The initial coin offering (ICO) is an innovative crowdfunding model that allows startups to bypass traditional early seed investment. However, not all ICOs are created equal; in fact, there are at least three types of tokens issued through these crowdsales.
Investors often struggle to discern what category an ICO token falls into, which is why Strategic Coin offers educational information and in-depth ICO research reports to help investors make informed financial decisions. Below, this article explains the three major categories of crypto tokens:
One of the most promising applications of Ethereum-based smart contracts is the potential for startups to issue stock–or equity tokens–through initial coin offerings. This will benefit startups since the barrier to entry into the financial markets will be much lower than in the past. It will make stock trading more accessible to the average investor and allow shareholders to take a more active role in corporate governance since voting can be conducted transparently through the blockchain.
Due to the current lack of regulatory guidance, few startups have attempted to conduct equity token sales. However, Delaware recently passed a bill that allows companies to maintain a list of shareholder names on a blockchain rather than conventional methods, which will enable blockchain-based stock trading. Consequently, it is likely only a matter of time before equity tokens take a central role in the crypto finance industry.
A security is a broad classification that refers to any kind of tradable asset. Through ICOs, investors have access to a wide variety of securities tokens, ranging from coins redeemable for precious metals to tokens backed by real estate.
In the United States, these token sales and investments are subject to SEC securities regulations. SEC v. Howey established the guidelines for whether a financial arrangement involved an investment contract and was subject to securities regulations. As described by Cooley LLP Fintech Team Leader Marco Santori, an arrangement is a security if it involves “an investment of money. And a common enterprise. With the expectation of profit, primarily from the efforts of others.”
Presumably, most tokens are securities since the majority of ICO participants view crowdsales as investment opportunities. However, if a token does not meet the three requirements of the Howey test, it may fall under the classification of a “utility token”. Utility tokens, which may also be called app coins or app tokens, provide users with access to a product or service.
For example, Filecoin–which raised an ICO-record $257 million–plans to provide a decentralized cloud storage service that will take advantage of unused computer hard drive space. ICO contributors received tokens that they will be able to use to purchase storage space from Filecoin once the service has launched.
Since total supply is fixed, utility tokens may appreciate over time if demand for the product or service increases. However, investors should be wary of startups that describe their token as a utility or app coin but also market it as an investment because it is likely that regulators will consider the asset a security.
It is important to note that “utility token” is an organizational distinction–not a legal one. The SEC has not given official guidance on utility tokens, so the industry does not with certainty whether they are subject to securities regulations.