BY ROBERT HOF From Silicon Angle

Initial coin offerings, a method of crowdfunding using cryptocurrencies such as bitcoin or custom coins or tokens, have exploded this year. A stunning $1.1 billion has been raised in 89 ICOs so far this year, 10 times as much as in all of 2016, and at least 110 more are planned this year.

But some of those ICOs have run into problems such as theft of the coins raised, and others are based on dubious legal grounds, thanks to a mostly unregulated environment. As a result, regulators from the United States to China are starting to impose new rules and even threaten crackdowns.

All that means that startups and other companies looking to do initial coin offerings need to prepare carefully before they jump into the fray. Among the many things they need to address are what the tokens they sell are for, how they’re going to market them and what pitfalls to watch out for to avoid running into lawsuits or regulatory issues down the road.

SiliconANGLE Media Chief Executive John Furrier sat down recently with Grant Fondo, a partner in the law firm Goodwin LLP, in the Palo Alto, California studio of SiliconANGLE Media’s theCUBE. Fondo, a former federal prosecutor who’s helping his firm advise companies in some two dozen ICOs, charted out the nitty-gritty process of doing an ICO from starting preparation with law firms and other service providers through how to sell and market the tokens to post-ICO tax issues.

For a primer on what ICOs are and under what circumstances they’re appropriate for a company, check out the first interview. Following is a lightly edited version of Part II of the Cube Conversation, providing a step-by-step guide to how to do an ICO:

The key issues
Furrier: I really want to walk through the playbook of the ICO process. Call this ICO 101. What’s the advice?

Fondo: The first question is: Where are you located? Where is the founding team? The threshold issue is whether they are in the U.S. or abroad. If they’re in the U.S., and they want to stay in the U.S. — and most don’t want to move, so they want to stay in the U.S. Okay, you’re going to be potentially subject to U.S. regulation.”

The next question is: Who is your target audience for the token sales? Are you looking to do accredited investors? Are you looking for U.S. people, are you looking for foreign, and who are those target people? The threshold issue is, as I mentioned before, are you looking for accredited or unaccredited investors? Most people would rather do unaccredited, because they believe in the democratization.

Furrier: And what’s the tradeoff between the two of those?

Fondo: The tradeoff is, if you really want to get a large market, you do the unaccredited route. And that means anybody can participate. With accredited, it’s much more limited, typically from 50 to 100 people, high-net worth individuals, there’s a paperwork process. Most of the token sales we’re seeing are unaccredited, although we’re seeing a trend now, too, that people are doing a hybrid of accredited U.S. investors and unaccredited foreign investors. It’s an interesting hybrid that we’re seeing.

We have many companies that say, “Well, what if we move our operations offshore? What if we open up a company in Switzerland or something like that?” And I think what they don’t realize is that if they are trying to seek U.S. money, or they are located in the U.S., or the money that they raise comes back to the U.S. in some way, that they’re going to be subject to U.S. regulations. So simply sticking something offshore doesn’t cut it from a regulatory perspective. And typically you set up different entities to raise the token sale.

Furrier: So do I have to stand a new company up, or subsidiary? What about a pre-existing companies?

Fondo: If you’re a Delaware corporate pre-existing company, sometimes we’ll set up a new entity, like a subsidiary. Sometimes just for typical corporate reasons it’s good to set up separate entities. The other issue, a threshold issue, is tax issues. We typically advise people to get sophisticated tax advice from CPAs, things like that. And that decision then becomes, do you set that entity up in a more tax-friendly venue than the United States? The British Virgin Islands and the Cayman Islands are two of the examples of where these people set these entities up for tax purposes.

Furrier: The tax thing seems like it would take time. Does that slow things down?

Fondo: It does. It has a couple components. It slows it down because there’s another player involved, you also have the potential transfer of assets and you have to figure out what are the assets that you’re going to trade, move from the Delaware corporation, for example, to the Cayman Island corporation? You also have obligations [such as] you have to go live in the Cayman Islands for a while, which is not a bad thing.

Furrier: My wife wants me out of the house, time to go to the Caymans.

