ICO fundraising more difficult amid heightened investor scrutiny: Kenneth Oh, Dentons Rodyk

Kenneth Oh, a senior partner in Dentons Rodyk’s Corporate practice who has handled ICOs in Singapore, sees companies offering the same facing increased challenges with fundraising as the market matures and investors increase their scrutiny of such projects.

Oh, who also serves as a partner in the firm’s China and Indonesia practice, and looks at corporate finance, mergers & acquisitions, with a focus on equity capital markets transactions involving IPOs (initial public offers) and RTOs (reverse takeovers), said that in the Singapore context – with regard to ICOs (initial coin offers) – it was helpful to the community that the city-state’s Monetary Authority had issued a very clear statement on how it would view these tokens.

He observes: “That still means you need to assess each token at the outset as to whether it is securities or not. If pegged as one at the offering stage, this will impact the tradeability of the tokens sold. This doesn’t just pertain to Singapore but is a worldwide issue; whichever jurisdiction where you intend to sell your tokens will need to assess its status as a securities product and would impact both its sale and subsequent liquidity.”

“From the perspective of most ICO companies, they’re seeking increased tradeablity, hence by Q1 2018 I think that the there will be a securities token exchange. If regulatory sandboxes could be offered from jurisdiction to jurisdiction while allowing for the trading of securities token, that would perhaps foster the further growth of fundraising in this space,” he adds.

In an in-depth interview with DEALSTREETASIA, Oh highlights key developments in the city-state’s ICO space such as its regulations, the liquidity options available to investors and the dynamics of this fast-moving area.

Edited excerpts:

Looking at ICOs,  we’ve seen private companies using this route to raise funds for themselves. In Singapore, there are fund managers exploring the issue of equity tokens in ICOs to raise funds, as has been done by the Russian VC players funds Finshi Capital and Starta Accelerator. What are some of the legal complexities that could emerge if raising such a fund in Singapore, especially given the equity tokens to fall under the Securities and Futures Act?

If the economic proposition offered by the fund manager to the funds’ investors is essentially one of the investment rewards and returns, then to me there is no difference, based on the existing guidelines where you offer units in a fund for subscription by investors in order to do fundraising. Otherwise, the existing securities regulations on fundraising would apply.

The MAS has also issued the latest guidelines in November 2017 that clarifies their position when it comes to the issue of digital tokens, particularly where the existing securities framework would apply – when it comes to the actual offering aspects of the fundraising process, there is no difference.

But because what you’re offering are not units in a fund, but bearer tokens representing units in a fund, then this added layer of complexity would actually be how – in an operational sense – you’re tracking ownership of the fund.

The question then is: Are you allowing for the trade in the tokens that represent in the underlying interest in the fund? That in itself would impact whether the fund is open-ended or is close-ended. If it’s close-ended fund, you still could be allowing trading between unitholders but if you are looking at an open-ended fund, this adds to the complexity of the fund.

You could have other new investors coming in to purchase these tokens and you’d then recognise whoever holds the tokens as the unitholders. This will impact how the fund works because most funds want to corporatise their structures. Based on some structures that we have explored so far, we may actually have looked at each token as representing an underlying unit within the fund.

What is the liquidity proposition for limited partners (LPs) that are back in a venture capital (VC) fund which has injected capital into an ICO? What are the key highlights that PE/VC professionals should understand in this particular context?

We have to be mindful that a lot of the VCs enter into an investment position in the ICO as an early backer. At this point of the investment lifecycle, there’s limited assurance as to whether the project will actually proceed. Even if the project proceeds, then depending on how the ICO project is run, there might not be sufficient assurance of an immediate return on the tokens.

There could be a different delivery outcome depending on the project. In terms of a liquidity exit, there’s also a different basis to this, depending on the ICO context.

In an initial public offer (IPO) context, most of the time there would have been an initial dialogue with these startups as part of the public offer to ensure that there are enough of their shares around in the buildup to the public float. In the ICO context, some projects will have commenced a dialogue earlier while others start later. For ICO projects, not all of the tokens are immediately tradable on token launch.

