An Initial Coin Offering (ICO) is now a new funding source for blockchain-based businesses. Australian startups, cryptocurrency investors and financial incumbents have shown a keen interest in supporting blockchain projects by participating in an ICO.
Some coins, also known as tokens, have experienced a meteoric price increase in recent years. But ICOs are high-risk, speculative investments, with some market observers referring to ICOs as a bubble. And although an ICO resembles other, familiar forms of capital raising, they lack the oversight typically found in that process. This means investors have little recourse if something goes wrong such as a cyber hack or theft.
In this article, we answer FAQs about the ICO process to help new investors guard against the risk of this form of investment.
How Does an ICO Work?
During an ICO, investors exchange real money (e.g. Australian dollars) or widely used cryptocurrency (e.g. Bitcoin or Ethereum) for digital tokens. The investor can then use their token to access goods on a trading platform or hold onto their token, speculating that the value of the token will increase over time.
The ICO Process
- Blockchain-based startups release a white paper (a document that describes the project).
- Issuers market the token on their website and social platforms such as Reddit and Slack.
- The token sale begins.
- Once a user makes a purchase, tokens are deposited into their digital currency wallet.
- Proceeds from the token sale are distributed to the startup selling the token.
- Purchasers can use tokens to access goods on the platform or trade tokens on secondary cryptocurrency markets around the globe.
What Should I Look For in an ICO White Paper?
A white paper is the document that describes the project. At a minimum, investors should look for, and ask questions about, the following:
- where the company and the management team are located. This will determine what laws apply to the company, and what rights or recourse you have as an investor;
- a description of the problem and the proposed technology solution. You should understand the business case and the technology to make an informed assessment of the token’s future performance and the likelihood of success;
- a clear and compelling reason for why the token exists. The white paper should identify why their solution requires a token or blockchain;
- clear expectations for the total token supply and distribution. This is important for the potential value of the token and the business, and your claim to that value;
- how you will make or participate in governance decisions and other decisions affecting the network (e.g. software upgrades). A proper governance framework should set out how the startup will comply with any regulation — both present and future — and what oversight the business has over senior management;
- how the blockchain startup will use the funds. You should know how your funds will help the business build their project (for example, what percentage is for project development and what percentage is for operational expenses); and
- the founding team, including their qualifications and business experience. This is important to verify whether the team can execute the vision they have articulated earlier in the white paper.
Is it Risky to Invest in ICOs?
ICOs involve new technology, new business models and new risks. Investing in an ICO is not like buying shares in a company — they are very different from traditional investments.
The regulatory uncertainty around ICOs can make it difficult to identify what protections you can access in what country.
It’s also difficult for retail investors to understand the risk of an investment and realise risk-adjusted returns because of the information asymmetry in ICOs as well as the secondary market for tokens.
We’ve described some key risks below to help you better mitigate against them.
All securities — shares, bonds, derivatives — are volatile. But, analysts can research, explain and even predict what event could impact the price of a security.
Regulatory uncertainty, market manipulation and hacks make tokens hard — if not impossible — to value, especially compared to traditional assets. And the price of crypto assets are susceptible to community sentiment (often expressed on social media or news events, such as hackers targeting exchanges and high profile entrepreneurs investing in a blockchain project). This makes crypto assets very volatile and can have large, often unexplainable, swings in price.
|Only invest cash that you are prepared to lose.|
|Because there is no history of these assets producing any revenue, an investor’s ability to compare the business to similar industry players at similar stages is limited. It may be difficult to apply standard valuation methodologies that consider a business’ revenue and cash-flow.|
Misleading Information about the Team
Be aware that the website may list advisors who aren’t advisors, or there are fake identities for team members.
|Research the team and their advisors|
|Use search engines to research team members and advisors listed on the startup’s website and in their white paper.
Bad actors will create fake social media profiles and work experiences. So, use this search as a starting point, along with assessing the proposed technology solution, and the project roadmap.
If your digital wallet or the trading exchange is hacked, and your tokens are stolen, there is little chance of recovering your money.
