Initial Coin Offerings for startups

How to raise seed-stage funding with token offerings?

Published in

Vishweshwar Vivek

5 min readMay 6, 2022

In the past five years, Initial Coin Offerings (ICOs) have become a popular way for startups to raise funds. An ICO involves raising funds by issuing new cryptographically secure tokens (coins) to investors. These tokens either represent equities (equity or security tokens) that guarantee their owners a share of the future profits of the startup or utility (utility tokens), which provide owners a means to pay for the future product or services offered by the ICO issuer (entrepreneur). Investors buy these tokens at a discount in the early stage of the startup and earn returns when the value of their tokens appreciates. They often sell these tokens in the secondary market to realize a return.

ICOs are very attractive for entrepreneurs because they can secure funding at near-zero transaction costs from a global base of investors with very few regulatory burdens. ICOs are great for investors because tokens offer a faster and more flexible exit option than VC investment. Almost all ICOs take place on the Ethereum platform. In 2017–19, ICOs delivered five times more capital compared to VC investing[1]. However, ICOs declined in 2019 due to regulatory risks in the US market[2].

How do ICOs work?

ICO launches have come a long way from their initial 2016 frenzy days. Today, the ICO environment is more mature, and most successful ICOs involve similar steps.

1. The entrepreneur and its start-up team decide to raise funds from investors by issuing cryptographic tokens (ICOs)

2. The issuer defines the token and its purpose which also includes determining whether the token is an equity token or a utility token

3. Issuers must also evaluate the legality of the ICO[3]. Some countries like China outrightly ban ICOs. Others, such as the US, have strict regulations for equity or equity-like tokens[4]

4. The entrepreneurs release a whitepaper. Typically, white papers include tokenomics, project description, team details, product roadmap, advisor list, ICO details, etc.

5. In the next step, issuers publicize the ICO and generate excitement about their project through online communities such as reddit, bitcointalk, twitter, discord, and telegram

6. The issuers disclose the execution plan for the ICO. This includes KYC requirements for investors, whitelist, restrictions, listing exchange details etc. Issuers share details around the token sale model: capped vs uncapped sale, open auction vs private sale, etc.

7. Issuers then complete the hardware setup required for ICOs. They release the smart contract and start minting tokens ( generally ERC-20 tokens). Issuers also set up fund collection and token distribution mechanisms

8. Finally, Issuers launch their ICO often through a centralized exchange. However, there are other ways to launch an ICO such as DEX offering, security token offering, SAFT, etc.

9. Investors often pay for the new token via fiat or through more established digital currencies such as BTC, ETH, DAI

10. Issuers use the newfound fund to launch or scale their startup, thus appreciating the token value (hopefully!!)

11. Investors may sell their tokens in the secondary markets such as exchanges to earn their returns

Regulatory Challenge with ICOs in the US

One major regulatory challenge for startups when fundraising through an ICO is the risk of classification of their token as a security. In the US, SEC has ruled that if a token resembles security, it can be classified as a security. In this case, all the SEC regulations for securities apply to the token. The regulation requires startups to register their token with the SEC (do an IPO) or seek registration exemption. Even with an exemption, the issuer needs to do a KYC and only allow accredited investors. Issuer also needs to limit the number of foreign investors and restrict investors from selling security tokens in the secondary market. Either way security-token classification severely limits the benefit of ICO-based fundraising.

In the past, SEC has penalized several startups for their ICOs after it deemed their tokens as unregistered securities. This list includes Unikrn[5], Telegram, Kik[6], Ripplenet, etc. SEC recommends Howey Test[7] to distinguish between security tokens and utility tokens. In fact, SEC even launched a fake token called HoweyCoin to demonstrate the concept of a security token.

Typically tokens that are tied to a single organization and rely on the future profits of that organization to generate returns are more likely to be classified as security tokens. Tokens that rely on a network and can be used to purchase a product or service are more likely to be classified as utility tokens[8].

ICOs addressing the regulatory challenge

Recently, issuers have tried multiple ways to safeguard their ICOs from regulatory risk.

1. Clearly establish the utility of the token by developing the project to the point when there is no ambiguity related to securities classification

2. Not launching their ICO in the US. Many recent projects are based outside of the US in crypto havens such as the Cayman Islands, Cyprus, etc.[9]. Examples include Tikka, Hashbon, etc.

3. Do KYC and not allow US citizens to invest Many US-based projects maintain a whitelist and restrict citizens from the US and some other nationalities from investing in their ICO. This includes Quadrant (eQuad)

4. Simple Agreement for Future Tokens (SAFT)[10] — Many startups use SAFT, a security that does not provide any token but promises future access to a utility token. SAFT allows startups to avoid ambiguity early on and ensure they can secure funding to develop their project enough to prove that their token is a utility. Since SAFT is clearly a security, securities laws govern it, and issuers need to create a whitelist, perform KYC, and only allow accredited investors. However, since no token is exchanged in the case of SAFT, there is no risk of their sale in the secondary market. Also, SAFT provides entrepreneurs access to capital in the US[11] market. Coinlist, a spin-off of AngelList, allows startups to raise through SAFT. Filecoin did an ICO through SAFT.

Final Words

ICOs are a growing means for fundraising. They provide entrepreneurs with easy and early access to capital if done right. They are the new seed funding, and capital-hungry startups will shoehorn ICOs into their fundraising model. As ICOs grow, cryptocurrencies will become more embedded in the technology and financial world. Here are my last words for entrepreneurs about ICOs:

Think again if you really need an ICO — ICOs take time and effort, and an unnecessary ICO will distract you from the core product
Learn from successful ICOs — Google knows all about them
Get a good lawyer — keep enough time for legal investigation
Work on your whitepaper, and get your smart contract vetted
Give adequate time to market your ICO