Fondo: I had a client who said, “Alright, let’s set up in the hotel right next to the airport,” and I’m like, “If you’re in the Cayman Islands, go to the beach. Don’t stay at the airport.”

Tokens or securities?
Furrier: What’s next?

Fondo: The next step is related to that: What type of sale are you doing? Are you doing a token sale or a security sale? That’s a big threshold issue. Most of the sales are token sales. But is the token that you’re using going to give someone equity in the company? Are they going to get a percentage of the profits from the company? Are they going to be able to control some of the decisions of the company? If so, that looks more like a stock. And so, therefore, it’s deemed a security token. That is subject to SEC regulation, and there’s a different route.

Many people don’t go that route, but some do — for example, people in real estate transactions where they want to give investors a percentage of the real estate profits. They’ll go the accredited U.S. investor route. The other pivot is toward the utility token, like an arcade token. It’s basically a token that works in the platform, and people use it so that they can transact on your platform; they can play games, they can get content, they can encourage people to find bugs in your software.

Furrier: So, transactional-type value.

Fondo: Transactional, exactly.

Furrier: OK, you make that decision, now what?

Fondo: The next step is, you need to do a white paper. And you need to hire a law firm to help you with the white paper and all the legal steps. So then we’ll take a look at the white paper, and we’ll advise them on what their token looks like. If they’re trying to do the utility route, we’ll walk through the different language and things of that nature. We also try to clear it up, make it just a little bit more readable. And then, once they do the white paper, we also help them with the presale documents.

Oftentimes they’ll do two sales. [One] is called a “presale,” which is where you give an opportunity for significant purchase, people who you believe will be significant purchasers of tokens, and they’ll come in and they’ll buy a large amount of tokens, let’s say $100,000 in tokens, but at a significant discount from the price that will be for a regular token sale, maybe a 20 percent discount. You raise a certain amount of money, and then you do the sale, the token sale, about a month later, typically.

Furrier: What about allocation of tokens? That comes up a lot. So I’m also thinking, OK, is there a structure for X percentage for the development, X percentage to sell, to offer to the community or network, how many stay in the company. So how do you put the pie chart together, the distribution of tokens?

The big red flag
Fondo: One of the things you have to figure out is: Are you going to sell all your tokens right off the gate, except for some of the ones you keep, or do you envision later releasing tokens over time? Some of our token companies will release tokens over time to continue to provide tokens to the users. So you have to make that threshold decision. What you typically see is a percentage kept by the company, usually 15 to 20 percent, although I’ve seen companies up to 90 percent, and then you’ll see a bunch of the tokens issued to the market, and they will tell people through their white paper what they intend to use that money for.

Most of the time it’s for R&D and development of the platform, and continued maintenance of the platform, but also legal and administrative expenses for that company. One of the big issues that companies face is where are they in the development of that platform? Ideally, by the time they do the token sale, the platform exists and the tokens can be used immediately. If you’re building a platform, and you’ve already got it up and running, that looks more like utility token. If it’s going to be a year or two before that platform’s available for use, the SEC may say that looks more like a security.

Furrier: And a lot of people get flagged in ICOs where it’s like, “We’re going to see something in late 2018.” And so they hope to raise money through the tokens to do development. And it can be like a Kickstarter kind of model there. But it can be scrutinized.

Fondo: The SEC gave some guidance a couple weeks ago. Especially going forward, companies, if they can, are better off having a platform up and running by the time they issue the tokens.

Furrier: OK, great, I’m rockin’ and rollin’, now I got to do some blocking and tackling. I need a white paper, I’ve got to have a website, what are the minimum viable elements that need to be in market for an ICO?

Fondo: Not every company is a super-sophisticated smart contract company. And so they’ll often hire vendors to do the smart contracts to set up the token sales. Those companies will also assist with the white paper, just like we do, but their primary platform, or purpose, is to help launch the smart contracts.

You’ll also have marketing companies that will assist with marketing the token sales, so that more of the community knows about your business, and that there’s a platform out there and that hopefully that’s a platform that you want to use tokens on, and so that’s another component. And then, also, the tax advice that I mentioned before.

Off to the Caymans
Furrier: Now I have my tax hat on. Bring in Deloitte, bring in tax guys. What are they talking about? How does that impact the process?

