Any time you buy first and ask questions later, be prepared to dislike the answers to those questions. This is the hard lesson facing investors – or possibly donors, depending on who you ask – who sent their money to a company called Tezos.
Welcome to the world of initial coin offerings. Cryptocurrency startups raise capital by selling a virtual token, bypassing the capital-raising process required by banks or traditional venture capitalists. By modeling the process on an initial public offering, startups create the impression that virtual tokens are analogous to shares in a company. If the ICO does not meet the minimum fund threshold the firm requires, backers get their money back; if the ICO succeeds, the company uses the money to initiate or complete the project they described in the funding campaign. In many ways, ICOs are more like crowdfunding than like heavily regulated IPOs.
While ICOs have been popular with cryptocurrency enthusiasts and backers who appreciate low barriers to entry, Tezos serves as an object lesson in why smart investors should be wary of them. The value of Tezos’ tokens, which have not yet been released, recently dropped more than 30 percent in the prelaunch market, The Wall Street Journal reported. The company’s founders clashed publicly with an official responsible for allocating $232 million in fundraising. During the dispute, those funds have ballooned in value to more than $400 million, because most ICO contributions were made in either bitcoin or ether, two popular cryptocurrencies.
Tezos co-founder Kathleen Breitman went on to surprise at least some of the company’s ICO participants by saying in an interview that they should not view any money they sent to her company as an investment. Instead, they should view it as a donation to a nonprofit network, with the virtual token serving as the cryptocurrency equivalent of an NPR tote bag. (Tezos’ Switzerland-based foundation is seeking nonprofit status.)
Whether regulators come to view the token as a security or a souvenir could have major consequences for Tezos. The Securities and Exchange Commission said in July that it may declare some virtual tokens to be securities, making them subject to greater scrutiny from regulators. Investors, too, would probably like to know whether they have purchased a security or received a gift in exchange for a donation. Regardless, unless and until Tezos’ network launches, its ICO backers will receive nothing at all. Boston-based law firm Block & Leviton announced that it has launched an investigation on investors’ behalf, but Tezos is prepared to insist it doesn’t have any investors in the first place.
Breitman and her husband and co-founder, Arthur Breitman, have said they regret their ongoing public dispute with the head of the foundation that controls the financial resources raised in the ICO. They announced that Tezos Foundation president Johann Gevers has been suspended; Gevers, in turn, has insisted he has no plans to depart. The original plan was for the foundation to acquire the Breitmans’ company after the ICO, but given the dispute between the co-founders and Gevers, it is no longer clear when such a transaction might take place.
Tezos is not an outlier. According to research site Token Report, less than 10 percent of the 226 ICO tokens it tracks back companies that currently offer an active product or service. Yet this has not stopped investors from pouring more than $3 billion into such ventures in 2017 alone.
In addition to the risk that a company will fail due to infighting, technological challenges or other problems, the cryptocurrency space has also attracted a certain amount of outright fraud. Reuters reported that authorities in the U.S., Switzerland, Canada and elsewhere are turning greater scrutiny on these transactions, and are likely gearing up to impose tougher regulation. China and South Korea have banned ICOs outright. The high-profile problems at Tezos may attract further regulatory attention to the company and ICOs in general.
Kathleen Breitman told Reuters in June that she and her husband had originally decided to use a foundation based in Switzerland because the country has “a regulatory authority that had a sufficient amount of oversight but not like anything too crazy.” But it seems likely that the common cryptocurrency startup tactic of using Swiss foundations may hit a brick wall if and when the country’s regulators tighten their rules on creating not-for-profit entities expressly to allow investors to profit from a sale.
For now, Tezos serves as a reminder of what can happen in a space with no rules and no accountability. It’s how the entire financial world looked, more or less, prior to the Great Depression, with self-evident results. Today we regulate things like initial public offerings for a reason.
If ICOs are to continue, the government needs to regulate them, for the sake of both backers and honest companies that want to play by the rules. Otherwise, participating in an ICO is not investing; it’s gambling – or gifting.