale,

and sometimes even a beta version as in the case of Storj.

o Funds are typically collected in Bitcoin, either via a global, public address (in which case the participants need

to send Bitcoin from an address for which they control the private key) or by creating accounts of each participant

and providing them with a unique Bitcoin address.

o ICO best practices suggest that all funds be held in a multi-sig address made public.

o Fundraising (usually only one) happens before the startup has launched its project, however duration of the

ICOs may vary depending on the success of the entrepreneurial initiative among the investors: the most

successful ICOs were concluded in a few minutes.

– The digital tokens are **listed on cryptocurrency exchanges for trading**. At the moment there are forty+

exchanges around the world that serve as secondary markets where cryptocurrencies can be traded for bitcoins

in an open marketplace.

– A cryptocurrencies’ **pre-ICO price** is arbitrarily determined by the start-up team that structured the ICO,

whereas the post-ICO price dynamics are determined by supply and demand. Instead of a central authority or

government in ICOs the network of participants determines the price: Successful entrepreneurial activities

increase the price of the tokens, granting profitable returns to investors. Should the start-up fail, the tokens’ price

will plummet.

2. Market Environment

Several market factors significantly depressed fundraising for startups before the ICO market materialized in 2012

and accelerated in 2015. Banking regulation enacted in the aftermath of the financial crisis of 2008-09 affected

the availability of resources for small and medium enterprises (SMEs), making fundraising for new entrepreneurial

initiatives more difficult. Basel III has further increased capital requirements and risk weighted assets, resulting in

a higher pressure on banks and their Return on Equity (RoE). While this led to more prudent business practices, it

also significantly constrained the financing instruments available for SMEs and companies below-investment-

grade. Moreover, the emergence of shadow banking, e.g. traditional banking services are provided by private

investment funds, insurance companies, crowdfunding, and peer-to-peer lending, only marginally support the

creation of new ventures and highly-innovative start-ups. ICOs’ rapid evolution was enabled in part by these

negative factors that affected startup fundraising.

Given this market environment for startup fundraising at the inception of the ICO market, ICOs filled a void and

enabled a democratization and inclusion process that facilitated banking disintermediation. ICOs allow startup to

fundraise bypassing both banking and non-banking entities, e.g. VCs, as well as their services. This allows

unlocking an unprecedented level of liquidity enabled by small investors who otherwise could not invest in highly

innovative ventures. The Argon Group, an investment bank exclusively focused on cryptocurrencies and token-

based capital markets, illustrates this trend in the evolution of investment banking services.

3. Crypto Economics

Monetary policy in crypto economics refers to the interaction of token supply, token release, and the maximum

issuance of tokens in a given token issuance. An issuers’ ICOs strategy can pre-define monetary policy by

predetermining the fixed number of tokens created and issued in the ICO. A maximum token issuance in

combination with controlled token supply releases can result in small increases in demand driving token prices

higher.

Several aspects related to the release mechanisms for tokens help manage the supply of tokens in circulation.

For instance, escrow accounts can hold tokens that were not issued in the ICO. Such escrowed tokens may be

released for future issuance to finance future projects of the issuer or support operational financing. To avoid a

token price crash, token escrow accounts should provide usage and access controls that assure investors that
escrowed tokens will not be issued at a discount. Lockups of escrowed tokens for a specified time period or

phased releases can also help minimize the risks of token price crashes.

The economic benefits token holders receive from holding tokens are a key concept associated with quasi fiscal

crypto policy. Two central questions help illustrate this point: 1. What is the underlying value of the issued

tokens?, and 2. What factors contribute to the value appreciation or depreciation of the issued tokens? For

instance, linking commercial benefits such as discounts and other benefits with token usage can incentivize token

holders to use the services etc. associated with a given token. Several benefits are associated with the quasi

fiscal tool of adjusting commercial benefits of tokens in crypto economics. First, the increase in commercial

benefits associated with a token heightens the aggregate demand of the given token supply. Second, commercial

benefits associated with a token issuance can help offset depreciated supply scarcity, e.g. the effects of a large

issuance / supply of a given token in circulation. Third, commercial benefits associated with tokens can be

adjusted as a form of quasi fiscal policy to control the flow of tokens in a given issuance through indirect economic

incentives. Adjustments in commercial benefits can help manage operational cost changes for the issuer and the

external competition with other token issuers experienced by the issuer, among other factors. Fourth, adjusting

the commercial benefits associated with a given token issuance avoids more drastic monetary policy intervention

by way of emergency sales or building token reserves or a decrease or increase of token supply in circulation.

