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CSO token sales: The best of equity and ICOs or new potential scam vehicle?

Posted: 14 February 2020 7:20 pm
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The world has a new method of fundraising, which means it's time to ask how it could all go wrong.

A startup called Fairmint has coined the phrase "continuous securities offering", or CSO, to describe a new type of token sale.

It's essentially a token that's backed by a company's future revenue. Or to look at it more analogously, it's a system for businesses to crowdfund a loan and then pay supporters back later with the principal plus interest.

The first CSO will be the Fairmint platform itself.

Read on to see how it works, or just skip straight to the bottom if you're only interested in seeing how scammers may be able to use it.

How the CSO works

The following is a step-by-step overview of the process that occurs when a company wants to raise funds with a CSO:

  1. Initialisation. The company creates a reserve. This is a pool of initial money, which will also grow over time as the company directs a set percentage of its revenue to the reserve.
  2. The CSO runs. Tokens are minted proportional to the amount of money in the reserve. These can be traded on the open market as well as minted and redeemed from the reserve.
  3. The CSO ends. The company ends the CSO by buying back all outstanding tokens.

Stage 1 in detail

Prior to creating the reserve, the company will initialise the CSO by laying out its terms. For example, it might commit to putting 10% of its annual revenue, distributed quarterly, into the reserve. It will also set a minimum threshold of investment required for Stage 2 to begin.

In this initialisation stage, investors commit funds. They can withdraw their investment at any time. The initialisation stage will run until the company either withdraws its CSO and all investors are refunded or until it hits the set threshold at which point the CSO will automatically enter the next stage under the specified terms.

The company gets the investors' money, and the investors get CSO tokens in return.

A company can also decide that a certain percentage of funds raised will go directly to the reserve. The general effect of a higher allocation to the reserve is a lower risk for investors as it turns some of the "maybe money" backing the tokens (the future revenue) into "definitely money" (cash in the reserve pool).

Stage 2 in detail

Now there's a reserve and a bunch of tokens in circulation whose value is backed by a combination of the money already in the reserve and whatever percentage of its future revenue the company is committing to the reserve.

There are three main things the general public (with some restrictions) can do with these tokens.

First, tokens can be traded on the open market at whatever price the market has decided a company's particular combination of reserves and future revenue is worth.

Second, tokens can be minted or redeemed directly from the reserve.

  • When investors mint tokens. The buyer invests more money into the company and the reserve automatically gives them tokens in exchange for the additional investment. The price of minting a token is directly proportional to the total number in circulation. The more tokens there are in existence, the cheaper it will be to mint more.
  • When investors redeem tokens. Tokens can be sold directly to the reserve and taken out of circulation. The redemption price is algorithmically determined based on the amount of cash in the reserve and the number of tokens outstanding. The higher the reserve balance per token, the greater the redemption price.

Because of the way Fairmint works, someone using its interface to buy or sell tokens will get routed to wherever they get the best price – either on the open market or directly through the reserve. This means minting will generally only occur when investor demand for a company's tokens outstrips the current market supply, while redeeming will generally be done when the market for a token should be contracting anyway.

The company can do similar things with different results, both of which are vaguely similar to buybacks.

  • When the company mints tokens. The company mints tokens with all proceeds going directly into the reserve, and new coins going directly to the company. The effect should be to increase the token price as it adds cash to the reserves without necessarily putting tokens into the public supply.
  • When the company redeems tokens. This is more like a conventional buyback. The company pays money to reduce the total number of tokens with a claim on the reserve to increase the redemption price.

In theory, the only way the balance in the reserve can decrease is when investors remove funds by redeeming tokens. The company cannot withdraw funds from the reserve and theoretically cannot redeem its own tokens.

Overall, the fair market price for tokens should fall between the redemption and minting price. The company is kept honest by being required to publicly disclose its earnings, like a publicly-listed company.

