ICOs: The Wild West of fundraising

Trucking companies may be tempted to raise quick funds through an initial coin offering, but there is large risk as well

For decades, companies that needed to raise cash had just a couple of options: If they were a private company, they could seek out investors, who often received a share of the company in return. If they were a publicly held company, they could sell more stock. For companies just starting out, that meant an IPO – initial public offering.

Thanks to technology, though, there is a new option that companies are flocking to: an ICO – initial coin offering. SLOGN, which stands for Smarts Logistics Network, was one of the first in the transportation space to attempt an ICO, but the world into which it stepped is really the Wild West of fundraising right now.

SLOGN says it is building an open-source platform for decentralized logistics using blockchain and artificial intelligence. However, according to the SLOGN Pre-ICO page, the company says it did not raise the required funds and gave instructions for returning the ether – or the “coin” used by participants to invest.

“Thank you for participation in our pre-ICO and interest to the project,” the note said. “We received many inquiries for business partnerships, software development and media coverage and are going to proceed with the project implementation and deployment in the U.S trucking industry. We anticipate to run the ICO in the future.”

In fact, according to its ICO page, the company only attracted 150 transactions. So clearly, at least in the transportation space, the interest in ICOs may not be there yet. However, many other companies have found success issuing ICOs, so it’s like that SLOGN won’t be the last technology firm in the transportation space to try and ICO.

ICO’s may seem like an attractive option to quickly raise funds – especially for a small trucking startup or an established company looking for funding to build new technologies – but right now, they may be fraught with more risk exposure than most companies are willing to digest.

So, what is an ICO and can it help companies in the trucking and logistics space? Understanding how an ICO works is critical, but it’s also important to note that they are generating plenty of legal questions and significant regulatory interest, even requiring the Securities and Exchange Commission to issue a warning to companies considering an ICO.

First, before U.S. companies and investors get too excited, it’s important to note that in general, U.S. residents are not allowed to invest in an ICO. There are ways around this, of course, but even SLOGN’s Pre-ICO page noted that the coins were not available in the U.S. and a handful of other nations.

What is an ICO?

ICOs are born out of the world of bitcoin. Since bitcoin debuted as a cryptocurrency residing on a blockchain, dozens of other cryptocurrencies have arrived. Cryptocurrencies are the equivalent of electronic money. A single bitcoin, for instance, was worth more than $2,000 earlier this year.

According to an explanation of an ICO by TechCrunch, “an ICO is a fundraising tool that trades future cryptocoins in exchange for cryptocurrencies of immediate, liquid value.”

What does that mean? For starters, an ICO – sometimes referred to as a “token sale” – is unlike a traditional IPO, where an investor buys shares of stock that give him a piece of the company. The token that is purchased in an ICO has no stake in the company, instead, investors are hoping that the value of the token itself increases and/or the company issues something in return, such as a product or exclusive content.

The Economist explains an ICO this way:

“Today most issuers simply write a ‘smart contract’ on Ethereum, a …blockchain,” the publication writes. “This piece of code then automatically creates tokens when it receives ‘ether,’ the coin of the Ethereum realm. Issuers typically publish a ‘white paper’ (a prospectus of sorts) and market their undertaking on social media.”

How does it work?

The Economist goes to cite the example of a company called Back to Earth, which launched an ICO on April 26. The company wanted to raise 750 bitcoin, which is equivalent to close to $1 million, through the selling of “StarCredits.” Investors who bought the StarCredits would receive a “Golden Ticket” giving them access to special content and future StarCredits.

So the investors are, in essence, getting access to a service or product by helping the company build that service or product.

“Token holders are effectively prepaying for a product or service,” Stan Miroshnik, who runs Argon Group, a digital finance-focused investment bank, told TechCrunch. “If I run a video game company, for example, I can sell you tokens that represent in-game purchases once the game is built. If you know you’ll buy swords and shields and things like that, you can just pay for them now. It helps me develop the game and gives me more capital to do it, and you benefit from the currency becoming more valuable over time, because there’s a finite amount of it issued.”