The anonymous and pseudonymous nature of tokens makes it difficult to trace stolen crypto assets — especially if the hacker is located, or has moved the tokens, overseas. It’s then incumbent on investors to protect their tokens and secure their digital wallets from bad actors.
|Secure Your Digital Wallet|
Fragmented Regulatory Environment
It’s not always clear what rules apply — some countries regulate cryptocurrencies while others have banned them. This can impact the efficient pricing of tokens, and make determining your rights as an investor difficult.
|Make Sure You Know Where the Company is Incorporated|
|This will determine what rules apply and what protections you can access as an investor.|
Fundraising for an Idea
ICOs don’t always involve a tangible product, making it harder to evaluate whether it’s feasible.
|Do Your Due Diligence on the Product and Opportunity|
|An ICO should have a good product, some indication of product-market fit and a strong team. It may be a red flag if the idea and team exist only in a white paper.|
Liquidity is how readily an asset can be converted into cash. Investors in traditional startups that are not listed on a stock exchange must typically wait to ‘cash out’ through a trade sale or a listing. This means they are locked in until the business they have invested in achieves an exit.
The ability to trade tokens on secondary markets (i.e. a crypto exchange where there are active buyers and sellers of crypto assets) much more quickly than traditional startups and realise liquidity faster has attracted many investors to the crypto space. Listing a token on an exchange (e.g. Coinbase) can improve access to liquidity.
But major exchanges with large investor bases will have a due diligence process that they undertake before listing, and so will not automatically accept every token. For example, the Australian Transaction Reports and Analysis Centre (AUSTRAC) now requires a digital currency exchange to meet anti-money laundering and counter-terrorist financing obligations. Regulators in other countries are likely to follow suit, targeting crypto exchanges, making them less likely to accept just any and every token.
If a major exchange refuses to list your token, or it’s only listed on a lesser-known exchange (with a smaller investor base), the token could have effectively zero-market value.
|Be wary of liquidity guarantees|
Some whitepapers will guarantee liquidity for your token — this is a red flag.
Although some startups, such as blockchain marketplace CanYa, are working to address the problem of illiquid crypto markets. The company recently integrated with the Bancor Protocol, allowing users to convert between tokens directly, rather than trading on the exchange. But investors should still take care as again, this will not guarantee you can realise the full value of your original investment in fiat currency.
There are some shortcomings around ICO governance including:
- Minimum oversight of the management team. For example, if this is a community-driven project, what are rights of the community versus the owners;
- Few investor rights other then the contents of the white paper, which can have one-sided terms; and
- Lack of transparency regarding large ownership concentrations, which can impact price.
|Ask Governance Questions|
|Ensure that the team can answer:
‘Pump and dumps’ or artificially inflating the price of a security through misinformation and inside information are illegal in regulated markets. ASIC can fine or even arrest the operators of these scams.
The ICO market doesn’t provide the same protections for investors. And it’s not uncommon for unscrupulous crypto traders to buy tokens at a low price, and then hype the company on social media (e.g. Telegram) driving the token price up. The trader then orders investors participating in the scheme to sell or ‘dump’ their tokens at the peak price, causing token prices to fall. Other investors are left holding their tokens at a reduced value.
|Be Wary of Fake Ads, and Sudden Spikes in Trading|
Low-volume cryptocurrencies that suddenly experience high trading can signal a ‘pump’. Fake news articles touting support from high-profile investors or celebrities can contribute to this spike. Most recently, Shark Tank judges Steve Baxter and Janine Allis were impersonated in a fake advertisement for ‘Bitcoin Trader’.
Also, look for exaggerated language in ads promoting token sales – statements that guarantee a profit or aim to create a false sense of urgency (e.g. ‘buy now!’).
What Happens If the ICO is a Scam?
Australia does not currently regulate ICOs under a specific legal framework. This means that the level of protection afforded to investors if the ICO is a scam will depend on whether the token falls under existing laws.
Australian law prohibits offerors from making misleading or deceptive statements in their white paper or other promotional communications, for example:
- publishing misleading information about their advisory board or development team;
- creating fake social media profiles to generate hype around the ICO;
- failing to disclose information in their white paper (for example, the criminal background of their founding or development team);
- falsely advertising high returns on their token or promising financial rewards without any risk;
- coordinating sales and purchases to generate the appearance of high activity for their ICO;
- falsely claiming that they have a partnership with an existing financial institution (for example, a bank or credit card company);
- falsely claiming that the token is backed by another commodity, such as gold, real estate or diamonds; or
- falsely claiming that a token is compliant or has registered with the regulator (ASIC).