On paper, the end result is what you'd expect from a "continuous security offering". It's a way for a company to continually offer securities and continually raise funds from investors within a particular window of time.

That window of time is decided in the initialisation phase, with the company laying out a minimum duration for the security offering among all the other parameters.

Stage 3 in detail

When the minimum duration has been reached, the company has two options:

  1. End the CSO by paying the exit fee to the reserve.
  2. Extend the CSO and just keep it going as before.

This exit fee is equal to the price of the most recently-minted CSO token, multiplied by the total number in circulation, minus the balance in the reserve. The company puts this amount of money into the reserve and is no longer required to pay a share of their revenue into the reserve.

So at this point, the reserve is fully topped up with the value of all its CSO tokens. Now token holders can, at their leisure, redeem their tokens for their share of money in the reserve.

If the company can't afford it, they'll just have to extend the CSO and try to take the next exit.

What's wrong with other types of fundraising?

The CSO is intended to serve as an alternative to other fundraising methods, falling somewhere between an initial coin offering (ICO) and an initial public offering (IPO), and offering the advantages of each without the downsides.

The problem with ICOs and equity sales

During the initial coin offering (ICO) boom, everyone realised it was easy to make enormous amounts of money by hocking a parade of mostly-worthless but often-entertaining cryptocurrency tokens at the retail market.

The value of most of these tokens quickly plunged to zero on the open market, leaving "investors" out of pocket, and the founders in the Bahamas. One study estimated that, as of mid-2018, more than 80% of ICOs were scams while a further 15% were just garbage.

But ICOs also had some good points. Some founders have described the ICO fundraising process in glowing terms, relative to the pains of trying to court venture capital investors. They're also a very accessible and egalitarian way for everyone to invest and/or get scammed.

By contrast, your more traditional venture capital fundraising is beyond the reach of retail investors, and the general public will never get a sniff of the best opportunities, while equity sales these days are largely locked up by venture capital firms. IPOs are on the decline, and even when they do happen, it's typically only after venture capital firms have all had their bites of the apple.

And companies themselves have plenty of bones to pick with all fundraising methods.

Even ICOs, the least-regulated and most founder-friendly fundraising method in history, cause problems for legitimate companies.

This is because, historically and anecdotally, the main role of retail ICO participants is to throw a bit of money at a project and then complain loudly about not instantly becoming millionaires. They'll clamour for an exchange listing for the sole purpose of trying to unload their holdings as fast as possible, which then tanks the token's price and causes cash-flow problems for the company.

ICOs also incur the cost of hiring community managers, and on at least one occasion (a coin called SAFEX), the token holders ended up being so abusive that the only exchange to list the token ended up removing it solely to escape the harassment of the community. The investors there literally destroyed the project they were investing in.

The general public is not a pleasant entity, especially when it feels like you owe it money.

Going after venture capital can also be painful. As Binance CEO Changpeng "CZ" Zhao described his experiences:

"Courting VC investors, doing powerpoints, business plans, pitch decks, executive summaries, due diligence, term sheets, investment agreements, offshore company structure setup, board of directors, make reports for them, getting a bridge loan because the VC lawyers insist on some totalitarian terms that essentially gives them absolute power and ownership of your company and hence delays the whole investment process… And at the end of a six months cycle, maybe getting $150K USD worth of angel investment, while the CEO (and other founders) spends a majority of his time and brain cycles on this, and not the core business. And repeat the cycle immediately again."

IPOing similarly involves high costs and regulatory overheads, while also inviting a degree of public scrutiny and requiring a company to satisfy both public sentiment and its shareholders.

Both investors and founders have a lot of reasons to dislike all the currently available options.

How different are CSOs?

There have been a number of efforts to re-invent fundraising on the blockchain.

On one side, you have a number of tokenised equity projects, which are mostly just digitised equity.

