Initial coin offerings (ICOs) have raised a combined $3.25 billion this year, creating the first visible ripple of what analysts believe could eventually become a multi-trillion dollar industry. Through the ICO fundraising model, startups can raise capital by issuing crypto tokens on a blockchain — most commonly Ethereum — and distributing them to token buyers in exchange for making a financial contribution to the project.
These tokens, which can be transferred across the network and traded on cryptocurrency exchanges, can serve a multitude of different functions, from granting holders access to a service to entitling them to company dividends. Depending on their function, crypto tokens may be classified as utility tokens or security tokens.
Utility tokens, also called user tokens or app coins, represent future access to a company’s product or service. The defining characteristic of utility tokens is that they are not designed as investments; if properly structured, this feature exempts utility tokens them from federal laws governing securities.
By creating utility tokens, a startup can sell “digital coupons” for the service it is developing, much as electronics retailers accept pre-orders for video games that might not be released for several months. Filecoin, for instance, raised $257 million by selling tokens that will provide users with access to its decentralized cloud storage platform.
Because the term “ICO” is a derivative of “initial public offering” (ICO), utility token creators usually refer to these crowdsales as token generation events (TGEs) or token distribution events (TGEs) to avoid the appearance that they are engaging in a securities offering.
If a crypto token derives its value from an external, tradable asset, it is classified as a security token and becomes subject to federal securities regulations. Failure to abide by these regulations could result in costly penalties and could threaten to derail a project. However, if a startup meets all its regulatory obligations, the security token classification creates the potential for a wide variety of applications, the most promising of which is the ability to issue tokens that represent shares of company stock.
Online retailer Overstock recently announced that tZERO, one of its portfolio companies, will hold an ICO to fund the development of a licensed security token trading platform. The tZERO tokens will be issued in accordance with SEC regulations, and Overstock CEO Patrick Byrne has stated that token holders will be entitled to quarterly dividends derived from the profits of the tZERO platform.
Many industry observers — Byrne included — believe that mainstream companies will one day issue shares through ICOs, either in place of or in addition to traditional public offerings.