Fondo: Anytime that you bring more players in, it obviously delays things. But they’re important players. All these are important players. And part of what you want to do is you want to bring them in early, versus waiting, because the tax implications are significant. It takes time to set up foreign entities, it takes time to go live in the Cayman Islands, not the worst time, but it takes time.

Furrier: What duration in the Cayman Islands would someone have to live?

Fondo: I’m not an expert on that, but you’re going to spend a couple weeks there, for sure, if not longer, and you’re going to have to stay there through the token sale.

Furrier: Does the boat get paid for as part of the token sale?

Fondo: I’ll leave it up to you on how you decide to spend that money.

Furrier: How does the location impact the process? Is it a tax issue, or is it just comfort?

Fondo: If you do it in the U.S., you can still have your operations here, and essentially you can have some people here, but the primary wallet, essentially — the entity receiving the money — would be in the Cayman Islands. Some companies decide the tax issues are not significant enough that I want to deal with setting up a Cayman operation, and deal with the U.S. tax issues. And so that’s just a business decision.

Furrier: Because the tokens are viewed as income?

Fondo: It would be viewed as a revenue for the company.

Furrier: Does that mean if a corporation wants to buy tokens, that’s an expense?

Fondo: We haven’t had that question asked, and I’m not a tax expert, but yes, I think it would be an expense.

Digital robbery
Furrier: It’s time for the ICO. What happens next? Do I ring a bell? Is it a digital bell? What happens?

Fondo: It’s kind of fun. Most companies, what they do is they put a countdown to when the ICO is about to start, and they usually give a window. And it’s typically a two-component thing. One is, if we raise X, so let’s just pick a number, $30 million. It’s a $30 million X amount of tokens we sold, the token sale will stop at that point. And/or a time limit, so let’s say we’ll have a two-week token sale.

And so, you’ll have the timeline, and they’ll actually register for you on their website how much they’ve raised, how many tokens have been sold, as well as where they are in that timeline. And then the timeline ends either through one of those two mechanisms, and then the token sale is closed.

Furrier: What about protecting the tokens? Because there have been stories that someone raised $34 million and lost it all. They’ve basically been robbed, digitally, by hackers. Who do you call, then? The Better Coin Bureau?

Fondo: We’ve dealt with that issue, and we can give advice when that happens, but it’s a tough issue. Obviously you notify the FBI….

Furrier: It’s a fatal flaw.

Fondo: It’s a real problem. Typically they are people abroad. So you have to assume it’s gone. One of the immediate things we talk about is security. And some of it is very basic security. If you are receiving all these Ethereum or Bitcoin, set up a bunch of different wallets. If you’re going to lose money, it’s better to lose one out of 10 wallets, or one out of 20 wallets, versus one wallet with all your money there. So some of that is just prudent, in a sense, but I also think you really need to make sure. That’s part of why you bring some experts in. If you don’t have that inside expertise, it’s going to make it extraordinarily insecure.

Furrier: You sprinkle it around, it’s like digging a hole, or putting mattresses all over your house. But how do I vet the service providers?

Fondo: Part of it is just word of mouth. People get referrals, they look for who has done other ICOs. Part of it’s reputational. Some of it, too, is when you talk to people, you can figure out, do they really know what they’re talking about? Hopefully you have some IT security people on your team who can really vet these providers. You’re betting a lot on it, so it’s a really important decision.

Furrier: Now the ICO is completed, everyone’s high-fiving, the clock is ticking. What’s the post-ICO consideration?

Fondo: One of the issues is the money: What do you do with it? There is a pre- and post-token sale issue: Do you provide employees, or founders, with tokens? The consensus now is that the more you provide tokens for employees and founders, the more it looks like securities. There’s a tendency for people, like advisers who come into the company, to provide them tokens. I think there’s a risk that if you do that, it looks more like securities. You have to continue to remember that that’s a utility token, not a security token.

As far as the money goes and what you want to use it for, you have to keep consistent with your mission. So it’s just like crowdfunding. If you ask people to donate money to an idea, you can’t change that idea. And if you do change that idea, you need to let them know about it. You have to be very transparent. There’s no such thing as “free money,” and I believe that one of the risks with the post-token sales is that some of these companies are not going to make it. Pretend, in a sense, that it’s truly your money, and every dollar that you spend is your own dollar. You want to use it wisely, and you never want to be embarrassed or ashamed or concerned about how you spent that money.

