Blockchain-based offerings provide effective capital-raising platforms
INSIGHT ARTICLE |
Raising capital as an early stage company can be a daunting endeavor for any founder. Few early stage founders are able to get in a room with sources of capital, and only 0.05% of early stage businesses are able to raise money from venture capital firms. 1
But innovative technology platforms are creating new ways for companies to raise capital. The 2012Jumpstart Our Business Startups Act allowed crowdfunding platforms such as Kickstarter and Indiegogo to decentralize the capital-raising process. Companies like Oculus Rift, which raised over $2.4 million on Kickstarter, can now avoid traditional funding routes and raise millions of dollars online. 2
The advent of blockchain technology is helping to continue the evolution of capital raising by expanding the number of ways early stage start-ups can access funding. Initial coin offerings, security token offerings and initial exchange offerings are three blockchain-based ways companies can fulfill their funding needs. Collectively called blockchain-based offerings (BBOs), these new capital-raising mechanisms have helped companies raise a staggering $30.6 billion between 2017 and Q2 2019. 3
Types of BBOs
While their technical aspects differ, all three types of offerings raise capital through the issuance of a blockchain-based digital asset:
Initial coin offerings: ICOs are the oldest of the three offerings and were most popular during the start of the digital asset boom. Unlike traditional fundraising, which typically involves the sale of equity, companies conducting an ICO usually sell a type of digital asset called a utility token, which is not associated with any equity interest in the underlying company. A utility token is a digital product that can be used on an online platform to buy services or is received for providing services to the platform. Most early stage companies during the ICO boom sold utility tokens in order to fund development of their platforms, while a small number of startups used their ICOs as a means to promote the use of their already built platform. ICOs are conducted primarily through smart contracts, which handle the collection of capital and distribution of the new digital asset. Companies issuing utility tokens set a time window, say two weeks, during which investors can send digital currency, usually bitcoin or Ether (the cryptocurrency of the Ethereum network), to the smart contract. At the end of that two-week period, investors receive ICO tokens based on an exchange rate and the amount of digital currency they had invested. Since 2016, companies have raised close to $30 billion through ICOs. 4
Security token offerings: STOs differ from ICOs in that the offering is for the purchase of a security rather than a digital product. During an STO, companies offer investors equity interests or debt instruments in the form of digital tokens. 5 Additionally, some STOs provide digital assets that have other characteristics of securities, such as a right to a future percentage of revenue from a platform, rather than equity or debt. Since a company conducting an STO is issuing a security, regulators hold them to traditional securities laws. This includes requiring offering companies to perform anti-money laundering (AML) and know your customer (KYC) procedures and the ability to use regulated exemptions such as Regulation D, A and S. STOs are similar to ICOs in that they both use blockchain-powered digital assets as a way to represent and track value. Since 2017, STOs have helped companies raise over $685 million. 6
Initial exchange offerings: IEOs are the newest form of BBOs and have gained significant traction since 2019. Companies conducting IEOs sell utility tokens or securities through an online digital asset exchange, relying on these exchanges to act as counterparties and to manage the issuance of their tokens. When conducting an IEO, the issuing company sends its newly minted tokens to the exchange, which then manages the collection of funds from and distribution of tokens to investors. Digital asset exchanges have begun creating separate exchange services to manage these offerings. IEOs helped companies raise over $1.5 billion in 2019. 7 Depending on the offering, IEOs may require registration with the Securities and Exchange Commission. 8
In 2016, a particular decentralized autonomous organization (known as The DAO) conducted one of the first major ICOs in order to raise capital for an automated, decentralized investment portfolio. The concept was extremely popular, but due to its popularity attracted some bad actors who found a significant flaw in the ICO’s smart contract; the contract was hacked. The hack resulted in over $250 million worth of Ether being put at risk of theft. 9 Although The DAO hack occurred early in the advent of BBOs and the specific problem that led to it has since been resolved, operational risks still exist. Companies conducting BBOs make it extremely easy to learn about their offerings. Websites and chat groups are created to help answer any investor questions. Easy access to information also means that bad actors have no problem finding potential targets. A company’s social media and networking application accounts are favored points of abuse. Bad actors create fraudulent accounts pretending to be executives of the issuing company, instructing investors to send funds to wallet addresses controlled by the bad actors. Companies and investors alike must be vigilant and confirm the authenticity of instructions before taking action.
