When Stewart Dennis was looking to raise a new round of equity financing for his company BitBounce this year, he found himself in what many entrepreneurs would call an enviable position.

He was meeting with Sequoia Capital and other top-tier venture capital firms, and a prior investor, the billionaire Tim Draper, had already agreed to take part.

Then he met Arthur and Kathleen Breitman, the creators of Tezos, a new blockchain network that recently raised a staggering $232 million ahead of its upcoming launch. They got to talking, and a new option presented itself.

"The technology is raw and the security issues are nontrivial," Balaji Srinivasan, a board partner at the venture capital firm Andreessen Horowitz, cautions about ICOs, though he's bullish on them.
Eyes wide open
"The technology is raw and the security issues are nontrivial," Balaji Srinivasan, a board partner at the venture capital firm Andreessen Horowitz, cautions about ICOs, though he's bullish on them.

On July 26, when Dennis began raising funds for his cryptocurrency-powered solution to email spam, he bypassed Silicon Valley — except for Draper — and turned instead to the crowdfunding method Tezos used: an initial coin offering. His goal is to raise $20 million by selling blockchain tokens over the internet to an untold number of investors.

Crazy as that sounds, he isn't the only entrepreneur cherishing such hopes. Dozens of so-called ICOs have been completed already this year, and dozens more are on the horizon.

The idea is that investors can partake of whatever protocol, platform or service is being built by buying the token associated with it. Unlike venture capital, which is typically locked up for years, tokens become liquid almost immediately, trading on web-based exchanges.

Token offerings signal a sea change in the way that blockchain startups and software protocols are being financed. Beyond upsetting the balance of the investor ecosystem, though, this new funding model, and the projects taking advantage of it, may herald the dawn of something even more radical: a decentralized internet powered by applications that blur the line between owners and users.

Inevitably, some observers are calling it an overheated market. Some are even comparing it to the dot-com bubble of the early 2000s. Most distressing to traditional investors, and even to early adopters of bitcoin, is the fact that some token projects have raised millions of dollars on the basis of little more than a white paper and a website.

The Securities and Exchange Commission recently raised the barrier to entry for American entrepreneurs and investors, and risks putting the kibosh on such innovation altogether. But many observers and participants still believe that blockchain tokens — distinct from true cryptocurrencies in their method of issuance and other aspects — will be the future of finance.

Eyes wide open"The technology is raw and the security issues are nontrivial," Balaji Srinivasan, a board partner at the venture capital firm Andreessen Horowitz, cautions about ICOs, though he's bullish on them.At bottom, the ICO model has caught fire because it has a number of advantages over old methods of raising capital. Until recently, companies looking to grow were limited to bootstrapping, borrowing money or selling equity to investors. All of those options are burdensome.

"If we take on debt, then that's something we have an obligation to pay back. If we give away equity, then we dilute our existing shareholders and, as an entrepreneur, you lose both ownership and control of the company," said Dennis.

Token sales, by contrast, are nondilutive. While tokens may act like a weird hybrid of securities and currencies, they don't typically grant their owners voting rights in any company. Instead they allow investors to grab a piece of internet protocols and platforms built on open-source code.

For those who believe the future of the internet and the global economy lies not with behemoths such as Facebook and Google but with scrappy decentralized services, the prospect is exciting.

Token projects "can scale much faster than normal startups," said Balaji Srinivasan, a board partner at the venture capital firm Andreessen Horowitz. "To become a Googler, you need to pass a centralized interview process. To become a token holder, you can just acquire a token on an exchange… . It may allow many more talented people to get behind a winning project more rapidly."

A thousand flowers bloom

The array of new ventures capitalizing on the ICO boom is dizzying.

There is Golem, intended to be a decentralized marketplace for computation, where users can pay in tokens to rent other people's unused processing power. There is Dennis's BitBounce, which fights email spam. Any senders who aren't on a BitBounce user's whitelist of accepted correspondents will get an auto-response inviting them to pay the recipient a fee — in bitcoin or the company's Credo token — in order for their emails to go through. The default fee is $0.05, of which 70% goes to the user, but users can set it lower or higher if they wish.