And on the other side, you have a field of new acronyms that are basically just ICOs under a new name, such as IEOs (lightly-vetted ICOs that start their life listed on an exchange) and SAFTs (the ICO you do when your lawyer says you're not allowed to have an ICO).

Fairmint's CSO model is very different to both. It's a token that's algorithmically tied to a company's future revenue. It can coexist with equity, and there's nothing stopping a company from seeking venture capital funding before launching a CSO – this is exactly what Fairmint itself is doing – or going public with an active CSO.

It's also intended to offer more investor protection than ICOs and arguably a bit more than stocks as well. Stocks and most tokens can go to zero, but CSO tokens should always be backed by at least some of the money in the reserves.

In terms of accessibility, CSOs veer closer to ICOs, being accessible to almost everyone. US residents, though, can only participate if they're accredited investors.

It's also a largely-automated DeFi arrangement, built on Ethereum, so beyond the challenges of working out what exactly they want to do with this facility, and the cost of managing their reserve, it's potentially a very flexible and low-cost source of funding for a company.

Of course, being a DeFi solution with fewer trusted intermediaries, it's also potentially more prone to abuse than other systems. It will undoubtedly be interesting to see how it unfolds and especially how people try to exploit it.

Opinion: What can scammers do with this?

This is not financial advice, and it's definitely not legal advice, but it appears scammers may be able to make some money from CSOs.

The age-old magic trick of "raise a lot of money from investors and then vanish" still appears to work perfectly fine with CSOs. In fact, the perceived safety of CSOs means it could be even easier. Just keep telling people that it's perfectly safe and their money is in the reserve, and they won't know what hit 'em.

The main thing to remember is that minting tokens through the reserve puts more money in the company's pocket than there is money backing the token in the reserve. The difference is meant to be made up of future revenue and market forces, both of which can be faked.

All you have to do is build up a lot of hype and then try to buy up a solid portion of the tokens being sold on the open market. This will force people to mint tokens through the treasury, which means more money in your pocket. Then through that alter ego, you immediately sell all your own tokens as fast as possible, first to the unsuspecting market and then to your own treasury. Now pocket the investors' money from the company treasury, pocket the money you made from selling your own tokens and start running.

With any luck, you'll be halfway to Panama before they glean to your scheme.

Depending on what kind of liquidity and regulation there is around CSOs, this could be either very easy or almost impossible to pull off. But in a more regulated environment, it's perhaps worth asking...

What happens if a company goes bankrupt with outstanding CSOs?

If you're not interested in fleeing the country, it may be more legal to simply go bankrupt after launching a CSO instead. Again, this is neither legal nor financial advice.

The first CSO hasn't launched yet, so there's naturally no answer to the question of where CSO investors sit in the order of bankruptcy proceedings, but "nowhere" might be a good bet. The security they hold, the CSO, entitles them to a portion of the money in the reserve and an agreed-upon amount of the company's future revenue. One could reasonably argue that they shouldn't get anything beyond that if the CSO-issuing company goes bankrupt.

Now remember, the redemption price is determined based on the reserve balance per token, so the higher the reserve balance is relative to the number of tokens, the higher the redemption price is. But when an investor buys into a CSO, most of their money goes to the company's coffers and a small portion (or none at all) may go to the reserve.

So, the more CSO tokens investors mint in a short time, the greater the gap between the amount of money they've given the company and the amount that can actually be redeemed through the reserve if it all goes belly up the next day.

It's feasible that a retail investor could mint a dollar of CSOs one day, then wake up the next and find that the company has gone into administration and that they're only entitled to 10% of their dollar (the amount that went to the reserve) while the other 90% (the amount that went to the company treasury) is put into the pile of assets for creditors to divvy up.

The fascinating case of the Dick Smith bankruptcy, which depending on who you ask was either the result of head-scratchingly bad decisions or "the greatest private equity heist of all time", could provide some additional inspiration for what a CSO heist could look like.



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Disclosure: The author holds BNB and BTC at the time of writing.

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