Raising capital, especially in the early stages of startups, is one of the toughest jobs founders will have to do. That’s why many have turned to ICOs (Initial Coin Offerings) instead of going the more traditional funding routes such as an IPO (Initial Public Offering). In ICOs, companies can raise money by issuing crypto tokens on a blockchain and sell them.
This approach is gaining popularity. In the first 5 months of 2018 alone, more than $7 billion worth of cryptocurrency was raised in ICOs.
There are three type of tokens that are commonly issued as part of this offering.
Equity Tokens
Equity Tokens are similar to owning stock. They represent an ownership of an asset. ICOs can issue equity tokens and voting rights over blockchain. These can be bought and sold in a cryptocurrency market. Equity tokens are subject to federal securities laws and regulations, just like stocks.
Security Tokens
Security Tokens are digital contracts for fractional ownership of a real asset. The asset, in this case, has a defined value, such as an equity position in a company or a physical asset like real estate. They are also subject to SEC (Securities and Exchange Commission) regulations.
“The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets,” said Stephanie Avakian, Co-Director of the SEC’s Enforcement Division.
Utility Tokens
While cryptocurrencies, such as Bitcoin, represented a defined value, utility coins have a specific use. These token grant right holders the ability to use the blockchain network and its services, and – in some cases – vote on governance. You might think of utility tokens as a pre-paid software license, which is used to access services.
A good example would be the ICO from Filecoin, which sold utility tokens providing user access to its cloud storage. Filecoin succeeded in raising $275 million dollars. Similar to other tokens, there is a limited supply sold. The data is spread across a network of computers that rent out the storage in exchange for Filecoin payments. It’s similar in concept to Airbnb or Uber, in which users are able to maximize utilization of their homes or vehicles by renting it out in small amounts to end users. In the case of Filecoin, it’s data centers and hard drives around the world that have unused storage space available to “rent.”
“I believe every ICO I’ve seen is as a security,” SEC Chairman Jay Clayton testified before the Senate Banking Committee in February.
Utility tokens, even as part of an ICO, may not be subject to such strict federal security laws. Utility tokens are not strictly investments. Think of them as a “digital coupon” for future services.
There’s increased interest in utility tokens since the state of Wyoming recently passed the Utility Token Bill. The bill classifies utility tokens as neither a commodity (regulated by the Commodities Futures Trading Commission) nor a security (regulated by the SEC). As a new asset class, the bill excludes token sellers from security laws if they meet certain conditions. Caitlyn Long, founder of the Wyoming Blockchain Coalition said the law defines utility tokens as a new form of property. Property, Long said, is generally the purview of state law instead of federal regulation. Other states are considering new legislation.
With utility tokens, in addition to less federal regulation, there is cost savings in legal and administrative filings, less record-keeping and duplication of records, and the automation of administrative tasks.
With these advantages and potential legislation exempting utility tokens from strict SEC and CFTC regulations, utility tokens appear poised to grow rapidly and become more viable options for future ICOs.