Ideally, that ought to be the case but sometimes it’s not the case. In an ICO project that is delivering the tokens, the fact that you’ve bought in and committed to the purchase does not definitely ensure there’ll be liquidity.

I think in recent times there have been exchanges which review tokens and find that they might carry some security features. Subsequently, they delist these specific tokens. For most jurisdictions, if a token is a securities product, then the exchange itself may be subject to the regulations that govern the securities market. From what I understand of the current practices of the crypto exchanges, they now reach out to an ICO project that seeks to have their tokens listed for trading on their exchange to first seek a legal opinion.

Because exchanges are scattered across the world, if you plan for an ICO then it makes sense, even as an investor, to ask the ICO company or fund manager (i.e. the VC backing the ICO) to find out which crypto exchanges the tokens are being listed on and how far along they are in that listing process. It is critical that investors actually have that liquidity.

Do you have any perspectives to offer on the current regulations in Singapore and how they balance investor protection against foreseeing the growth of ICOs as an entrepreneurial finance instrument?

The current regulations are obviously crafted based on the securities framework we have in place. At least in the Singapore context, it’s certainly helpful to the community that MAs actually come up with a very clear statement as to how they would view the tokens.

That still means you need to assess each token at the outset as to whether it’s securities or not. If pegged as one at the offering stage, this will impact the tradeability of the tokens sold. This doesn’t just pertain to Singapore but is a worldwide issue; whichever jurisdiction where you intend to sell your tokens will need to assess its status as a securities product and would impact both its sale and subsequent liquidity.

From the perspective of most ICO companies, they’re seeking increased tradeablity, hence by Q1 2018 I think that the there will be a securities token exchange. If regulatory sandboxes could be offered from jurisdiction to jurisdiction while allowing for the trading of securities token, that would perhaps foster the further growth of fundraising in this space.

There could be parameters of course, in terms of restricting how much much funding could be raised on the basis of the securities that fit within these parameters.

How does raising funds through an ICO impact the exit potential of a firm, particularly through a public listing? Effectively, an ICO can translate to raising funds without diluting equity, as in the case of utility tokens. But at the same time, entrepreneurs can’t control the value of the tokens that are issued and also risk overcapitalisation. 

This question has come up in my dialogue with potential investors into ICOs. When they invest in the tokens themselves, this represents an opportunity for them to explore alternative investments.

For most investors, the purchase of the tokens means they don’t actually hold an equity stake in the entity. Yet the proceeds raised from the ICO are actually important for the benefit of the company and its equity holders.This means that those companies which have done an ICO can have two separate valuations. The value of the tokens actually would have their own market capitalisation distinct from the equity capitalisation of the business venture.

Now, how you value the underlying business and how you value the token proposition are going to be rather different, as well as how the users actually perceive the value of the tokens and the product/service they’ve bought into.This is especially so for utility tokens which are totally decoupled from the balance of the profit and loss position of the underlying company. Investors should be viewing it as two different propositions.

Most ICO companies maintain a reserved pool of tokens that are usually held by the ICO entity, the issuing foundation. The foundation raises capital which is then injected into the operating entity, which is also invested in the ICO by virtue of the product that they develop and the network they host.

Whether you’re a token investor or equity investor, only a securities token that’s actually linked to the profit and loss of the firm will really impact the outcome.

Singapore has emerged as the third largest ICO centre globally after the US and Switzerland. What’re some of the non-profit structures in these jurisdictions that could apply to the Singapore context and the city-state can learn from? 

What we have observed in the Singapore context is that it’s the foundation structure for ICO offerings that’s been very popular in Switzerland. We’ve seen ICO projects run via foundation entities which would be companies incorporated as a public company limited by guarantee as well foundation-type companies which are companies limited by shares.

There are multiple structures which are actually being operated because this space is relatively new, so it’s hard to identify the actual trend. Every structure that we look at or which we advise on, we accounted for a lot of considerations ranging from the security regulations right down to the tax implications of the token sale.

