Initial Coin Offerings (ICOs) are presently probably the most hyped way of procuring venture capital not only in Germany but worldwide. ICOs associate elements of crowdfunding with Blockchain technology. By the end of March 2018 alone, this innovative financing mechanism generated around 6 billion USD – more than during the whole of 2017 (5.6 billion USD). This is sufficient reason for us to shed some light on the issue:
Which are the steps in an ICO?
An ICO is a process, in which typically young companies or start-ups generate, and sell to investors, their own cryptocurrency units (so-called coins or tokens) at a previously defined price in exchange for already established cryptocurrencies (like Bitcoin, Ether etc. ) or in exceptional cases for state currencies (euros, dollars etc.) The capital raised in this way is used by the company to realize its project – which, in most cases, is still at an early stage.
From a technical point of view the process is based on Blockchain technology. Most companies do not, however, create a completely new Blockchain but use existing Blockchain technologies, especially the Ethereum Blockchain, because this allows to offer the tokens with considerably less (technical) effort which, is the reason why this option is usually selected for ICOs.
The tokens are offered for sale for a previously determined period of time, which is mostly divided into a pre-sale (exclusively) available to institutional and/or large-scale investors and a crowdsale which is available to anyone. Upon expiry of the sales period, the company may not issue any further tokens, the quantity of tokens offered is finally determined (creation cap). However, the issuing company will usually seek to be listed in a (cryptocurrency) exchange to make its tokens tradeable on the secondary markets – in accordance with the principle of offer and demand. In its own interest, the company will not issue the total supply of tokens but retain certain parts of tokens in view of a downstream sales opportunity. The decisive price factor will be the future success of the project funded by way of an ICO.
Which types of coins and tokens exist?
Depending on the specific design of the ICO, different types of coins or tokens can be distinguished: currency coins, utility tokens and equity tokens. The first category are designed as a virtual currency, which means that its only function is to be used as a digital means of payment. Generally, currency coins are built on their own Blockchain to which confirmed transactions are chained in so-called blocks and thereby documented. Famous examples of this type of coins are Bitcoin, Litecoin, or Ripple. Utility tokens are tokens that may (also) be spent (in the future) for using a product or a service provided by the company. In such case, the token has virtually the same function as a digital voucher. Lastly, equity tokens represent a right with respect to the issuing company or a similar right: Depending on the specific design, equity-token holders may be entitled to exercise a voting right or to participate in the company’s economic success. Thus, the functions of equity tokens are similar to those of share certificates or stock.
What is the difference between an ICO and an IPO?
ICO stands for “Initial Coin Offering”, which is inspired by the term “Initial Public Offering” (IPO). Despite this similarity of terms, the two financing instruments are rather different both in legal and technical terms: According to the opinion of the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht; “BaFin”), the German stock corporation law does not apply to ICOs. Tokens must not include any membership, information, control, or voting rights. Conducting an ICO is not limited to a particular type of company, whereas share issues are only possible for stock corporations (Aktiengesellschaft; AG) or European companies (SE). Finally, the investors in ICOs generally have no right to attend general meetings and their tokens confer no pre-emptive rights in the event of a capital increase.
Regulation framework for ICOs in Germany
Given that the regulation regime of the stock corporation law does not apply, one might be inclined to believe that ICOs generally fall into a “legal vacuum”. The impression may even be reinforced by the consumer warning meanwhile published by BaFin, which rather sweepingly warns consumers against the “high risks for consumers” and, among other things, refers to the “absence of regulation” in this context.
It is true, at least at a global level, that so far a comparatively large number of investors have been victims of so-called “exit scams”, where the funded project was only a fake and the initiators disappeared at the end of the ICO, in some cases, after having generated substantial proceeds. The double scam “Pincoin” and/or “iFan”, which was discovered only three weeks ago in Vietnam and in which around 28,000 investors were defrauded of a total of some 660 million USD, certainly constitute an “inglorious record”. It is also true that to date Germany has no regulatory measures aimed directly at ICOs.
However, this should not distract from the fact that current German laws are sufficiently broad to include ICOs. As early as in 2011, BaFin already classified “Bitcoins” as financial instruments in the form of units of account pursuant to Section 1 (11) 1st sentence no. 7 of the German Banking Act (Kreditwesengesetz; “KWG”). As a consequence, Bitcoins – and probably other comparable virtual currencies – fall within the scope of the German Banking Act, which means that an obligation to obtain an authorization cannot be ruled out a priori. In addition, an ICO may be subject to a prospectus requirement pursuant to the German Securities Prospectus Act (Wertpapierprospektgesetz) or the German Asset Investment Act (Vermögensanlagengesetz, “VermAnlG”), at least if it involves an issue of tokens that entitle their holders to other than ownership rights, e.g. an issue of utility tokens or equity tokens. The only thing that is presently sure is that regulation under the Payment Services Supervision Act (Zahlungsdiensteaufsichts¬gesetz; “ZAG”) can be ruled out given that no transfer of amounts of national money or e-money is involved in an issue of cryptocurrencies.
ICOs – an innovative and cost-efficient funding method for start-ups
The wild-west-atmosphere frequently invoked in the context of ICOs is inappropriate in such sweeping terms. Despite the revolutionary approach of blockchain technology and the inaction so far shown by the German legislator, there is no reason to talk about the development of a “legal vacuum”. However, in view of the scam tactics used time and again (first of all in foreign countries), a regulation of the ICO market is to be expected in the foreseeable future. In the meantime, ICOs optimally adapted to the (current) legal framework conditions may constitute an innovative and cost-efficient method of raising capital for the first time especially for young companies whose business model is based on Blockchain technology
Our specialist attorneys will be pleased to advise you on company financing by ICOs. You are welcome to contact us.