Many companies use smart contracts to automate their BBOs. Using a smart contract to automate an offering has dual risks. A bad actor could attack participants through deception, as noted above, or attack the smart contract itself. If a smart contract is improperly coded, investors’ money could be stolen or the contracts could be executed incorrectly, leaving funds stranded. Companies should use skilled coders, conduct code audits and create bug bounty programs that reward friendly hackers to ensure their contracts are properly coded. Finding an employee or third party with the right experience and requisite skills can be difficult.
Doing proper research on exchanges and wallet providers before hiring them is essential to creating a securely coded smart contract. Companies conducting IEOs rely on exchanges to manage capital collection and token distribution. When deciding on an exchange to work with, companies and investors should consider the reputation and security of the exchange before proceeding with an offering. Companies conducting offerings also need to carefully consider how the funds raised are stored. Ensuring strong, detailed internal controls that leverage segregation of duties specific to the unique wallet processes associated with blockchain technology is important. Offering companies may want to consider using an outsourced wallet provider that can assist with secure storage.
How to account for digital assets has become a much debated topic within the accounting community. Accounting regulatory bodies have been silent on the topic, leaving companies to attempt to apply the already established accounting framework to these digital assets. This is problematic because the current framework does not fit perfectly with the nature of most digital assets. Companies conducting traditional equity and debt offerings have less accounting uncertainty because they can rely on traditional security issuance guidance. Companies that are conducting BBOs, on the other hand, will need to carefully navigate the accounting considerations for their offerings, ensuring that the characteristics of their tokens are properly evaluated in context of accounting policies.
As the issuing company, one of the key considerations to understanding how to account for a BBO is to review the intended purpose of the issued digital asset. If the digital asset is a utility token, which is designed to be spent or received on the platform for goods or services, then there may be consideration for deferred revenue recognition as holders use their issued digital assets on the operating platform. If the issued digital asset is a security token that represents equity or debt, the accounting considerations are similar to a traditional debt or equity offering. Other considerations for understanding how to account for a BBO focus on the valuation and presentation and classification assertions. Important issues to consider are whether the characteristics of the issued tokens represent an intangible asset, financial instrument, cash or cash equivalent, or inventory. Are there are other identifiable risks to be disclosed, such as liquidity, theft or hacking? Additionally, it is important that the issuing entity give careful consideration to the development of a valuation policy that is consistently applied when valuing the issued digital assets on financial statements.
Although the American Institute of Certified Public Accountants published a nonauthoritative practice aid in December 2019—which states that under U.S. generally accepted accounting principles almost all forms of digital assets are intangible assets—the practice aid concludes that the accounting treatment will ultimately be driven by the specific terms, form, underlying rights and obligations of the digital asset. Due to the absence of authoritative guidance from accounting standard setters—and the challenges associated with applying existing accounting frameworks to the nature of digital assets—a company should exercise close scrutiny, detail and management review over its final conclusions.
Unlike the accounting regulatory bodies, the IRS has been more vocal about how they want individuals and companies to treat taxation of digital assets. In 2014, the IRS published Notice 2014-21, which stated that “For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency. 10 In October 2019, the IRS published Revenue Ruling 2019-24 and an updated FAQ on virtual currency transactions. The new guidance provided explanations on the taxation of hard forks and airdrops, and provided details on the accounting and calculation of gains and losses on virtual currency transactions. The updated guidance did not provide any particular details related to BBOs, but commentary in the FAQ section details the taxable impact of exchanging one virtual currency for another. Examining the established IRS standards governing the sale or transfer of property can help BBO participants gain some clarity around tax considerations.
