Initial Coin Offerings (ICO’s) seem to be everywhere. Not a day goes by now where we don’t hear about an ICO, talk about an ICO, or read about an ICO (good or bad). The initial debate going on right now is if ICO’s are a security or utility. The SEC came out and said in so many words….it will depend on the facts and circumstances on a case-by-case basis. In many instances, the token will likely be a security which is why there is so much discussion about offering the token in a legalized way through Regulation A (Reg A+) such that both accredited and unaccredited investors can participate. For utility tokens, many are discussing using a Simple Agreement for Future Token (SAFT) through a Reg A+ or Regulation Crowdfunding (Reg CF) offering when the Company is yet to develop the utility token. The SAFT is expected to take similar form compared to a Simple Agreement for Future Equity (SAFE).
But let me pose an issue that I believe will be a much more difficult problem regardless of utility or security determination; the accounting consequences post-ICO.
The issues don’t arise for companies that simply want to sell a token like a share of stock whereby that share can be traded in a regulated way outside the influence of the Company…very much like we trade shares of public companies every day. The issue arises when companies want to use tokens as part of their business model and within their operations.
Let’s talk through a scenario of a security token being issued for a chain of retail stores. The company raises money (generally easy to account for) and has investors setup a digital wallet that can be funded with said tokens. Unlike a traditional security, the company wants these tokens to be exchangeable for goods and services, including and mostly in their own business, similar to a utility token. There are a few issues a company needs to worry about. The first is “who owns the tokens”? Remember, these are securities, so you need to know who owns a portion of your Company. The second issue, is how do you account for the exchanging of tokens. If a customer redeems tokens for product, is that revenue and a buy-back of stock? Is the subsequent issuance of tokens then stock/token compensation in one form or another subject to 1099 reporting or is the token treated more akin to a loyalty point which has its own set of accounting guidelines? The blockchain technology has to be able to track, verify, and report in such a way that you can account for all transactions in accordance with generally accepted accounting standards (GAAP), and it needs to be auditable by third parties (i.e. external auditor). Also, don’t forget about the IRS and tax reporting.
Utility tokens will be no different. The Company will have to have the ability to track issuances, redemptions and any transactions that runs through the Company. These could be revenues, expenses, loyalty point redemptions, deferred revenues, etc. The type of uses for tokens are endless, and so are the accounting requirements for each type of business.
One of most significant hurdles is the reporting system and/or wallet that tracks the tokens. This is where the ICO folks get really mad at me because of the auditor’s inability to trust the blockchain process (well justified after recent wallet failures). When auditors need to test transactions that are numerous in number through a system, internal controls are usually tested so they can be relied upon to reduce the risk assessment related to the financial information. For instance, when auditing a 401(k) plan, auditors routinely rely on the system of controls where the 401(k) assets are held and administered. To provide that assurance the service provider gets a special audit as part of a SOC 1 Report (Service Organization Controls Report). These are extremely costly. I anticipate the system tracking ICO’s (wallets or otherwise) will have to undergo similar testing to verify the technology and controls underlying the system are effective.
Last but not least, some of the benefits I read about the blockchain pertain to how its immutable, has less risk of fraud or scam, and is resistant to attack due to the decentralized nature. That is all well and good. But what would prevent a company, and more specifically someone in that company, from creating a token that is linked to revenue generating transactions, and then setting up multiple anonymous bitcoin or other cryptocurrency accounts to buy said company token thereby artificially inflating the revenue? Although the blockchain technology may carry less fraud risk, the fraud risk actually increases due to the anonymity of the purchaser if anonymity is allowed.
The bottom line is for ICO’s will go through legal channels to raise money; it’s not a matter of if, but when. However, the down-line accounting consequences are still unknown and there isn’t a lot of guidance available. To complicate it even more, even different governments can't agree on what these are: digital property, commodities, currency, etc... How will transactions be captured, reported and accounted for? Will a transfer agent be used? How will a company notify shareholders of a vote if the token represents a class of stock? How will this all be audited and reported annually for Reg A+ or other requirements and will IT specialists need to be utilized? This is just scratching the service of the problems that may arise.
My prediction is that companies going through this process early on will need to be prepared to expend significant capital on professional services and compliance and any company doing this for an inexpensive process will be sorely mistaken. Companies will have to take away the ability of purchasers/investors to remain anonymous because to do this in a regulated manor there will need to be transparency and reporting. Finally, companies will really have to think through the model of their business to determine the accounting impacts of the tokens based on how they are used.
dbbmckennon is a full service CPA firm with offices in Orange County, San Diego and Santa Monica. We specialize in companies filing with the SEC and utilizing equity crowdfunding through Reg A+ and Regulation Crowdfunding. For additional complimentary information regarding this topic or other questions you may have please call one of dbbmckennon‘s offices located in Southern California or contact us here.