Dennis points out that spam costs the global economy an estimated $20 billion a year. "The more consumers we have adopt our spam filter, the more compelling our argument is for marketers, because more of their emails are being BitBounced and aren't going through to the end user," he said.

Anthem Blanchard, the entrepreneur behind the gold-backed cryptocurrency Anthem, is preparing an ICO for a "supply-chain verification token" called Hercules. Its first use will be for his company to verify the existence and location of its physical gold, which is stored in a bunker in Texas. From there, Blanchard hopes to expand its use to other companies needing to do supply-chain management.

"The total available market is any interchangeable physical good," he said.

Using blockchain technology, entrepreneurs could create decentralized versions of Facebook, Ticketmaster, LiveNation and other platforms, their value shared among token holders worldwide. Some are already being developed.

Ultimately, the existence of tokens as a class of liquid digital assets with monetary value could enable a host of new economic interactions not possible today.

Greg Murphy, a partner at Outlier Capital, said recently at an event hosted by the New York law firm Morrison & Foerster that he envisions a future blockchain system connecting electricity producers and consumers, so that communities can sell energy without energy companies as middlemen. Someone with solar panels on her roof could get paid in tokens for whatever surplus energy she doesn't need for her own personal use.

An overheated market?

As a way of funding blockchain startups, ICOs have far outstripped venture capital this year. Crowdsales for Tezos and other token projects have raised $1.3 billion so far in 2017, a more than sixfold increase over the total raised in all of last year, according to Autonomous Research.

"That to me was epic," Blanchard said of the moment this spring when it became clear that ICOs had "blown past" venture capital as a means of raising funds for blockchain startups.

It isn't just the amounts raised that are soaring. There were 80 token sales in the first half of 2017, an average of more than three per week — well above the 2016 total of 69 ICOs, according to research firm Smith + Crown.

But not all of those tokens will prove to be winners.

Jeremy Gardner, co-founder of Augur, a token-powered prediction market that is set to launch in late summer, tweeted recently, "Most #ICOs I have seen wouldn't get venture capital money in a million years. Think about that when the next sale raises tens of millions."

Gardner should know. Augur held one of the first ICOs, raising a little more than $5 million through the sale of its REP tokens in September 2015 — a time when, as Gardner recalls, the price of bitcoin was only about $250 and Ether was a mere $0.90. He now works at Blockchain Capital, a San Francisco venture capital firm that raised $10 million of its new fund through its own token sale this past April.

"If we take on debt, then that's something we have an obligation to pay back. If we give away equity, then we dilute our existing shareholders," says Stewart Dennis, founder of BitBounce. Token sales, by contrast, are nondilutive.
Why ICO?
"If we take on debt, then that's something we have an obligation to pay back. If we give away equity, then we dilute our existing shareholders," says Stewart Dennis, founder of BitBounce. Token sales, by contrast, are nondilutive.

Blockchain Capital's Jeremy Gardner said he receives on average three ICO proposals a day. The day after the SEC released its guidance, he received three times that number.Concerns like Gardner's increased in number and volume as the cryptocurrency market exploded this spring. Some bitcoin diehards, while convinced that digital currency is a beneficial technology, are skeptical of tokens. It can be difficult for the unschooled to separate a promising project from fairy dust.

Not that that buys them any sympathy from certain crypto-enthusiasts.

Michael Goldstein, a longtime bitcoiner and president of the Satoshi Nakamoto Institute, routinely mocks the whole notion of application-specific tokens. He issued a PSA in June: "To anyone investing in [bitcoin knockoffs] and ICOs, just remember that I warned you in 2014: ‘Everyone's A Scammer.’”

"If you get [wrecked] by ... appcoins, ICOs or any other masturbatory crypto-scams, you deserve zero sympathy," he added. "You only had to listen."