Is it safe?

One of the concerns surrounding ICOs is that they are mostly unregulated, leading to the opportunity for companies to issue an ICO and never deliver on the promise. That is starting to become more difficult as the market matures, Matt Chwierut of Smith+Crown, told the Economist. More ICOs are now using escrow accounts to hold the money, providing some additional levels of trust, but it is still not a widespread practice.

Ninety-nine percent of these ICOs will be garbage. It’s like penny stocks but with less regulation.

— Jeff Garzik, publisher of Bloq

Some companies are falling in love with ICOs. Fortune magazine reports that cryptocurrencies have a current worldwide value of over $100 billion, growing more than ninefold in the past 12 months and there have been 30 companies so far this year that have completed ICOs, raising more than $540 million.

Lawyers and regulators, though, are not feeling that same love. Because ICOs are unregulated, there are few legal requirements for them, unlike IPOs, which must pass plenty of regulatory checkpoints to receive Security & Exchange Commission approval.

Jeff Garzik, who runs Bloq, tells Fortune that “ninety-nine percent of these ICOs will be garbage. It’s like penny stocks but with less regulation.”

Still, there are some investment firms that are starting to advise their clients that ICOs hold potential as funding sources.

Marco Santori, a digital currency lawyer with the firm Cooley, told Fortune that future ICOs will change because of possible regulation. He adds that if regulators determine that tokens are the equivalent of securities, the SEC and IRS would be involved and investors will have more legal recourse for companies that don’t deliver to their investors.

In fact, just this week, the SEC issued a statement regarding ICOs.

“Lawyers are relying on case law that defines what a security is,” Miroshnik explained to TechCrunch. “The most well-known case is the ‘Howey Test,’ created by the Supreme Court for determining whether certain transactions qualify as investment contracts. If they do, then those transactions are considered securities and are subject to certain disclosure and registration requirements. When tokens are structured basically as the sale of a service or product, they’re designed to make sure the various prongs of the test are not triggered.”

The SEC issued an advisory release, if you will, following its investigation of DAO, which was a digital decentralized autonomous organization. DAO had no formal management and was run completely autonomously. It was written by open-source code and used the Ethereum blockchain. In May 2016, DAO ran an ICO, setting a record for the most raised in a crowdfunded campaign at that time. It was valued at over $150 million, raised from some 11,000 investors.

But, some users exploited a vulnerability in the DAO code and siphoned off nearly one-third of the funds into a subsidiary account.

The SEC investigation led to it issuing the report “cautioning market participants that offers and sales of digital assets by ‘virtual’ organizations are subject to the requirements of the federal securities laws.”

“Whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction,” the SEC added.

SEC found that the tokens offered by DAO were in fact securities and therefore subject to federal securities laws. “The report confirms that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies.”

SEC’s advisory also seems to lean heavily on encouraging investors to stay away from ICOs.

“Investors need the essential facts behind any investment opportunity so they can make fully informed decisions, and today’s report confirms that sponsors of offerings conducted through the use of distributed ledger or blockchain technology must comply with the securities laws,”  William Hinman, director of the Division of Corporation Finance, said.

“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,” Stephanie Avakian, co-director of the SEC’s Enforcement Division, added.  

So for now, the Wild West of investing remains a buyer-beware environment.

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Brian Straight

Brian Straight covers general transportation news and leads the editorial team as Managing Editor. A journalism graduate of the University of Rhode Island, he has covered everything from a presidential election, to professional sports and Little League baseball, and for more than 10 years has covered trucking and logistics. Before joining FreightWaves, he was previously responsible for the editorial quality and production of Fleet Owner magazine and Brian lives in Connecticut with his wife and two kids and spends his time coaching his son’s baseball team, golfing with his daughter, and pursuing his never-ending quest to become a professional bowler.