Institutional investors should be wary of the lure of initial coin offerings (ICOs) with a number of hidden traps potentially waiting for those not prepared.
That’s the word of Melbourne tech legal expert from KHQ Lawyers Darren Sommers who says that while ICO’s naturally generate a lot of excitement, little consideration is given to the impact an ICO has on existing shareholders, including venture capital investors.
Sommers explains that as a number of businesses generate substantial returns from successful ICOs, there are definitely good reasons to invest.
However, Sommers urges investors to be extra diligent.
He adds that the although the current lack of regulation was attractive to many businesses and investors, it also meant there is a distinct lack of protection.
Given the lack of regulatory certainty, Sommers says investors need to be mindful of the different classes of ICO tokens, which he outlines as:
"The ICO is a “security” (e.g. its terms of issue classify it as a known security, such as a share, option, debenture, warrant, derivative and so on)."
2. Quasi security
"The ICO is not expressly specified to be a security, but has similar rights (looks like duck, quacks like a duck….)."
3. Utility tokens
"The token is essentially a voucher which allows the purchaser to buy goods and services (usually from the issuer)."
In addition, Sommers has broken down some of the main problems his clients are encountering:
"A successful ICO creates an unexpected power imbalance in favour of founder shareholders vs the typical venture capital investor."
"Why? Well, the company doesn’t need your money in subsequent rounds, so they won’t be as friendly."
Sommers says regulators are still puzzled by ICOs.
"Are they shares? securities? financial products? or simply vouchers? Even ASIC is still working that one out."
"However, regulatory uncertainty creates risk for nominee directors of venture capital investees. The last thing a nominee director wants is ASIC or the SEC knocking on their door."
Inability to participate in later rounds
"Some venture capital investors invest small amounts early on to see how a business is progressing, and then reserve the right to have a first go at a later round."
"However, if the company has a successful ICO, it may not need later rounds of funding. This removes the investor’s ability to increase their investment."
"Traditionally, venture capital investors seek protection against a later issue of shares at a price which is lower than what they paid."
"However, these protections may not come into play if an ICO is issued, particularly at a price which indirectly values the company at a lower valuation than what the investor invested at."
Convertible notes and safe notes
"These traditionally convert to equity at the next funding round. However, a funding round may not take place, or may be substantially delayed, if a successful ICO occurs."
"This may delay conversion or possibly worse (for the investor), allowing the company to repay the convertible note without the investor having the ability to up their percentage of the company."
No pre-emptive rights
"If a company issues shares, then existing shareholders usually have an ability to participate in that issue," says Sommers.
"However, if a company issues ICOs, then existing shareholders may not have the contractual right under the shareholders agreement to participate – particularly where documentation is already in place and doesn’t cater for cryptocurrencies."
Sommers explains, "If an ICO is not a security or share, then it is likely that it is a contractual right, meaning that the holder of the ICO would be a creditor on liquidation/winding up of the company. They would rank ahead of existing shareholders."
Overall, Sommers suggests that venture capital investors should carefully consider whether they permit their investee company to undertake an ICO.
“However, the power to block an ICO would assume an investor has the relevant blocking rights to do so,” he adds.
“Most shareholder agreements do not directly deal with ICOs so the power to block them may be limited.”
“While you can’t change the past, you can change the future.”
Sommers concludes, “Moving forward, I encourage investors to review their standard investment terms to consider in each case what powers or rights an investee company might undertake in an ICO.”