In a recent posting, we talked about what initial coin offerings (ICOs) were and why the coin type matters for the offering. Today, we’re going to take a look at the two major types of coins investors receive in an ICO: equity tokens and utility tokens. We’re going to break down the differences between the two types of assets in an easy-to-understand way so investors know exactly what they’re getting the next time they contribute to an ICO.
Equity Tokens vs Utility: Why Does the Difference Matter?
We may be inclined to think that the nature of a coin or token doesn’t matter. After all, it’s something we buy and, chances are, we’re probably going to sell it again at a higher price later on. In many cases, that’s exactly what happens. However, there are plenty of situations where that doesn’t happen at all. The reason(s) the distinction is important is because of when it comes to the tax man and regulators.
Because of the nature of the digital asset, the laws surrounding taxation and regulation change drastically. Uncle Sam (and other relevant tax authorities) are wanting to know the why when it comes to investing in an ICO. While utility tokens can serve a variety of purposes, equity tokens tend to really just act like unregistered securities. And in case we weren’t already aware, regulators are not big fans of unregistered securities. So what’s the difference anyway, and how can we know what type of token something is?
Equity tokens are the main concern when it comes to ICOs. These coins and tokens are digital assets that serve no real-world purpose outside of speculation. It should be noted that that’s not necessarily a bad thing. Equity tokens have historically been a great way for new projects to raise funding for product development. An easy way to think of equity tokens is a lot like a more traditional equity like a stock.
Likening certain coins and tokens to traditional securities often won’t get you many kudos in the crpyto world, but it’s important to be aware of how regulators view them. These coins and tokens don’t serve a function on a future platform, instead, they’re really focused on investors who want to see the project succeed and help fund the team behind it. Holding “equity tokens” also implies a certain amount of ownership or say of what happens in the company that you’re effectively holding equity in.
The DAO is one perfect example of an equity token. Not only was it rather obvious at the time, but the SEC came out warning against it immediately. Currently, the DAO has been closed down. However, it remains an excellent case study.
The setup was simple. The “decentralized autonomous organization” (DAO) was an investor-funded VC group. Those holding DAO tokens (it used the Ethereum blockchain to run) would decide what projects to fund. Token-holding investors held voting to decide on the investment strategy of the pooled funds.
Investors purchased equity tokens in the case of the DAO; it’s difficult to make a case to the contrary. Investors purchased equity in the organization and influenced both the decisions and directions of the organization based on their holdings. That’s about as clean-cut as it gets with equity tokens. But what about the other token type: utility tokens?
On the other side of the spectrum, we have “utility tokens.” These coins and tokens serve an actual purpose within the platform being launched. Unlike equity tokens, these tokens offer a real use other than crowdfunding.
To better explain the difference, we’re going to borrow an analogy from Joshua Ashley Klayman, a specialist who deals with the legal issues of cryptocurrencies in the modern world:
“If you think about it in terms of a video game arcade, at some arcades you can just put quarters in the machine. In others, you have to put tokens in the machine. So users have to buy the token to transact within the ecosystem. The idea is that people really want to use the product or service that the company is offering, and that the token is the only way to access it.”
In this example, the token is serving not as equity in the business, but as a necessary requirement for interacting with the platform. To use Klayman’s analogy, think of “Chuck E. Cheese’s.” Unlike special edition coins investors can purchase, expecting the value to increase over time, Chuck E. Cheese’s tokens are a necessity to play arcade games in the venue. Because of that necessity, the physical tokens are not an asset being purchased for capital gains, but rather a token purchased with the intent of engaging with the platform.
While Klayman’s analogy is one of the single-best explanations available for a utility token, it’s not always accurate. In some cases, coins and tokens act like both an equity token as well as a utility token. This causes some legal issues.
What to Look For
When it comes to equity and utility tokens, there are some clear signs investors should be looking for. Many companies in the industry developing a new cryptocurrency will throw terms like “utility token,” but that doesn’t mean it’s correct. Sometimes a “utility token” is really just an equity token with a name slapped on it to avoid scrutiny from the SEC. This doesn’t work.
It’s always a good idea to look into the nature of the coin or token investors are purchasing. Investors should look to ask questions like: “What does the coin do?” “How will this be used?” “What is the reason others are buying these?”
If you find yourself looking at a coin that others are purchasing purely because of price speculation, there’s a good chance you’re dealing with an equity token. On the other hand, there are coins that don’t fit into either category. A growing trend is developing with “asset coins.” These coins are really just a “tokenized” version of other, real-world assets. Those fit into an entirely new category that we’ll take a look at in the future.
At the end of the day, the best bet is to do some research. Find out how the coin or token will be used and know how it’s classified. Ultimately, for those of us in the US, we’re going to need to wait for the SEC to clarify. However, there are certainly some cases where a coin is serving as a utility and not a security. Now that we have an understanding of the basic differences, we can make much better judgments. There’s nothing wrong with equity tokens either, but we should know what we’re getting ourselves into with our investments.