The Take

ICO vs IPO: Why you should know the difference19/10/17

Image: Crypto News, 2016

EFS Alumnus and Operations Analyst at SmartBooks Online Peter Park discusses the ins and outs of Initial Public Offerings and Initial Coin Offerings in this week’s edition of The Take:

Disclosure: I’m not a blockchain expert. Therefore, this article represents my own interpretation and understanding of blockchain, ICO and different opinions around regulating ICO. I did some research to ensure that information provided is at least factual. Feel free to point out any incorrect information. Many thanks in advance.

Blockchain???
Blockchain is a relatively new term that may not be well understood by many. I thought it would be useful to go over the concept briefly before diving deeper into the topic.

dlt-cheatsheet1
Image: Bits on blocks, 2017

Distributed Ledger Technology (DLT) is best known for its application to blockchains. Blockchains are a bundle of unrelated transaction ‘blocks’ in a public ledger network. Only those who hold a unique reference to another block — called ‘hash’ — can facilitate transactions by forming a ‘blockchain’. Such transactions are subsequently recorded live in a blockchain network. Pseudonymity and transparency which may sound mutually exclusive are why the blockchain technology is heralded as the generational revolution for transactions of any kind. You have the unique reference and transaction details of a chain but you don’t know who the unique reference belongs to.

What is Initial Coin Offering?

Cryptocurrencies such as Bitcoin and Ethereum are applications of this blockchain technology. As these cryptocurrencies exploded in popularity and trade volume, and as the blockchain technology became more known to the public, people started to create their own. One of them is an Initial Coin Offering (ICO) where a company seeks to raise capital by issuing its own cryptocurrencies (ICO Coins). This was excellent news to growth businesses that often struggle with access to equity and debt financing.

Just like other cryptocurrencies, the price of ICO Coins is determined by market demand and supply. ICO companies create a document called a ‘White Paper’ to tell you why you should invest in them which in turn influences your expectation of those companies.

ICO vs IPO

At this stage, a rational person would ask, “so is this like investing in ASX-listed companies through an Initial Public Offering (IPO)?”

Well, our common sense says “yes” but the Australian Securities and Investments Commission (ASIC) says “maybe”.

Here’s why:

  1. An IPO is a regulated financial activity because it offers shares in a company — a share is a financial product that has financial conditions attached to it, i.e. ownership of the company, voting rights. Because ICO Coins do not represent equity in companies and they don’t carry voting rights, it’s hard to see ICO as IPO. Greg Medcraft, ASIC’s Chairman, currently views ICOs as “a prepayment for goods/services to be launched” — goods/services being the ICO Coins.
  2. But this does not mean that ICO will not be regulated like IPO. In fact, ASIC is prepared to view ICO Coins as a type of “securities” if they have similar characteristics to company shares or ICOs would be considered as providing “financial services”. This would result in the same level of regulations applicable to IPOs being imposed on ICOs, which is very strict.

Please visit ASIC website for more information.

Are ICOs safe?

Does an ICO provide any protection that you are not being ripped off in the absence of regulations? That’s what a White Paper does. It discloses investment risk by explaining what the company does and how it plans to grow from capital raised through ICO. But is this ‘sufficient’? That depends on who you ask. But unlike IPO prospectus, ICO companies are not required by law to disclose risk. In other words, the level of risk disclosure could vary significantly for every ICO.

Sure, you must assume some risk as an investor. My point is that while White Papers may be satisfactory for some, should ICOs be seen as IPOs, it becomes a question of whether risk is being disclosed and discharged according to the standards set by the ASIC.

Should ICOs be regulated?

According to ASIC, it appears to be a question of ‘when’, not ‘if’. An ICO is one way of raising capital for capital-hungry companies. It also makes sense to provide appropriate protection to ICO investors through regulations. But ASIC is not jumping straight to a conclusion. Firstly, ‘ICO = IPO’ is a big statement that has significant implications for many parties involved in ICOs. Secondly, most ICO companies are start-ups and SMEs in need of capital so it is highly unpractical to subject them to an ‘IPO-level’ of regulations.

Where to now?

We have already seen a similar phenomenon in the crowd-sourced equity funding (CSEF) space. Governments in Australia and around the world created exemptions to regulations so small-scale capital raising can be done without strict IPO standards. Through CSEF platforms, start-ups and SMEs have access to more capital from retail investors, which used to be only available to ‘sophisticated and professional investors’, i.e. high-net-worth individuals and people who invest for a living.

When it comes time for the ASIC to regulate ICO, something similar could happen.

Therefore, anticipating this situation, it makes sense for the ASIC to wait and see how the blockchain technology evolves over time and along with it the validity of ICOs as capital raising process.

Before you buy those ICO Coins…

If you plan to invest via ICO, regardless of how good an opportunity may be, I strongly encourage you to exercise some level of due diligence. Start with simple things like whether the company is incorporated in recognised jurisdictions and if it has a unique company registration number, e.g. ACN in Australia. If you are investing a large sum of money, you may want to consider engaging a professional firm for the best practice due diligence.

I would like to believe that despite lack of regulations most ICO companies are reasonably diligent with risk disclosure and you are happy with the level of risk disclosure. But when your hard-earned money is involved, it never hurts to do some extra research and pay attention to details. This level of caution should be maintained until the ASIC (or the world indeed) is ready to regulate this space.

Peter has been working in the Venture Capital and start-up sector for the past 2 years, where he has specialised in due diligence, financial modelling and operations. Peter is also a qualified lawyer in the state of Queensland. 

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