Tuesday, September 22, 2020 / 02:00PM /
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This is the second part to the article on Regulating Cryptocurrency and Initial Offerings: The Nigerian Perspective, (read part one here). In part two, we explore Initial Coin Offerings (ICOs), how it is used to raise funds, the Nigerian legal framework on ICOs, and the pros and cons of ICOs.
A New Way of Raising Capital
The rapid increase in the value of cryptocurrency and the possibility of high gains within a short time frame has seen a number of companies deciding to use the technology driving cryptocurrency to raise funds.
Companies have started seriously considering ICOs as a viable tool to raise capital as opposed to Initial Public Offerings ("IPOs"). This is because ICOs are not subject to as much regulatory oversight as IPOs considering the definition of tokens fall outside the scope of regulated investment instruments in most jurisdictions, thus simplifying the offering process. In addition, companies get to protect their shareholding against dilution as the assets on offer during are ICO are tokens and not shares in the company.
2017, it was posited by financial experts that there was an ICO Bubble1, (a situation where the price of coins
far exceeded their fundamental value due to their connection to ICOs) This was
supported by the fact that in 2017 alone, USD1,362,588,431 was raised from the
top ten ICOs2 globally.
Though the bubble may have burst in 2019 due to ICOs not being able to meet
their targets and the prevalence of fraudulent ICOs, they are still being used
by companies to raise capital3
and the promise of rapid, large investment returns makes it more appealing to
IPO vs ICO
There is still a debate in the financial industry that tokens constitute a share or security of the company; therefore it is similar to an IPO because ownership is being sold through the use of the tokens instead of shares. This assertion has its flaws because fundamental differences exist between an IPO and an ICO which will be highlighted below.
The company sells part of its ownership through shares for additional capital.
The company has a unique technology or a project they need to raise funds for.
The capital gained is used to grow the company and help in operations.
The tokens are usually sold to gain stakeholders who will become users of the product or will be in the product ecosystem (blockchain native to the token).
The owners of the shares will usually gain dividends and reap the benefits of the company's growth.
The owners of a token gain product value as they are able to do various things with the token acquired from an ICO. They can sell their tokens for a higher price, exchange it for other tokens or coins, or use the product that the token was created for.4
IPOs are heavily regulated and are typically subject to regulatory oversight and requirements.
ICOs are hardly regulated and the level of entry is low. A company following the right steps can easily set up an ICO.
An IPO involves a lot of money as the company seeking to raise capital would have to invest in brokers, roadshows to discuss the benefits of their IPO to potential investors, issuing houses and even Underwriters.
An ICO does not involve spending large amounts of money since everyone on the internet can easily access the ICO and purchase the tokens and there are minimal third-party expenses required to ensure the success of the ICO.
The characteristics of an ICO and the freedom it affords companies looking to raise capital has aided the increasing popularity of token sales and in recent times, ICOs have been categorized and broken down for potential investors to understand the intricacies of the process.
The Token Sale
An ICO or a Token Sale is the process of raising capital through the sale of tokens to the public for a limited period in exchange for cryptocurrency5. Instead of receiving shares like a typical IPO, investors receive tokens and pay in cryptocurrency (or cash in some instances). The tokens received represent the participation of the investors in the project the ICO was created to raise capital for.
So, Investors in a Token Sale are usually called participants because ICOs are a form of Crowdfunding; however the company will be receiving cryptocurrency rather than cash.6 This can be compared to equity-based crowdfunding where the public donates cash in exchange for shares in the company7.
Types of Token Sales
There are two major types of ICOs the Private ICO and the Public ICO. In a Private ICO, a limited number of investors, typically financial institutions and high net-worth individuals, participate in the process. The company can choose to set a minimum investment amount8.
A Public ICO on the other hand, is open to the general public, with no limits on who may participate, subject to any regulatory considerations in the relevant jurisdiction9.
However, Private ICOs are becoming a more preferred option compared to public offerings as regulators are now looking at ways to regulate Public ICOs in order to protect the investing public.
Characteristics of a Token Sale
In order to mitigate the risk investors associate with ICOs, companies have had to be strategic in structuring ICOs and four characteristics have emerged as the foundation for any Token Sale Model.
The structure of an ICO and the benefits a token offers determines the type of investors it attracts. The utility the token offers is also one of the factors that will determine whether an investor will use the token he acquired or trade it off in return for another token with a different utility or cash.
The Types of Investors in a Token Sale
There are two types of participants in a Token Sale - Stakeholders and Speculators. Stakeholders are buyers who acquire a token to be able to use it for the true utility it was created for. In the first article, we talked about the Brave browser and how it is using its Basic Attention Token (BAT) to create value by rewarding people who advertise on its browser with the token when a user views their ad which does not have an ad tracker or is transparent11. If the Brave browser was to have an ICO, they would most likely sell their BAT and a Stakeholder buyer would acquire it to use in securing an advert space on the browser because the BAT can be used in the Brave ecosystem to gain products or services12.
Speculators are investors who do not wish to use the utility that a token offers. They participated in the Token Sale with the hope of making a return on the token when its value rises, either by selling to Stakeholders or other Speculators.