The Token is a Financial Product
If the token is a financial product, then the Corporations Act 2001 (Cth) will apply, and the company must comply with strict disclosure obligations (for example, issuing a prospectus or a product disclosure statement).
The Act also prohibits misleading and deceptive conduct. If a company does not make sufficient disclosure or includes false statements in their white paper, they would be breaking the law, and an investor could either:
- recover their investment;
- take action against the company; or
- refer the matter to ASIC for investigation.
The Token Isn’t a Financial Product
If the token isn’t a financial product, Australian Consumer Law (ACL) applies. Australia’s consumer watchdog, the Australian Competition and Consumer Commission (ACCC) delegated its powers to ASIC to take action against ICOs that breach the ACL. This means ASIC can now take action against a company for misleading and deceptive conduct connected to an ICO regardless of whether it’s a financial product. This action may include:
- seeking an injunction to stop the ICO from proceeding; or
- pursuing damages if the investor has suffered a loss because of the offeror’s misleading statements.
However, ASIC’s challenge will be tracing and recovering the tokens, especially if a website shuts down after completing its ICO. It’s then up to you, the investor, to educate yourself about the risks of investing and avoid giving your money to fraudsters.
How are Tokens Taxed in Australia?
|How are you using the crypto asset?||How will the ATO tax the asset?||Example|
|Carrying on a business trading crypto assets.||
Individuals are taxed at their marginal tax rate.
Companies are taxed at either 27.5% or 30%.
Trader Company acquires $10,000 worth of crypto in Year 1. This acquisition gives rise to a $10,000 loss because the company had no income.
The company sells the crypto in Year 2 for $25,000. The entire sale proceeds are $15,000 ($25,000 – $10,000). And this is the actual amount that is taxed.
|Acquired digital tokens to sell for a profit.||
If you are an individual, profits are taxed at your marginal tax rate.
A company’s profits are taxed at either 27.5% or 30.
In the example above, the $10,000 purchase price is not deductible in Year 1, and only the $15,000 profit component is taxed.
Here, a different method is used but the result is the same.
|Held as capital assets for investment purposes.||Your profits are taxed as a capital gain and you may be eligible for the general 50% capital gains tax discount (individuals only)||
Erica buys $50,000 worth of crypto as an investment in Year 1. In Year 4 Erica sells her crypto for $250,000. Her capital gain is $200,000 ($250,000 – $50,000).
Erica can take the first 50% of her capital gain ($100,000 out of $200,000) tax-free and only pays tax on the remaining half of her capital gain ($100,000).
|Personal use of tokens that are less than $10,000.||The ATO will disregard any gains or losses from the personal use of a crypto asset||Using the token to purchase an item for personal use or consumption.|
ICOs provide blockchain startups with a novel way to finance legitimate innovations. And we expect that as the industry matures, more investors will want to participate as regulations become more certain, particularly around investor protection. But ICOs are volatile, and they carry risks including cyber theft, fraud and pump-and-dump schemes.
Ultimately, it’s up to you to protect your tokens and secure your digital wallet from bad actors. Before deciding to part with your money, do your due diligence. We’ve summarised some steps you should take below:
- research the team and advisors listed on the startup’s website and in their white paper;
- understand the risks of a cyber attack, and secure your digital wallet;
- make sure you know where the company is incorporated (in Australia, you can check this on ASIC Connect for a small fee);
- do your due diligence on the product and opportunity;
- be wary of liquidity guarantees;
- be wary of fake ads, and sudden spikes in trading; and
- ask the founding team questions.
If you have any questions about initial coin offers, get in touch with LegalVision’s cryptocurrency lawyers. Fill out the form on this page or call us on 1300 544 755.
Claudette Yazbek contributed to this article. Claudette is a lawyer and LegalVision’s Communications Manager. As a 2017 Australia-Endeavour Awards Fellow, she worked in the US Senate researching emerging technologies with a focus on cryptocurrencies.
Madeleine Hunt contributed to this article. Madeleine is a lawyer in LegalVision’s Business Structuring and Capital Raising teams. She provides end-to-end guidance for companies as they scale, from choosing the right corporate structure to deciding on funding options.
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