In this regard, there are ICOs which you see being run out of both Singapore entities as well as offshore entities. Every project is unique in that regard and it would be difficult at this juncture to actually identify what is a one size fits all structure.

In 2017, ICOs had surpassed early-stage VC funding. VCs also have an incentive to be involved in ICOs as it represents an accelerated path to liquidity. What’s its impact on the classical venture capital model in the Asia Pacific and ASEAN in particular?

A lot of VC investments could be structured on the basis of preference shares or convertible loans, particularly for early-stage startups. But with the ICO process, in the token space, the investment documentation is still relatively simple. Most pre-ICO sales are governed by a document known as SAFT (Simple Agreement for Future Tokens).

In the early days of the ICO investment space, with the early investors, there wasn’t that much demand for investor protection. Hence, the documentation was inadequate. For VCs looking at more comprehensive protection or more elaborate investment structures with more extensive protections, they probably need to manage their expectations if they are looking to invest in this space at the moment.

There will be other investors who are willing to invest in ICO companies without expecting the same level of investor protection. Because this is a new area, I think the VCs should be very mindful about the risks associated with investing in ICOs.

Whereas in a traditional startup venture you’d have – depending on your stage of entry into the venture –  at least some groundwork done by the startup venture, with ICOs its very often just a concept that’s been put on a white paper.

Even the team that’s written the white paper to form the startup is a new team and it could be that some project teams are simply assembled ad hoc. You’ll even find cases of their advisors serving multiple ICO projects.

There are some ICO projects where the founders may have worked on a project and seek liquidity in order to move onto another project. Whereas, in the traditional equity investment space the expectation would have been the found would actually have stayed on and run the project in the long term.

I think VCs should be very mindful of the projects which they are investing in. Looking at both the actual investment horizon as well as what the liquidity proposition is, they need to bear in mind that at the point of ICO launch, there could be no underlying business that actually supports. There’s a significant risk in terms of project execution because the projects are conceived when there has been minimum roll out.

Whereas if you’re investing in an IPO, the company that is going to IPO usually has a team with a proven track record that going on to more extensive fundraising. With ICOs, the whole investment process has been turned upside down where you do the fundraising first and then deploy the product.

In fact, a lot of the ICO companies may not even have a full finance team on board in terms of internal risk, management, or business personnel. They’d be looking to hire this after the whole ICO, especially that.

Given your background in ICOs and dealing with ICOs, how do you see the ICO space evolving in terms of regulations and maturity in the coming years?

For the initial ICOs, increasingly  ICO projects may find it harder to actually raise funds because there are so many more projects on the ICO market than there previously were.

Depending on the nature of the ICO projects we are seeing, the first phase of ICO projects were really blockchain projects. We’ve been seeing other projects whereas you have a non-blockchain business introducing a blockchain component into the business to further enable it.

The question is when you are reaching out to investors to raise this funding, what was actually the take-up? Bearing in mind that for the first phase of blockchain companies, the investors which they attracted had already started off by buying into cryptocurrencies at a very early stage when their cost of entry was low.

Having a huge appreciation in the cryptos, they’d then be more amenable to be investing in ICO projects. For the new wave of investors coming in now who are using fiat money, they have to buy into cryptocurrencies when prices have gone up significantly.

Logically, this new wave of investors is scrutinizing the investment proposition in the ICOs a lot more. I reckon that the environment will be more challenging for the ICOs to raise funds. The investor community will be increasingly discerning and definitely evaluate the investments a lot more before purchasing a token.

As it matures it, can we expect ICOs to become an additional financial instrument in entrepreneurial space or is it just a passing fad?

I think ICOs are here to stay, because even in the traditional investment space when you were to make an investment into a business where equity would have been popular, a big issue always has been the liquidity. You’ve made the investment but how are you going to be able to exit from the asset?

In the case of an ICO, if you were to buy the digital tokens, most ICOs would actually have liquidity almost immediately. And liquidity certainly is a very important factor from the perspective of any investor.

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