To create a more significant effect, the quasi fiscal policy tool can be combined with monetary policy. If the

aggregate demand for a given token issuance increases through better commercial benefits associated with the

tokens, the issuer can simultaneously increase the total supply in circulation. Options for increasing the total

supply of tokens in circulation include issuing escrowed tokens or even secondary issuances. The combined

effect of quasi fiscal policy (increasing benefits associated with the tokens) and monetary policy (increasing the

token supply in circulation) may or may not have an effect on the market price of the respective tokens. The

balance of commercial benefits of a token offering and associated use cases of the token in combination with

supply scarcity is critical in the issuance of a token offering.

III. Disruptive Effects

ICOs have significant disruptive effects on finance. The venture capital, startups, and banking institutions are

affected by the increasing prominence of ICOs in capital formation. The reorganization of capital formation with a

more efficient financing tool and crypto currencies may also affect the economy as a whole.

In particular, the ICOs disrupt the traditional business model of venture capital funds, an asset class that has

traditionally played a crucial role in financing highly innovative start-ups. The disruptive effect of ICOs on the

venture capital industry is in part the result of the venture capital fund lacking innovation. Paradoxically, venture

capital funds continuously invested in innovation, while insufficiently innovating themselves. In the second quarter

of 2017, ICO issuances exceeded venture capital financing of startups for the first time, with $210 million invested

in ICOs versus $180 million invested into startups via traditional venture capital funds. This trend can be expected

to continue given the superior allocation of capital at lower cost via ICOs.
ICOs display several core characteristics that make them preferable for many startups to the traditional venture

capital funding model. First and foremost, ICO promoters and their developers are not forced to sacrifice their

equity in the project in exchange for the funds they raised. Through borderless online sales, ICOs are directly

marketed to a worldwide potential pool of investors, bypassing the typical legal, jurisdictional, and business

hurdles in traditional venture capital financing. Moreover, ICOs benefit from limited accreditation standards, as

well as from multiple global cryptocurrency exchanges that provide continuous access to trading with significant

liquidity.

Capital formation via ICOs also disrupts the traditional hierarchies in venture capital. Traditional venture capital

funds typically only allow a smaller group of elite investors to invest in highly innovative projects generally

unknown to the investing public. By contrast, ICOs provide a much more inclusive option for all investors. ICOs

increase the diversity and the heterogeneity of startup funding. Because of to the low barrier to entry and the

borderless nature of the online token sale ICOs allow small investors from all over the world to invest.

ICOs facilitate faster capital formation for crypto startups. By contrast with traditional venture capital financing, the

inclusive elements in combination with increased efficiencies, significant simplification, and better timing of capital

formation provided by ICOS contributed to the creation of more liquid venture funds. Given these benefits, ICOs

have the potential to disrupt other funds and asset classes including private equity and real estate funds. Given

the competitive elements of ICOs, the venture capital industry is investigating ways to participate in the ICO

market.

Venture capital funds increasingly try to capitalize on the opportunities presented by ICOs. The disruption of

legacy finance by ICOs has triggered attempts by venture capital funds to capitalize on the source of disruption

within the existing business model to benefit from its advantages. For instance, venture capital funds can

capitalize on the exponential growth of cryptocurrencies. Cryptocurrencies created by blockchain startups

generate investment returns that cannot be matched by legacy investments. For example, several

cryptocurrencies such as Monero and NEM increase in value by 2,000%. Similarly, Ether increased by 2000% in

one year, and Litecoin more than the 900%.