But others who have long been bullish on bitcoin, such as Srinivasan and Draper, are enthusiastic about tokens, too.

"Token offerings allow entrepreneurs a new way to transform society," Draper said in a press release for his investment in BitBounce's Credo token. "They are doing everything from banking the unbanked to streamlining how people transact business to helping secure people's identities."

BitBounce's Dennis says Draper bought 10% of all Credo tokens prior to the ICO, having negotiated a discount on the ICO price. The total number of Credo tokens that will ever exist is 1.37 billion.

Even Gardner admitted in a later tweet that he was "super excited for the ICOs that do make sense" and provided a short list of upcoming token sales in which he plans to participate.

Regulation blues

Into this gold rush on July 25 came the Securities and Exchange Commission.

In an investigative report, the agency made it clear that some tokens are securities and will need to register as such. American retail investors would be barred from participating in the ICOs for such tokens. If they aren't, offerings of such tokens will be in violation of federal law.

So much for the boundless frontier, then. The SEC singled out the DAO, a decentralized investment fund that launched on the Ethereum network, as a bad actor. The DAO's crowdsale in 2016 constituted a sale of unregistered securities, according to the SEC.

While the agency declined to punish the DAO's creators, it cited the need to protect investors from scams and snake-oil salesmen, no matter what technologies they use.

Experts' reactions to the SEC report ran the gamut. While some were relatively unfazed, saying the guidance wouldn't change what smart entrepreneurs were already doing, others treated the July 25 bombshell as a game-changer.

"The pipeline for ICOs just got a lot smaller," said Arnold Spencer, general counsel for the bitcoin ATM network Coinsource.

While the July 25 report wasn't breaking any new legal ground, he added, it was a major turning point.

"Issuers will have to choose between the expensive process of registering with U.S. authorities or forgoing U.S. capital markets," he said. "The era of quick ICOs in the United States based on an investment concept, and not based on a new functionality concept, is officially closed."

The SEC's report also indicated the agency's willingness to crack down on the online exchanges that support token trading. Exchanges will be required either to drop any token that could be considered a security or to bar U.S. users from their platforms, unless they go through the expensive process of registering as national securities exchanges.

Otherwise, if they facilitate even a single trade of a tokenized security, they could be found in violation of U.S. law.

"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, said in a press release.

But the SEC left open the question of which tokens it will consider securities and which it will not. While some fear the agency will employ a broad definition, others think many tokens will be exempt.

Carol van Cleef, a partner at the law firm BakerHostetler, said she wasn't surprised by the SEC's announcement and that it "definitely does not mark the end of the road for tokenizations. In fact it should have a very positive effect on the token market. It removes much uncertainty in the market and clarifies that the SEC will not consider all tokens to be securities."

"It is very consistent with the advice we have been providing to clients," van Cleef added.

What seems clear, then, is that anyone issuing a token solely to raise money for a startup will have to comply with federal securities laws, which means average U.S. citizens won't be able to participate in the ICO. It also means that Wall Street jocks of the type who previously bragged to this reporter that there were no such things as insider-trading laws for blockchain tokens — a fact they exploited to reap profits — have been put on notice.

Entrepreneurs who instead are issuing tokens with real utility, such as Augur's, which is meant to power a crowdsourced prediction market that is set to launch this summer, should be exempt from securities laws, van Cleef said.

Crowdfunded projects such as Tezos, which intend to launch a brand-new blockchain network, just as Ethereum did, should also be in the clear. (The Commodity Futures Trading Commission ruled some time ago that cryptocurrencies such as bitcoin and ether are commodities.)

Some in the cryptocurrency world have asserted that if the SEC takes a too-broad approach to its regulation of tokens, innovators will simply go abandon the U.S., engaging in a kind of regulatory arbitrage.

Marco Santori, a partner and head of the blockchain practice at the New York law firm Cooley, threw cold water on that hope. He predicts that securities regulators in other major countries will follow the SEC's lead in their approach to tokens.

