Over $1.5 billion has been raised by token offerings – also known as initial coin offerings or ICOs – so far in 2017. Not surprisingly, many startups are eager to capitalize on this possible funding source.
Although ICOs can be a useful method of raising capital, a number of legal issues must be considered in structuring and completing an ICO. One such issue is whether the tokens being offered in an ICO will be considered securities. A report issued by the SEC late this summer highlights the issue.
The SEC’s report was related to a token offering by an organization called The DAO. In its report, the SEC concluded that the tokens issued by The DAO were securities. Prior to the issuance of the SEC’s report, some advisors were telling startups that ICOs would not raise the same sort of securities concerns as traditional capital raises. Although the SEC has not issued formal guidance or regulations in this area, the report makes it clear that at least some tokens will be considered securities and that some platforms will be considered securities exchanges.
Many practitioners argue that there is a distinction between “security tokens” (designed to raise capital) and “utility tokens” (designed with some functionality and not purely to raise capital). The analysis in determining whether a token is a utility token is complex. Some tokens with utility characteristics may even be securities.
The law surrounding ICOs and the treatment of tokens is still evolving. Startups wishing to purse an ICO should seek legal advice early in the process. The danger of not doing so can be dramatic – since the date of the SEC’s report, at least one ICO was cut short after the SEC launched an inquiry into the ICO. The founders had not considered securities implications of conducting the ICO and ultimately decided to refund the funds raised to investors.