On Cryptocurrency IEOs and ICOs
Initial Coin Offerings (ICOs) were a relatively new phenomenon, but have quickly become a dominant topic of discussion among the blockchain community and accountants.
Many view ICO projects as unregulated securities that allow founders to raise an unjustified amount of capital, while others argue it is an innovation in the traditional venture-funding model. Between 2016 and 2019 ICOs were used as a main fundraising mechanism for most new start-ups. Instead of an initial public offering (IPO), which requires a ton of SEC scrutiny, an ICO has little or no SEC oversight.
The SEC has recently reached a decision regarding the status of tokens issued in the infamous DAO ICO which has forced many projects and investors to re-examine the funding models of many ICOs. The most important criteria to consider is whether the token passes the Howey test or not. If it does, it must be treated as a security and is subject to certain restrictions imposed by the SEC.
ICOs are easy to structure because of technologies like the ERC20 Token Standard, which abstracts a lot of the development process necessary to create a new cryptographic asset. Most ICOs work by having investors send funds (usually bitcoin or ether) to a smart contract that stores the funds and distributes an equivalent value in the new token at a later point in time.
There are few, if any, restrictions on who can participate in an ICO, assuming that the token is not, in fact, a security. And since you’re taking money from a global pool of investors, the sums raised in ICOs can be astronomical.
A fundamental issue with ICOs is the fact that most of them raise money pre-product. This makes the investment extremely speculative and risky. The counter argument is that this fundraising style is particularly useful (even necessary) in order to incentivize protocol development. The problem was due to lack of oversight, many investors or “miners” got burned.
Now, it’s time for some definitions. The definition of a digital coin is an asset that is native to its own blockchain. Think about Bitcoin, Litecoin or Ether. Each of these coins exists on their own blockchain.
So, to make this a little clearer:
- Bitcoin operates and functions on the Bitcoin blockchain
- Ether operates and functions on the Ethereum blockchain
- NEO operates and functions the NEO blockchain
- Transactions of digital coins can be made from one person to another. However, no physical coins move when you send and receive them. All the “coins” exist as data on a giant global database. This database (or blockchain) keeps track of all the transactions and is checked and verified by computers around the world.
Digital coins are generally used in the same way as a real-life coin is – as money. You can think of coins like Bitcoin, Litecoin, and Monero just like the coins in your wallet or piggy bank. Often, they don’t serve any other purpose than to be used as money. These “cash only” coins are used for many things.
Tokens often get called digital coins. However, this isn’t correct. There is a major difference!
Tokens are created on existing blockchains. In fact, thanks to the creation and facilitation of smart contracts, the most common blockchain token platform is Ethereum. Tokens that are built on the Ethereum platform are known as ERC-20 tokens.
However, there are others such as NEO, Waves, Lisk, and Stratis. While, as mentioned above, tokens on the Ethereum platform are known as ERC-20 tokens, NEO uses tokens known as NEP-5 tokens. Anyone can make their own custom token on one of these platforms.
Most tokens exist to be used with decentralized applications, or dApps. When developers are creating their token, they can decide how many units they want to make and where these new tokens will be sent when they are created. They will pay some of the native cryptocurrency on the blockchain they are creating the token on at this point.
Once created, tokens are often used to activate features of the application they were designed for.
For example, Musicoin is a token that allows users to access different features of the Musicoin platform. This could be watching a music video or streaming a song. Binance (the exchange) also has its own token. When users trade with BNB (Binance token), their fees are 50 percent less.
Some tokens are created for a whole different kind of purpose: to represent a physical thing. Let’s say you wanted to sell your house using a smart contract. You can’t physically put your house into the smart contract, can you? No. So, instead, you can use a token that represents your house.
A smart contract is a computer protocol intended to digitally facilitate, verify, or enforce the negotiation or performance of a contract. Smart contracts allow the performance of credible transactions without third parties.
One of the best things about the blockchain is that, because it is a decentralized system that exists between all permitted parties, there’s no need to pay intermediaries (Middlemen) and it saves you time and conflict. Blockchains have their problems, but they are rated, undeniably, faster, cheaper, and more secure than traditional systems, which is why banks and governments are turning to them.
Smart contracts help you exchange money, property, shares, or anything of value in a transparent, conflict-free way while avoiding the services of a middleman.
The best way to describe smart contracts is to compare the technology to a vending machine. Ordinarily, you would go to a lawyer or a notary, pay them, and wait while you get the document.
