How to ICO. Security vs Utility Tokens

Lift off

After you decide that your product is a good use case for a blockchain and it makes sense to issue your own cryptocurrency it is time to determine the type of your token. The thing is that if your token is considered to be a security, the ICO is a subject for legal regulations (like IPO) in many countries. Therefore, security token issuance may require significant resources allocated to paperwork and lawyers.

Utility tokens

Let’s start with simple – utility tokens. Utility tokens play the role of a coupon and give an access to the company’s product or service. A good example to demonstrate how utility tokens work is a subway token.

When you buy a subway token, does that mean that you own shares of the subway?

Hell no.

Can you earn significant money buying a bunch of subway tokens and then selling them to somebody else in a few months?

Hardly possible.

By buying subway tokens, you:

  • Support the subway.
  • The subway owner will be able to invest your money into their infrastructure and make the subway better.
  • Use the subway, obviously.

In case you issue utility tokens you need to understand that this way you “borrow” some money from the crypto community in order to build something they would want to use. This is a pretty common case for Kickstarter startups, but if you have a blockchain integrated and your own cryptocurrency – utility token ICO seems to be a great idea.

Anyway, you should not forget that you will need to return the investments in some way or another. Include this in your business plan. Utility token sales are not regulated by law.

Security Tokens

The distinctive feature of security tokens is that they are considered as tradable assets and can be transformed into capital. If your tokens are securities, the offer and sale of these virtual coins or tokens in an ICO are subject to the securities laws. In the US ICOs are regulated by SEC, in Canada – by CSA.

Now, let’s talk a bit more about the difference between security and utility tokens. The thing is that many ICOs try to represent their tokens as utilities to escape such regulators as SEC. Let’s see what a security token is from a legal perspective. Currently, this term is defined by the Howey Test, which states that a transaction is an investment contract (or security) if:

  • It is an investment of money (later, they have expanded the term “money” to include investment assets other than money)
  • There is an expectation of profits from the investment
  • The investment of money is in a common enterprise
  • Any profit comes from the efforts of a promoter or third-party.

Simply put, you cannot treat your token as a utility token if your investors expect to gain profits (trade the token or receive dividends). How many people would like to invest in your projects in exchange for your future services or just donate their money? Here is the biggest confusion: many ICOs declare their tokens as utilities but trade them in public to people who are willing to make money on the tokens.

If you are going to sell your tokens as securities legally, it can be as challenging as running IPO. If you think that your token is utility, be prepared to prove that legally.

Save resources during your security ICO

There are a few solutions that can save your resources on running your token sale:

  • Wavesplatform provides a set of tools to build blockchain applications and issue your own token.
  • Polymath Network is designed specially for security tokens. They allow issue your security token and raise funds legally right on their platform.

There is another workaround to bypass security regulators like SEC: private token sale. Such regulators as SEC are not really concerned about professional investors and venture capitalists, their mission right now is to protect ordinary people from mass fraud.

However, private ICO is risky. Just imagine that a small group of people will be holding a large number of your tokens. That brings additional centralization and dumping risks, so you need to be careful with your private sale smart contracts. Anyway, a private sale can be a good way to raise enough funds to run a public sale.

Next Steps

In our next post, we are going to describe existing token sale models and analyze the difference between them. Bear with us!

Pavel Demeshchik

Pavel Demeshchik

CEO at datarockets

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