Initial coin offerings (ICOs) or token generation events (TGEs) are revolutionizing the nature of early seed fundraising.
They have the potential to change the mainstream investment ecosystem itself. Startups can use ICOs to raise capital by issuing crypto tokens on a blockchain – especially that of Ethereum – then sell them to investors or contributors.
Tokens are fungible and tradable just like cryptocurrencies. They’re unique as their value is derived from what they represent – such as company equity or access to a service. Their value is not measured in their utility as a currency or store of value. Recently the SEC announced their intention to consider ICOs as a new viable way to raise funds. This highlights the need for a new regulation. There are two common types ICO coins – equity (security) tokens and utility tokens.
Tokens represent shares of a business. According to the SEC announcement, any token that cannot pass the Howey test is considered a security under the 1934 Security Exchange Act. The Howey test considers the following:
- Is it an investment of money or assets?
- Is the investment of assets or money in a common enterprise?
- Do you expect to make profits from the investment?
- Does the efforts of a promoter or third party help generate profits?
The final factor of the Howey Test considers any profit generated outside the investor’s control to be a security. This is where confusion crops up as it makes any utility token a potential security as they can be traded on a third party platform.
Equity tokens are a subcategory of security tokens. They represent ownership of an asset such as debtors or company stock. A startup can forgo a traditional initial public offering (IPO) by employing blockchain technology and smart contracts. Then they can issue shares and voting rights over the blockchain. A lender could even create tokens that represent debt owned by the company, allowing the buying and selling of loans in a high-liquidity environment.
Utility tokens often called app coins, or user tokens, allow users future access to a product or service. You can buy utility tokens or units of services sometimes at a discount off the finished product’s sticker price. You can compare these tokens to API keys, used to access the service.
They’re a means to fund projects of shared infrastructure that was impossible to fund previously. To enable the building of such ecosystems, some tokens can be “pre-mined” in addition to being sold in “crowd-sales” during token launches.
Utility tokens are not designed as investments. But people still contribute in their ICOs speculating the value of the tokens will increase as the demand for the company’s product or service increases.
The fluctuation of utility token prices is comparable to those of sporting event tickets. The value of a ticket to a future sporting tournament may increase if a certain team is expected to progress to the knockout stages of the event.
On the other hand, that same ticket may decrease in value if that specific team is knocked out in the early stages of the tournament.
In summary, while both equity and utility token prices can fluctuate, the major difference is that equity tokens entitle the holder to ownership rights. Utility tokens simply function as coupons and do not provide holders with ownership rights in a company’s platform or other assets.