With smart contracts, you simply drop a bitcoin into the vending machine (i.e. ledger), and your escrow, driver’s license, or whatever drops into your account. More so, smart contracts not only define the rules and penalties around an agreement in the same way that a traditional contract does, but also automatically enforce those obligations.
An Initial Exchange Offering, as its name suggests, is conducted on the platform of a cryptocurrency exchange. Contrary to Initial Coin Offerings (ICOs), an IEO is administered by a crypto exchange on behalf of the startup that seeks to raise funds with its newly issued tokens.
As the token sale is conducted on the exchange’s platform, token issuers have to pay a listing fee along with a percentage of the tokens sold during the IEO. In return, the tokens of the crypto startups are sold on the exchange’s platforms, and their coins are listed after the IEO is over. As the cryptocurrency exchange takes a percentage of the tokens sold by the startup, the exchange is incentivized to help with the token issuer’s marketing operations.
IEO participants do not send contributions to a smart contract, such as governs an ICO. Instead, they have to create an account on the exchange’s platform where the IEO is conducted. The contributors then fund their exchange wallets with coins and use those funds to buy the fundraising company’s tokens.
One of the main advantages of IEOs is trust. As the crowdsale is conducted on a cryptocurrency exchange platform the counterparty screens every project that seeks to launch an IEO on its website. Exchanges do this to maintain their good reputation by carefully vetting token issuers.
Therefore, IEOs can eliminate scam and dubious projects from raising funds via cryptocurrency exchange platforms, and it becomes much harder to scam contributors with IEOs.
The RAID IEO case is an excellent example. Recently, Bittrex announced that it had canceled its IEO for the RAID project a few hours before the start of the crowdsale. The reason for canceling RAID’s plan to raise $6 million from contributors was a terminated partnership between RAID and the e-gaming data analytics company OP.GG.
According to Bittrex, the partnership between the two companies was a vital part of the project, and when the cryptocurrency exchange became aware of the event, it decided to cancel the token sale as they believed it was not in the interest of Bittrex’s customers.
Token issuers do not have to worry about the crowdsale security as the exchange is managing the IEO’s smart contract. The KYC/AML process is also handled by the crypto exchange as most service providers do KYC/AML on their customers after they create their accounts.
Token issuer startups benefit from the more flawless process of launching IEOs on exchange platforms – compared to doing their ICOs “on their own.” While the fundraising organizations have to pay fees for listing and a percentage of their tokens, the exchange will help them with marketing. So, startups launching their IEOs require a lower marketing budget than if they decide to go with an ICO. Moreover, token issuers can take advantage of the exchange’s stable customer base to receive more contributions to their projects.
As token listings are also “in the deal,” it is a natural process that the cryptocurrency exchange where the IEO is conducted lists the coin of the startup after the crowdsale is over.
While IEOs seem like a more secure and efficient alternative to ICOs, the costs associated with token sales can be high for startups. Listing fees can go as high as 20 BTC (~$288,000), while exchanges can even take a 10 percent cut from the tokens of the fundraising companies.
As IEOs are currently, relatively rare in the crypto community, it is not that hard to find one that you like. After you’ve found your IEO of choice, you need to find which exchanges are hosting the crowdsale.
The next step is to register an account on the cryptocurrency exchange and complete the KYC and AML verification process. After you are done with that, check out the cryptocurrencies you can use to contribute to the IEO, and fund your account with a coin that is accepted in the crowdsale. The last step is to wait until the IEO starts to buy your tokens.
ICOs created a fundraising boom in 2017 and 2018. However, a significant percentage of the crypto projects were operated by scammers or were of a dubious nature. Because of this, as well as ICO bans, we can say that this is not an efficient fundraising model for cryptocurrency startups.
On the other hand, IEOs provide an increased level of trust among cryptocurrency projects, because the exchanges hosting the crowdsales actively participate in the fundraising process, which improves the efficiency of the crowdsale. Therefore, IEOs have the potential of becoming the standard model for raising funds in the crypto space and maybe even creating the next fundraising boom.
The main reason for ICOs and IEOs is for companies to circumvent the cumbersome and relatively expensive course of going public through an IPO. The reason why this article is so important is, as mentioned previously, smart contracts are the cornerstone of the blockchain platform.
The blockchain will take over the financial world within the next ten years. The applications of smart contracts as well as the blockchain are far more practical than artificial intelligence. Moreover, the taxation of IEOs and ICOs are something we are all going to need to watch.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...