Srinivasan, of Andreessen Horowitz, nevertheless argues that "smart regulators will mimic the examples of places like Singapore and Switzerland, which are doing their best to attract highly mobile blockchain talent and investment."

While it seems clear the SEC intends to rein in the worst excesses of the ICO boom, it remains to be seen whether the agency's guidance will really slow the pace of new project launches. Early signs indicate that many token creators are forging ahead.

Blockchain Capital's Gardner said he receives on average three ICO proposals a day. But on Wednesday, the day after the SEC released its guidance, he received three times that number. Although he and other insiders had long expected SEC action, and he said that Tuesday's report "changes nothing," he was still shocked that so many entrepreneurs weren't even taking a beat to study its implications.

The future of funding

Talk to token entrepreneurs and investors and you may come away convinced, as they are, that ICOs represent the future of finance.

One of these is Sasha Ivanov, the founder of Waves, a blockchain platform being used, like Ethereum, to launch new tokens. Within five to 10 years, he predicts, the legal issues will be solved and securities laws will have been changed to accommodate this emerging technology. (Waves raised about $16 million in its own crowdsale in 2016.)

Indeed, the SEC's decision not to bring charges against the DAO or to classify all tokens as securities, released less than a week after Ivanov's comments, gives some credence to his view.

Waves has already helped a factory and a farm in Russia to launch ICOs. Unlike Ethereum, which has attracted mainly software projects, Waves is being used by "real businesses," Ivanov said.

The ICO funding model, he said, "won't go away. The sooner [regulators] realize that, the better."

As frothy as token markets have been this year, the real boom may lie ahead.

For now, people invest in ICOs by sending bitcoin or ether to specified addresses. The floodgates will truly open, said Ivanov, "when people realize they can invest with normal money."

In other words, we ain't seen nothing yet — though Srinivasan cautions that it will take some time to get there.

"The technology is raw and the security issues are nontrivial," he said.

Indeed, more than one token project has had its ICO disrupted by hackers or been the victim of theft.

In July, a project called CoinDash was forced to halt its token sale after it was discovered that the Ethereum address to which investors were sending funds had been swapped for another address, which meant that somebody else was scooping up investors' digital currency. CoinDash said it would still provide all participants in the sale with their allotted tokens, though the future value of a token associated with such a hack is anyone's guess.

The bulls remain bullish nonetheless. Token offerings, said Blanchard, "are so far superior to all of these other ways to raise capital in the traditional financial system."

Why ICO?"If we take on debt, then that's something we have an obligation to pay back. If we give away equity, then we dilute our existing shareholders," says Stewart Dennis, founder of BitBounce. Token sales, by contrast, are nondilutive.For anyone who has dealt, as Blanchard has, with the complexities of corporate finance, the simplicity of token investments is remarkable. When Draper made his purchase of Credo tokens prior to the ICO, said Dennis, "I sent him tokens and he had someone wire us money, and that was it."

Whether or not tokens emerge as a true apex predator of finance, they certainly present a challenge to venture capital firms, according to Nick Chirls, a partner at Notation Capital, who spoke at the Morrison & Foerster event. Institutional investors rely on private information, the ability to see the best deal flow and place bets only on the best of the best. But token sales, combined with the open-source software ethos, allow entrepreneurs to fund and build projects right out in the open.

Venture capitalists, however, appear unwilling to accept their obsolescence. The new move, for those not restrained by their limited partners from investing in token projects, is to get in before the ICO, as Draper did with Credo, offering entrepreneurs super-early-stage funding and guidance in exchange for access to the token at a discounted price. In this way, Silicon Valley types can still get an edge on the masses.

One firm taking this approach is Boost VC. In May, co-founder Bryan Williams wrote a blog post detailing how his investment strategy is evolving in response to the ICO boom.

"Because our goal at Boost VC is to fund and accelerate cryptocurrency and blockchain founders," he wrote, echoing a statement he had made earlier to the news site CoinDesk, "we are not trying to fight this new trend, we are ready to play our role."

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