Like playing a video game
Furrier: As long as it’s not buying a boat or having a, like on Silicon Valley, renting out Treasure Island and having a big party. Use it wisely, and to the mission of the firm.

I get the utility token. That creates value for the currency, you’re not selling the appreciation as an investment, it’s a transactional component of a smart network with smart contracts, and values the creation and distribution of that value. But if a company wants to do that, they can still have an equity plan, I assume, because you have to assume that that utility is contributing to the value of the overall enterprise itself. That’s where the employees would get the stock options in a normal stock option plan.

Fondo: Yeah, it’s just like any other company. When you raise money, you still have equity. So I think they are generally Delaware corporations that stick with the standard structure. You can give options in the company. There’s no concerns with that.

Furrier: What else, post-ICO? Cross your fingers and hope you can use the development cash?

Fondo: Be careful how you talk about the token sales … throughout the process from the beginning. Don’t talk about, “We’re going to try to increase the value of the tokens.” Remember, the token is a utility token. It’s an arcade token. It’s not a security.

Furrier: It’s like playing a video game. Pinball Wizard. You pump it in, play your game and people get value out of that.

Fondo: That’s fine. But you don’t want to encourage people to continue to trade and buy the token for the purpose of (hoping) it’s going to go up in value, and not use the platform.

Furrier: Even though everyone’s doing that.

Fondo: There’s some truth to that. That’s the elephant in the room. But there are different ways to do that. As you build your community, as you talk about it and you’re excited about your company, and people are. It’s a great, it’s a fantastic tool, and what’s really been fun about it is you’re seeing these companies that hadn’t thought about the blockchain and utility tokens and say, “Wow, this is such a great mechanism to build this huge community, and have all these people participate through these tokens.”

Setting aside the fundraising aspect of it, it’s a great mechanism to do this, the democratization of my platform. And I can reach internationally. So focus on that. Don’t focus on the value of the token.

There’s another issue, which is putting them up on exchanges, particularly pre-token sale. I think you need to think twice about trying to connect with an exchange and sticking your tokens up on an exchange.

Furrier: Why?

Fondo: Because it sounds like security again. It sounds like you’re trying to develop this market for more people to buy this token to go up in value. Now, it’s okay to provide a platform, just like the arcade owner, it’s okay if that arcade owner thinks that other people can sell his token for him, or her token for him, that’s fine, but you got to be really careful about how you do it.

No shortcuts
Furrier: There’s the Brave browser, which is obviously a utility, it has BAT [Basic Attention Tokens]. They’re listed, I believe.

Fondo: You can list. I think it’s just a risk. You don’t want to say, “We’re listing our tokens and trying to encourage people to buy the tokens.”

Furrier: So it’s optics. It’s how you position it.

Fondo: The optics are important.

Furrier: What’s all this going to cost and how long will it take? Is it going to cost a million dollars or $20,000? How do you engage on fees, and then what’s the process timeframe?

Fondo: The process depends in part of the company. How far along are they on the white paper, how far along are they on the platform? But setting aside that issue, and more from the legal technical adviser, it generally takes two to three months. We’re seeing some that are longer. It takes time to put the white paper together, and we proof[read] it and give advice, and then I’ll also have some of the other advisers give advice on it. It does take time to set up the tax structure, so if you’re doing the Cayman Islands, that’s probably a two- to three-month process for sure. It also depends on how much IP you transfer as well, so that can slow things down.

Furrier: It’s like standard legal stuff. There’s no fast track. There’s no shortcuts.

Fondo: There’s no shortcuts. You’re bringing in an initial consultant, so it takes time to negotiate.

Furrier: The No. 1 question here today for you is: Who’s going to pay for this hour?

Fondo: You’ll get my bill.

IMAGES:

Goodwin partner Grant Fondo (Photo: SiliconANGLE)

The Cayman Islands offer tax advantages for ICOs (Photo: BobSpicer/Pixabay)