ICOs require an understanding of a combination of finance, technology and the regulatory requirements that may hinder the process in the jurisdiction the issuing entity resides in. Therefore, the steps highlighted below in order to be successful will entail an understanding of the subject matter aforementioned.
Kickstarting a Token Sale
Because the mechanism for an ICO is fairly simple, it has a low barrier of entry and in most jurisdictions, it can be started without jumping through regulatory hoops. There are typically four stages in kickstarting an ICO:
This includes the preliminary stage where the company or the token issuing entity identifies their potential investors and the project they want to fund.
After identifying its potential investors and its underlying project, the token issuing entity will issue a White Paper (similar to a Prospectus for an IPO) that provides details of the underlying project and details of the tokens that will be issued in exchange for cryptocurrency13.
The White Paper is made publicly available, usually through the issuing entity's website. The White Paper will include the mechanism for payment of cryptocurrency to the issuing entity's account. t is now common practice for payments to be made into an escrow account, to foster investor confidence in the validity of the ICO14.
The tokens are created. The tokens will be the representations of an asset or a utility on the blockchain native to the token and are tradeable for other tokens or coins15. The issuing entity does not need to create new tokens, instead they can build on existing blockchains such as Ethereum which allows the creation of tokens on its blockchain.
The issuing entity will usually run a promotion campaign to attract potential investors. These campaigns are usually executed online to achieve the widest investor reach. It should be noted that a lot of online platforms such as Facebook and Google ban the advertising of ICOs16; therefore, it is recommended that the campaign run on the issuing entities website or on cryptocurrency exchanges.
After the creation of the tokens, the tokens are issued and the token purchasers or investors will pay for the tokens, usually in cryptocurrency. Issuing entities can request for fiat currency if they wish, but common practice is the use of coins to buy tokens.
Once the purchasers have paid for the token, they can use their tokens in the project ecosystem as a utility for the product or trade the token on a Cryptocurrency exchange, subject to any lock-in period prohibiting the exchange or sale of the token -this will be stated in the White Paper.
Cryptocurrency is financially risky as we highlighted in our first article, so in order to assuage the fears of investors, the management team of the issuing entity usually take tokens themselves to prove to potential investors that the ICO is relatively safe.
Below is a process flowchart highlighting the stages of a typical ICO:
The Nigerian Legal Framework on ICOs
As defined in our first article, a token is an asset built on top of an existing blockchain, which has the ability to replicate such functionality or assets18. We also explained how securities are financial assets and provided the definition of securities according to the Nigerian Regulatory Framework for securities19.
The regulatory framework for securities being offered to the public or to private individuals in exchange for cash comprises of the following rules and regulations:
Article 279(1)(c) of the SEC Rules provide that all securities subject to registration by the Securities and Exchange Commission ("SEC") may be offered through the following methods:
The SEC Rules also provide that an entity may offer or transfer its securities electronically: provided that where an investor elects to have a certificate, such certificate shall be issued by the issuer20.
The aforementioned principles of the SEC Rules seem to give a legal foundation for potential ICOs in Nigeria but sadly, coins and tokens do not fall under the scope of securities set out in the ISA and therefore, cannot be registered as securities that can be offered to the public or to private entities in exchange for capital in Nigeria. Also, the SEC is yet to classify what coins or tokens are in Nigeria, hence, ICOs are unregulated in Nigeria.
This position may soon change as the Proposed Rules on Crowdfunding by SEC21 seem to permit equity crowdfunding and ICOs are an offshoot of it. The proposed rules provide that an entity may issue other investment instruments approved by the Commission (including simple contracts) without registering the securities or investment instruments with the SEC. Tokens being offered in ICOs are investment contracts that are built on blockchains and are easily programmable to provide any type of utility the issuing entity programmes the smart contract to perform. This position has not been affirmed by the SEC but it is hoped that ICOs can take advantage of the proposed provisions of the Proposed Rules.
Also, the National Blockchain Strategy released by the Federal Ministry of Communications and Digital Economy, while admitting that there is no regulatory or legal framework for cryptocurrency in Nigeria, believes that there is a promising future for blockchain in Nigeria due to the adoption of blockchain by various Nigerian start-ups for numerous purposes. The Blockchain Strategy lists out the various regulations that the Federal Government has released to create an enabling environment for cryptocurrency in Nigeria22. It goes further to explain how the Federal Government wants to use cryptocurrency and blockchain technology as one of the paths towards a digital economy and one of the strategic objectives is the creation of investment opportunities through blockchain.
According to the Blockchain Strategy, "Blockchain has the potential to completely transform traditional models in several sectors both private and public. By promoting blockchain adoption and providing an enabling environment, new business models will spring up to open opportunities for businesses that will drive investments in a market such as Nigeria."
This seems to be a nod to ICOs and the government's consideration of it to diversify the Nigerian Economy and the methods of investment in Nigeria.
Furthermore, the Final Report of the Fintech Roadmap Committee of the Nigerian Capital Market by the SEC, lists out recommendations that the Capital Market Community will take into consideration regarding ICOs:
ICOs - Risky Business or Not?
