Have you ever wondered how entrepreneurs raise money for their business? We have heard the story of many start-ups led by not-so-financially affluent people but subsequently valued at high prices and raising millions of dollars. This situation applies explicitly to the blockchain domain as well.
Before moving forward, let’s examine some history.
MasterCoin- the first ICO
In January 2012, J. R. Willet published a paper titled “The Second Bitcoin Whitepaper”. The paper explained building a MasterCoin protocol layer over the existing Bitcoin protocol. The MasterCoin layer will have software tools allowing users to design and release their custom currency without requiring software development. This was based on the assumption that building an alternative to Bitcoin would be more financially competitive than making something that works on top of it. The design also expects to raise Bitcoin values.
Willet needed funds to implement his idea. The following year, on July 31, 2013, an updated version of the same whitepaper was released, and it also included a request for funding the Mastercoin project. The MasterCoin team announced a Bitcoin address called Exodus Address, to which interested investors may send Bitcoins. In return, they will get MasterCoins- a custom token granting the holder several features of the proposed protocol. Anyone sending Bitcoins to this address before August 31, 2013, received a proportional number in Mastercoins and extra Mastercoins (MSC) depending on the week the send transaction occurred. By the end of the one month, the sale raised more than 5,120 bitcoin, worth approximately $500,000.
In short, Willet had an idea that was yet to be implemented. Conventionally, he could either try to get a loan or register his company and offer its equity-the total value of the company’s assets, minus total liabilities, in return for investment. But he tried to raise funds for the implementation by offering the investors the services of his future system, represented in tokens, in return for their bitcoin investment. Thus Willet successfully launched the world’s first Initial Coin Offering or ICO. Now let’s see what it is.
Initial Coin Offering
ICOs are a crowdfunding method that creates and sells digital tokens to fund project development. In ICO trading platforms, the investors receive cryptocurrency tokens in return for their investment in the business. These tokens give investors access to specific project features the issuing company runs. They help fund open-source software projects that would otherwise be tough to finance with traditional systems like loans.
The main advantage of ICOs is that it eliminates the need for intermediaries, and almost no transaction costs are involved, making them very appealing to entrepreneurial firms.
What can the tokens offer?
Based on the characteristics, tokens can be classified into multiple types:
Utility tokens promise that they can be redeemed for the ICO project’s products or services once they are developed. They do not represent any ownership stake in the project. The value of utility tokens usually fluctuates, depending on the demand for the project and may be profitable for the token holder if the project achieves its proposed goal successfully. But many jurisdictions do not have any facility which gives the investors enforceable claims.
The success of ICOs was followed by many projects following similar plans. But unfortunately, the ease with which money was raised also attracted malicious participants who took advantage of the unregulated
ICO market to scam investors and, consequently, a crash of the crypto market. The lack of jurisdiction was a significant factor leading to the exponential number of scams. Eventually, a new form of ICO, called Security Token Offerings (STO), was created. STO is a hybrid between traditional Initial Public Offerings and ICO’s. They have more strict requirements and regulations associated with them.
An initial public offering (IPO) is a public offering in which shares of a company are sold to investors. To conduct an IPO, a company must register under a regulatory authority and formulate a “prospectus”, which is a legal declaration of its intention to issue its shares to the public. It must include key information about the company and its upcoming IPO to assist potential investors in making an informed decision.
Security tokens derive their value from an external, tradable asset. They represent the ownership of the underlying digital or physical asset and are regulated by authorities like the U.S. Securities and Exchange Commission (SEC). If the underlying asset gains profit, the token’s value will rise and vice-versa. Since governmental bodies regulate them, they are much safer, and investors get returns proportional to the company’s performance.
How do you check whether a token is a security token? For this, we have Howey Test.
The Howey Test
Government-level regulations are in place for investment contracts. There were many situations in the past where authorities took action against illegal investment contracts managed by private firms. In 1946, a controversial case under US Supreme Court was between the SEC and Howey Co., where the SEC claimed that Howey Co. failed to register their investment contract transactions with the SEC. The Supreme Court formulated four criteria to determine whether an agreement should be considered an investment contract. An investment contract is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”.
Since then, the U.S. Supreme Court has used the Howey Test to decide whether specific transactions qualify as investment contracts. If transactions qualify as investment contracts under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are considered securities.
Since cryptocurrency and blockchain-associated assets are decentralised, the regulatory bodies often need clarification about whether a given token fits under the existing regulatory frameworks. Howey test determines whether a token offering falls under the security category. If the answer to the above questions is yes, the user invests in a security token. Security token holders are guaranteed a percentage of profits generated from the entity even though they do not have any ownership rights to the company they invested in.
So is there a token that represents ownership? Yes. We have equity tokens, a security token that denotes a percentage ownership of the company’s shares. The terms and conditions will be specified in the contract just like any other equity offering but stored in a distributed ledger. Equity token holders may also get a part of profits, voting rights, or similar privileges. For example, if a company issues 100 equity tokens, each token offers 1% of the earnings and 1 out of 100 votes to its owner.
Equity tokens may be issued through fundraising by tokenizing the company’s assets in a private sale or a public sale. Whatever the method, the token must be registered on the equity token exchange for this purpose. Companies conducting equity token offerings (ETOs) are subjected to due diligence by regulators or investment banks to ensure compliance with the fundraising requirements. These arose as a solution to ICO scams.
Finally, the token may also represent a monetary value, a pure currency token. These tokens are digital currencies like Bitcoin. They are regulated under the taxation laws of cryptocurrency within a jurisdiction. These tokens do not represent ownership or stake but derive value from regular market forces like a commodity.
Success factors for token offerings
Theoretically, token offerings can be employed during all funding stages- early stages or for a project under development. Unlike IPOs, token offerings attract all types of investors. The close-to-zero transaction cost is a factor that drew the public to early ICOs. After an ICO phase, the token will usually be listed in standard token exchanges. This market liquidity- the ease at which a token can be swapped in exchanges- attracts investors and gives the freedom for easy exit.
Token price volatility is the central challenge faced by token offerings. ICO scams are numerous, and pseudonymity often makes it difficult to identify the scammer. The decentralisation feature also challenges the authorities to penalise fraudulent activity.
Currently, investors are more aware of scams, and token offerings are reviewed based on many indicators like — the quality of the management team, the project’s vision, ICO profile and so on.
World’s first programmable blockchain, Ethereum, was funded initially through an ICO in 2014. Investors received ether (ETH) in exchange for bitcoin. By the end of the sale, more than 50 million ether was sold, valued at around 17.3 million dollars. INX Ltd, the blockchain-based global trading platform for digital securities and cryptocurrencies, have raised 84,000,000 USD in a security token and equity offering.
 Campino, J., Brochado, A., & Rosa, Á. (2022). Initial coin offerings (ICOs): Why do they succeed? Financial Innovation, 8(1), 1–35. https://doi.org/10.1186/s40854-021-00317-2
 Momtaz, Paul. (2020). Initial Coin Offerings. PLoS ONE. 15. 1–30. 10.1371/journal.pone.0233018.