I have been a relatively regular attendee of Ethereum and blockchain meetups in the San Francisco Bay Area as well as NYC for 2 years now. Past meeting highlights include Vitalik showing up to meet 30 or so of us (almost 100% developers) in a small conference space in Mountain View and David Haussler of the Human Genome Project meeting 25 of us in San Jose in early 2016 to discuss how Ethereum could be instrumental in de-siloing genomics data worldwide.

These were intimate, hugely informative affairs where everyone had the sense of being a part of something special. None of us questioned whether the rest of the world would come on board, it was only a matter of time.

Needless to say, it was extremely gratifying to walk into a Bay Area meet up earlier this month to find a conference space for 150 people filled to capacity with another 25–50 people waiting in a hallway for the post-talk reception. (This was an ICO related meet up, no surprise there.)

The community’s growth has been truly wonderful to watch, and while it is incredibly validating to see how quickly interest has grown, it is also important to remain principled and pragmatic when assessing which developments in the ecosystem contain real substance versus those that are mainly hype.

To that end, I want to use the rest of this space to review the implications of the recent regulatory announcement followed by guidance on what to look for in ICO’s with high speculative potential.

Let’s start with the SEC announcement:

First: when the SEC talks (as they did here on July 25th) it is a good idea to listen. The SEC has moved more swiftly than many, including myself, anticipated. The reason for this, no doubt, is the eye-popping scale of several recent ICOs (I am looking at you: Bancor).

The SECs key announcement was their intention to apply the howey test to digital currencies in order to determine whether a given token should be classified as a security.

A security in the eyes of the SEC is defined in part as: “…any certificate of interest or participation in any profit-sharing agreement or in any transferable share, investment contract, voting-trust certificate…” etc. Find the full, legal definition of a security here.

This announcement has at least a two-fold ramification for U.S. investors: 1. U.S. based ICOs are now much more likely to be limited to accredited investors (as was the case with Filecoin). 2. Many ICOs will now look to do business offshore to avoid filing an S1 (a multimillion dollar legal undertaking for which the vast majority of token launches would not even qualify) potentially making it illegal for U.S. residents to participate.

For development teams the ramifications extend even further. In order to avoid classification as a security, the design and function of the token must follow some very specific criteria. In short, tokens that are not considered securities by virtue of the Howey Test must avoid profit sharing while requiring the token holder to take an active role in the management and curation of the network.

To highlight this, consider a contrived example comparing two ICOs with tokens named Share Token ($SHT), and Participate Token ($PPT). Imagine that both these ICOs are for the purposes of launching an online decentralized marketplace. SHT holders are entitled to receive profit from the marketplace on a pro-rata basis.

Share Token is clearly a security for the following reasons: 1. SHT holders take no active role in the operations and maintenance of the marketplace. They are completely passive and rely on a central team to manage everything. 2. SHT holders receive a form of profit sharing in exchange for up-front capital proportional to their token holdings, in the same way a share of equity entitles the holder to a proportional share of profits. SHT is clearly a security and should be regulated as such.

Now let’s take the case of Participate Token. In this model, there is no central team cultivating the marketplace and ensuring the business is running smoothly. Rather, PPT holders are in charge of making decisions regarding who should be allowed on the platform and resolving disputes between parties. PPT holders receive rewards in proportion to the value they bring to the network. In other words, in order for PPT holders to make money, they must contribute to the marketplace in some way that adds value. In addition, the network is reliant upon PPT token holders in order to successfully function. PPT is clearly not a security in the same way SHT is and should not be regulated as a security.

The reasoning behind the differences in security classification between these two tokens is hopefully quite clear. Unfortunately, there is often far more gray area than in this idealized example.

It is important to identify early in the development process which route a team plans on taking. The legal costs and token parameters will be guided by this decision.

Now on to cracking the ICO code:

Let me begin by clarifying two very different lenses through which an ICO might be analyzed: 1. The academic lens. 2. The speculator lens.

In theory, these two categories of analysis should not differ much. An academic salivating over an ICO with a well defined, highly innovative solution to a noteworthy economic problem should correlate with investor returns for speculators. This is the case to a large extent, but a comprehensive speculative analysis must go beyond technical promise when assessing an ICO.

1. Is the ICO technically avant-garde (as introduced above)?

2. Is the development team committed to the project long term?

Just as with Venture Capital, assessing interesting, but untested new ventures: No matter how innovative the idea, the team must be ambitious and, above all, you must have confidence in their ability to execute on their proposal. Ideas don’t build successful companies (or marketplaces). Teams do.

3. Does the token mechanism lend it self well to value appreciation?

In other words: Is the underlying token scarce or perhaps deflationary and/or is it requisite to accessing the platform. Or is it simply a way for the team to raise money. Z-Cash is a good example of a token with incredible technical potential but with a poor inflationary model from a speculative perspective.

4. What is the valuation of the ICO raise?

This is important because many investors I have spoken with are unaware that as little as a couple percentage points of the outstanding Token supply might be sold at the ICO. If an ICO offering 5% of their tokens raises $25mn what you thought was a reasonable early-stage valuation might actually be closer to Fortune 500 size.

5. Where is the money going after it is raised?

One thing I love to see following a successful ICO is teams turning around and building an accelerator or development ecosystem to build out applications on their platform. Too often millions are raised and then the team disappears for months with little communication. Last time I checked, you do not need $100 million to pay even a fairly large development team.

6. How much media coverage is out there that is organic vs. manufactured?

Business Insider Example

This is a subtle point but it is crucial to determining whether an ICO might be overvalued. When reading articles about upcoming ICOs ,be sure to check if there is a sponsored label to see if it was paid for by the team. In addition, be wary of reddit posters submitting overly flattering comments about a specific ICO in various blockchain forums. In many cases these contributors are either automated or compensated and do not represent organic excitement. In fact, if you have never heardof an ICO before stumbling across their website, it is often a good sign that the team has its head in the right place.

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