To participate in a BBO, investors use digital assets, usually bitcoin or Ether, to make their investments. An offering company’s basis in the digital asset received is the fair market value of the assets on the date they were received. The receipt of digital assets may not be an immediately taxable event for the offering company, but rather deferred revenue if they are issuing a utility token. If the offering company subsequently sells the digital assets, a gain or loss would likely be recognized on the difference between the assets basis and the FMV at the time of sale. On the other side of a contribution, the investment of digital assets would likely create a tax liability for the investor. The IRS would likely treat the investor’s contribution of digital assets as a sale of those assets. Investors would recognize a gain or loss using the FMV of their digital asset at the time of their contribution. The FMV is used to calculate the investor’s cost basis in the new token.
When the contribution period has ended, the offering company issues its new token. If the offering is an ICO, the total value of the tokens issued could be presented on the company’s balance sheet as deferred revenue. As tokens are used, the company would begin to recognize that revenue. The recognized value of these tokens could be considered and taxed as ordinary income for the offering company. When the investor uses the token, the IRS could consider this to be the sale of property by the investor. Investors would have to record the gain or loss on the token as part of their taxable income.
The IRS would likely consider an investor’s virtual asset contribution during a BBO to be the sale of that virtual asset. While offering companies may choose to treat IEOs in a similar fashion, some questions still remain as to how investors should report the sale of a token issued through an STO. At the time of IRS Notice 2014-21, the concept of security tokens and STOs did not exist in practice. The continued language used by the IRS in both the notice and recent guidance updates seems to state that all tokens created through BBOs should be treated like property, regardless of what they represent.
Considering the uncertainty surrounding taxation of tokens representing debt and equity, an investor should consider taking the most conservative approach and treating these digital assets as property. Companies performing a BBO should consult the proper professionals to ensure they understand the tax outcome of conducting or participating in an offering. There are few things worse than an unexpected springtime tax bill.
A popular form of offering, not without risk
Early stage companies often struggle to raise the capital necessary to continue their operations. When early stage companies go out of business, the innovative ideas they are working on often do not get the opportunity to be tested in the market. It can be difficult to get an audience with venture capital and angel groups, and conducting an initial public offering is extremely expensive. Raising money at an early stage has become largely dependent on the founder’s existing network.
ICOs, STOs and IEOs are changing that dynamic. BBOs represent a new and innovative globally sourced solution that allows early stage companies to access the capital they so desperately need. BBOs also give investors a way to diversify portfolios through investments in companies to which they otherwise might not get exposure.
Investor demand for these new forms of offerings is clearly illustrated by the billions that have already been raised. 11 As BBOs may continue to grow in popularity, it is imperative that companies stay abreast of the operational, accounting and tax risks associated with these offerings. There is a significant amount of depth and complexity to these risks. Digital asset and blockchain regulation is in its infancy, with many questions yet to be answered. Although BBOs offer an innovative way to raise capital, companies should still be cognizant of the changing regulatory environment associated with their use and continue to monitor the demand and legal matters associated with them. Finding the right advisors to help navigate these murky waters can make or break an offering.
1 Wood, M. “Raising Capital for Startups: 8 Statistics that will Shock You.” (June 19, 2019) fundera.com.
2 Rubin, P. “The Inside Story of Oculus Rift and How Virtual Reality became Reality.” (May 20, 2014) wired.com.
3 Huillet, M. “Token Offerings Raised Twice More Than Blockchain Equity Deals in H1.” (Aug. 8, 2019) cointelegraph.com.
4 “Crypto Token Sales Market Statistics.” (Aug. 1, 2019) coinschedule.com/stats.
5 Curran, B. “What is an STO? A Complete Guide to Security Token Offerings.” (Sept. 25, 2019) blockonomi.com.
6 “Crypto Token Sales Market Statistics.” (Aug. 1, 2019 coinschedule.com/stats.
7 Sinha, S. “IEOs, ICOs, STOs, and Now IDOs – How to Raise Funds for Crypto in 2019?” (September 1, 2019) cointelegraph.com.
8 Pirus, B. “US SEC Warns Investors That IEOs May Be Breaking Securities Law” (January 14, 2020) cointelegraph.com.
9 Leising, M. “The Ether Thief.” (June 13, 2017) bloomberg.com.
10 IRS. “Notice 2014-21.” (March 25, 2014) irs.gov.
11 Coin Schedule. “Crypto Token Sales Market Statistics.” (Aug. 1, 2019) coinschedule.com.