Venture capital funds can benefit from the early liquidity provided by cryptocurrencies. In the existing venture

capital model, venture capital funds invest significant amounts of money in the hope of finding the next unicorn

startup. This investment process is subject to long, complex, and time intensive processes leading up to a very

late liquidity event in the form of an IPOs or acquisitions. By contrast, ICOs provide liquidity to investors much

faster and allow venture capital funds to capitalize on existing profits early. Venture capital funds who invested in

crypto startups gain access to much earlier liquidity via ICOs by converting their cryptocurrency profits into Bitcoin

or Ether through any of the cryptocurrency exchanges and can thereafter transfer into fiat currencies via online

services such as Coinsbank or Coinbase.

Blockchain Capital provides a prominent example of venture capital funds’ attempts to capitalize on the benefits

associated with blockchain technology and ICOs within the VC industry. After the release of an offering
memorandum on April 3, 2017, the ICO for the Blockchain Capital III Digital Liquid Venture Fund was launched on

April 10. Blockchain Capital’s ICO campaign, was intended to raise 20 percent of the firm’s next fund. The ICO

raised raised $10 million in in six hours, unlocking unprecedented liquidity in previously illiquid secondary venture

markets. Blockchain Capital’s ICO was the first know your customer (KYC) and anti-money laundering (AML)

compliant crowdsale. The entity that engaged in the ICO was incorporated in Singapore. Under applicable

Regulation S and D exemptions, the ICO was able to raise money from both international and domestic investors.

In summary, ICOs’ comparative advantage over venture capital funds consists mainly of their highly cost-effective

capital formation capabilities in the emerging crypto marketplaces that operates according to highly complex yet

unpredictable economic dynamics. Given these ICO adnvantages, traditional regulated IPOs and venture capital

funds increasingly fail to adequately capitalizing crypto and legacy ventures driven by new economic paradigms.

1. Risk Factors

Several risk factors associated with ICOs affect investors. First and foremost, the 2012 to 2017 ICO model

allowed cryptocurrencies to be raised via a token sale without any conditions, landmark requirements, or security

measures to protect investors. Investors’ deposit of a cryptocurrency for a crypto platform in exchange for tokens

that provided a right to use the platform associated crypto product in the future did not provide such investors with

any or very limited influence over how such funds were used by the ICO promoters. While most issuers typically

established a form of a foundation or basic contracting to supervise promoter use of ICO proceeds, the traditional

ICO model, in essence, allowed the promoters / issuer to do with the ICO proceeds as they pleased. Further

limitations for token holders that amount to significant risk factors include token holders’ inability, unlike

shareholders in the traditional infrastructure, to vote for or against directors or to nominate directors. While

institutional investors may be able to influence the promoter decisions in the ICO pre-sale, actual ICO investors

typically don’t have such influence and simply need to trust the promoters and their business intent. The only real

control power for token holders is their decision to hold or sell their tokens and even that may be limited until the

token is fully listed on an exchange.

Intangible or No Product

Crypto platform issuances of tokens provide an intangible or no product. During the lifecycle of a crypto platform,

the platform typically starts the ICO when it has an intangible product based on a basic crypto idea but typically

with no product that can be associated with such idea. Accordingly, token holders typically invest in the future

promise of the idea associated with the platform. While that works well with core infrastructure products such as

Ethereum, most other platforms struggle to fulfill that promise.

Associated with the lack of an existing product is the inability of most crypto platforms to generate revenue to

offset costs like traditional businesses. While most crypto platform businesses in the form of a foundation may be

equipped to pay their developers, crypto platforms typically do not have employees in the traditional sense that

create and advertise the platform product. Similarly, while the creation of the crypto platform is associated with
significant costs, crypto businesses typically do not have customers that create revenue for the business to pay

for such costs. Cost associated with running a crypto platform can include the foundation itself, its developers,

and the crypto marketing team, among others.

