Legal, Startup Advice

Everything you need to know before you do an ICO

John Bassilios /

ICO

Special counsel at Hall & Wilcox John Bassilios. Source: Supplied.

Initial coin offerings (ICOs) offer another avenue for startups to raise funds aside from more traditional methods such as IPOs, venture capital and crowdfunding. Yet ICOs are unlike any other form of fundraising, and this still-evolving area currently brings many quirks and regulatory issues to negotiate.

ICOs use blockchain, a distributed immutable ledger, as a single source of truth. It is more transparent, highly secure and difficult to hack. It’s decentralised, which is more efficient, able to provide faster transactions and cost savings.

Blockchain technology provides an almost unparalleled opportunity to access large numbers of potential investors from all over the world, while also introducing complexities regarding how the ICO is defined and regulated across markets.

A popular myth has taken hold which suggests financial regulations don’t apply. Make no mistake, financial regulations are likely to apply to ICOs, and it’s essential any startup knows exactly which regulations apply to them.

This needs to be done early, as mistakes made when creating the foundations for an ICO can come back to haunt.

Here are the main issues startups need to know before taking serious steps to commence an ICO.

Regulatory risk

There are complexities around ICOs, and whether tokens are financial products, pre-payment for a good or service or commodities. It’s important to get advice to know where you sit.

Firstly, understand ICOs differ from crowdfunding, which is heavily regulated and follows strict rules in Australia. ICOs can potentially be offered to a much wider pool of potential acquirers and are not generally constrained by geographic boundaries. There are no caps on the maximum amount of funds raised, whereas crowdfunding has caps.

There is also regulatory risk regarding different jurisdictions. A common misconception is you can, for example, set up a blockchain company in Malta and avoid Australian law, but this is not the case. It doesn’t matter if the company is based in Malta, or Iceland or Singapore, if it is marketed to Australians it must comply with Australian law.

Within Australia, ICOs are subject to Australian Consumer Law, where the tokens issued are not classed as financial products. If the tokens issued are classed as financial products, the ICO is subject to the Corporations Act 2001 and the Australian Securities and Investments Commission Act 2001.

Ambiguity around definitions

There is currently much scope for confusion under existing frameworks about whether an ICO token is a financial product, or whether it is a utility token. (A utility token is an online currency allowing you to buy goods and services.)

An ICO as financial product will fall within established financial services and securities laws. This may require issuers to comply with obligations as they might apply to those undertaking an IPO, the sale of an options contract, or the sale of units in a managed fund. This may involve detailed disclosure documents, complete independent audits, the need to hold certain licences, to submit specific reports to regulators and comply with a range of financial services provisions.

If a token grants the holder an equity interest, a right to expected future cashflow, or where its value is linked to the performance of a real or financial asset, then it will be considered a financial service.

There are times when the distinction between a financial services token and utility token is not so straightforward. For example, if the digital token performs multiple functions at different times during the project lifecycle. Startups also need to be careful about any ambiguity relating to the digital token and its attached rights and obligations, the project or company to which it is attached.

Current regulations for utility tokens are unclear because, currently, utility tokens may come under the managed investment scheme regime, which is an entirely inappropriate regulatory regime for utility tokens.

Understand privacy concerns

Blockchain can reveal significant information about people’s profiles, allowing for re-personalisation of pseudonymous data. Once stored on the ledger it cannot be erased, which could seriously affect the privacy of individuals.

Startups need to understand how personal information will be used and disclosed, and which privacy regulations you fall under. Australia has the Privacy Act, but other jurisdictions will introduce other complexities. For example, the EU’s GDPR regime can be challenging.

Valuation issues

ICOs provide high transparency and security, but there may still be challenges in valuing a business. Token prices may exhibit high volatility, and tokens may be listed at different prices on different exchanges.

Tax issues

ICO arrangements may be structured in several ways, which means there is no single manner in which ICO proceeds are taxed. There are a huge range of possible tax outcomes, and it’s essential any startup understands the tax implications before they commit to a specific structure.

NOW READ: Australian blockchain startup Loki registers as charity after staring down million-dollar tax bill

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John Bassilios

John a special counsel at Hall & Wilcox, practising in corporate and commercial law, with a particular specialisation in financial services, funds management, startups, fintech companies, blockchain and cryptocurrency. John is also a mentor for the RMIT blockchain strategy course.

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