Though the advantages of an ICO were mentioned earlier in this article, they need to be highlighted again to understand why ICOs are being strongly considered by companies as a way to raise capital.
Lack of Regulatory Oversight: Most ICOs lack regulatory oversight, hence it is an interesting opportunity for founders or entities to adopt it as a method to raise capital. Bypassing the regulatory oversight that comes with IPOs is a major boost to the appeal of ICOs to issuing entities and even investors.
Substantial Gain Quickly: Since ICOs have a target and an estimated time to achieve the target which is usually short23, investors usually gather their funds to invest heavily in ICOs due to the potential returns that are projected. Most times the returns projected is higher than returns on fixed or floating assets such as bonds or shares respectively. The recent furore for and discussion around the novelty and profitability of ICOs has whetted the risk appetite of certain investors hoping to make a huge return on their investments, which means that the issuing entity also sees a quick inflow of capital.
Anyone can Invest: Due to the nature and accessibility of ICOs which are typically offered online, issuing entities are not limited to investors within their geographical area, and do not incur costs that are typically seen with the traditional methods of raising capital. Anyone can invest in an ICO and the pool of potential investors is essentially every user of the World Wide Web. The use of cryptocurrency also means that the issuing entity does not need to worry with the currency in which to dominate the offer and thus, bypasses any foreign exchange concerns.
So, with all the advantages mentioned above, why are ICOs still considered risky business? Well in 2017 alone, 80% of ICOs were identified as scams by Statis group, an ICO advisory firm24. To put in context, US$11.9 billion of investor money fell to scams in 2017 and three fake ICOs alone consumed US$1.31 billion25.
Also, the lack of regulatory oversight means most ICOs end up "going dead"26 and investors cannot recoup their money due to the lack of a mechanism or a reporting procedure to reclaim their funds.
In addition, investors and issuing entities are faced with the risk of digital currency theft as cryptocurrency wallets - where the coins or tokens stored - are hackable. A study27 from CipherTrace, a cryptocurrency intelligence firm based in Silicon Valley provided an overview of the major cryptocurrency thefts, scams, and fraud worldwide in 2019. The study showed that criminals and fraudsters netted approximately US$4.26 billion for the first six months of 2019 and US$1.7 billion for the entire 2018 according to the study.
Although exchanges, wallets, and other cryptocurrency custody services are strengthening their defenses, hackers continue to innovate and outpace even the current state of the art in cybersecurity, the CipherTrace study notes28.
ICOs are not popular in Nigeria and are hardly used to raise capital by entities in this part of the world. Also, given the fact that coins and tokens are not classified in Nigeria, the absence of classification makes Nigeria a very harsh terrain for an ICO to be conducted, but that may soon change.
In January 2018, SureRemit a Nigerian non-cash remittance start-up raised $7 million through an ICO29. ICOs may become the rave for Nigerian tech companies who do not want to jump through the regulatory loopholes of the SEC for raising capital and registering securities.
The drive of the Federal Government and SEC is also duly noted as the government and its apex capital market regulatory body looks into the future to tap the benefits of cryptocurrency and all the technology that comes with its use.
This article is part of the series titled THE CHANGING OF FINANCE IN NIGERIA highlighting the various modern financial developments in Nigeria. Other articles in the series may be accessed here.
4. Deloitte, "Initial Coin Offering a new Paradigm" https://www2.deloitte.com/ru/en/pages/financial-services/articles/initial-coin-offering-a-new-paradigm.html. accessed 6 August 2020
6. ACCA, "ICOs: real deal or token gesture? Exploring Initial Coin Offerings" https://www.accaglobal.com/content/dam/ACCA_Global/professional-insights/Initial-coin-offerings/pi-initial-coin-offerings.pdf accessed 6 August 2020.
7. Oyeyosola Diya, "The Changing Face of Finance in Nigeria : Crowdfunding" https://www.aelex.com/wp-content/uploads/2020/03/THE-CHANGING-FACE-OF-FINANCE-IN-NIGERIA-CROWDFUNDING1.pdf accessed 6 August 2020.
9. Corporate Finance Institute, "Initial Coin Offering (ICO) An initial public offering that uses cryptocurrencies"
12.Deloitte, "Initial Coin Offering a new Paradigm" https://www2.deloitte.com/ru/en/pages/financial-services/articles/initial-coin-offering-a-new-paradigm.html accessed 6 August 2020
16. Corporate Finance Institute, "Initial Coin Offering (ICO) An initial public offering that uses cryptocurrencies" https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/initial-coin-offering-ico/ accessed 17 August 2020.
Previous Posts from Aelex
1. Regulating Cryptocurrency and Initial Coin Offerings: The Nigerian Perspective - Part 1 - September 15, 2020
2. Works Forming Part of the State of the Art are Ineligible for Protection - A Case Study - September 15, 2020
3. Innovations Covered Under the Value Added Services (VAS) Licence Framework In Nigeria - September 13, 2020
8. Finance Act, 2019: Tax Implications for the Private Equity Industry - July 13, 2020