Because of the lacking product and no revenue to offset costs, ICO revenue raised by crypto platforms are often

required to last for the lifecycle of the platform. Accordingly, crypto platforms are required to set aside a large

number of tokens for future funding needs. Because the token supply is controlled by the ICO promoters, the

token holders may be diluted in the future if the platform decides to issue more reserve tokens to additional

investors. Increasing the supply of platform tokens to satisfy future funding needs and the resulting dilution

because demand for the tokens decreases if supply increases means that token holder’s token value can be

diminished without their ability to protect themselves against such events. The only real control token holders

have to protect themselves is to sell their tokens post ICO. In fact, many venture capital funds that received

tokens in exchange for their pre-ICO investments often quickly sell their tokens to protect themselves against

devaluation. Other means of protection against such supply side induced devaluation of tokens can include

hardcoded lockup periods for tokens. However, while such lockup periods may protect token holders against

dilution, it also decreases much needed token economic flexibility for the promoter team to raise additional funds

when needed.

Early Liquidity Despite Little Information Creates High Volatility

ICOs provide unprecedented liquidity without sufficient information resulting in high volatility. Unlike any prior

financing vehicles, ICOs provide the highest possible liquidity for investors. Unlike typical legacy businesses that

mature over time, increase available information pertaining to the business which eventually leads to a liquidity

event such as an initial public offering, ICOs provide a liquidity event for promoters and investors alike at a very

early stage in the lifecycle of the platform. Legacy businesses that experience liquidity events for promoters and

institutional investors have been subject to reporting requirements under the federal securities laws, accounting

standards, legal infrastructure requirements, among many other requirements for several years if not decades,

before they can experience a liquidity event. Because of these requirements, the investing public gets significant

assurances of the underlying business success of the entity which drives demand. Because ICOs take typically

place at the beginning of the lifecycle of a crypto business/platform, ICOs investors typically invest – and the

token exchange – on very limited information which increases volatility of the tokens and the entire cryptocurrency

market. Accordingly, ICOs and cryptocurrencies are a much riskier investment. Their riskiness may, however, be

offset by the near unlimited use cases for blockchain technology.

Open Source

Crypto businesses use typically open source code which creates risk factors not associated with legacy

businesses. Most token offerings are based on open-source software. While it is possible to consider a token

issuance with a closed system, such closed binary creates significant security concerns. By contrast, the open

source code and all its features can be copied at any times. Accordingly, the utility of a token that was issued to
investors can at any time be recreated in another token with the same or essentially the same features at

marginal costs. Investors cannot rely on the implicit promise that the token promoters and their developers will

increase the value of the acquired token and not create another token with identical features. Starting another

token with the same features entails rather limited financial penalties. Moreover, if a given token offering was very

successful, other promoters may have incentives to copy the token and its features. A concrete example of this

risk is provided by Stellar. Stellar is in essence a copy of Ripple with almost identical features. While open-source

crypto startups have licenses that help protect them from competitor companies who may be using their code for

profit, legacy businesses that own their code and can sue competitors who copy such code which provides a

different incentive structure and makes ICO investments riskier.

No Liquidity Preference

In the case of bankruptcy or termination of the promoter’s business / the platform token investors invested in,

token holders typically do not have a liquidity preference. After the debt holders and outside creditors were

satisfied with the liquidation value of the corporation, token holders typically have no recourse at all. By contrast,

in a typical venture capital seed stage investment, the venture capital fund should typically obtain at least a simple

liquidity preference, e.g. the venture capital fund typically will be able to reclaim their initial seed investment

before other claims will be paid. Some venture capital funds can get more than their initial investment back,

depending on the agreement and other factors they may obtain a 1.5 or 2 times liquidity preference. Again, by

contrast, token holders typically lose everything they invested as they have no liquidity preference at all.

Legal Uncertainty

The lack of a regulatory framework creates significant legal uncertainty in the ICO market. Moreover,

cryptocurrencies are censorship-resistant and arguably regulation-resistant by design, leading some to argue that

regulatory uncertainty associated with coin offerings may sooner or later lead the Securities and Exchange

Commission to declare ICOs illegal. Token valuation is also largely uncertain and subject to incalculable

risks. ICOs are not subject to predefined regulatory procedures. Whitepapers do not follow prospectus disclosure

guidelines, are not reviewed or unaudited by any authorities and are not subject to any forms of rating of the new

entrepreneurial initiatives. To combat these shortcomings, a private initiative, a joint-venture between Ambisafe

Inc. and the Russian-based rating agency ICOrating, has been created to ensure high-quality standards,

supporting investors in their due-diligence and identify potential opportunities of investment in cryptocurrencies.

The parameters to evaluate the entrepreneurial initiatives take into account different indicators, that span from

economic and financial parameters to more technical elements. To provide support for crypto investors,

companies like Deloitte and Price Waterhouse Coopers have built specific expertise in the identification of

vulnerabilities within the code and the business model of startups. Identifying legitimate projects, distinguishing

them from scams, is vital to pursue investors’ protection while creating the conditions for ICOs to proliferate.

Bitcoin’s and Ethereum’s founding characteristics of decentralization, independence, openness and consensus

based on proof of work provide a relatively easy way to identify scams.

2. Red Flags

Zombie ICOs are ICOs that really have little chance of creating a successful market for their tokens. Such ICOs

have become increasingly common in 2017. Zombie ICOs often cannot succinctly answer core questions in their

whitepaper or in response to questions by possible investors. Their inability to respond to legitimate questions

often involves addressing issues such as the core business and infrastructure problem the investment proposition

solves, allocation of ICO proceeds towards building the underlying product, most viable products or pre-

production solution, availability of underlying assets. Moreover business plans of Zombie ICOs often cannot

clearly articulate how the product of the respective company works or why the investing public and customers

should care about it. Zombie ICOs teams also often do not have sufficient experience in starting and running a

business. Finally, investors often do not obtain sufficient information for their investment decision in the respective

ICO.

Core Problems with ICOs in 2017 can be narrowed down to several uniformly identified bad practices. First, ICOs

that propose uncapped raises without an underlying product constitute a very serious red flag for any investor.

Uncapped ICOs have several disadvantages. First, promoters who engage in uncapped raises are often

perceived by the crypto community as greedy. Second, for crypto investors, uncapped ICOs raise the uncertainty

for investors about the valuation of the underlying platform / product there are buying with their investment.

Because of such concerns, capped token issuances became the dominant structure between 2016 and 2017. As

Vitalik Buterin emphasized, “capped sales have the property that it is very likely that interest is oversubscribed,

and so there is a large incentive to getting in first.” Examples include the token issuances Blood and BAT. With

regard to the former, an amount of tokens equal to $ 5.5 million was sold in two minutes, whereas in the latter $35

million were sold in 30 seconds. The Gnosis ICO ($ 12.5 million) was another landmark in the structural evolution

of ICOs. To mitigate the inefficiencies and the risks of a capped sale, the Gnosis ICO was structured as a reverse

dutch auction, i.e. not only the ICO was capped to $12.5 million, but in addition the time necessary to complete

the sale impacted the quantity of tokens distributed among the investors, with the rest held by the start-up team.

ICO promoters should avoid several emerging bad ICO practices. Such practices include allowing tokens to be

traded before underlying protocol network or application is live, using a landing page that focuses almost

exclusively on the ICO with project timeline etc. but provides less content on product, project, technology, and

team. Moreover, ICO promoters should include significant and ongoing disclosures on vesting and lockup periods,

should never manipulate the smart contract to change ICO sales rules mid-course during the ICO. Moreover, the

ICO disclosures have to be as clear as possible and should avoid an unclear or uncertain use of proceeds pie

chart and should be very clear on cryptocurrency conversion plans into actual company reserves. Finally, ICO

promoters should always disclose changes in company via 10k 10q 8k equivalence.

Conclusion

ICO practices will continue to evolve and improve the capital formation for crypto startups. Bad practices in ICOs

will over time be curtailed via voluntary or imposed industry practices. Through ICOs’ evolution and continuous
practice improvements, the ICO industry and underlying crypto businesses can become the foundation of the

emerging crypto economy.