The Ethereum ICO: Where did all the tokens go?

Quick Take

  • Was ether a security at some point? The first place legal experts should look into is the project’s crowdsale
  • More than 40% of the ether sold went to the top 100 purchasers. And the three largest purchasers went home with roughly 1 million ether each
  • The largest beneficiaries of the contributor allotment were the project’s eight co-founders, but the “reward” distribution was egalitarian, according to Ethereum’ creator Vitalik Buterin  
  • Until a judge steps in, the issue will continue to be open to debate

One nagging question hanging over the crypto space is whether ether, the native token of Ethereum and the third largest cryptocurrency by market cap is—or was—a security.

Bill Hinman, director of the division of corporate finance at the U.S. Securities and Exchange Commission (SEC), in June brought more clarity to the question, saying he did not consider ether a security in  its current “decentralized” form. This, however, is not an official ruling, and the SEC itself has not said anything definitive.

Ultimately, the decision will likely to be made by a federal district court, an appellate court or even the Supreme Court. If that happens, a judge will apply the Howey test, a basic rule for deciding whether something fits the definition of a security, and other guidance to make a decision.

If legal experts do start digging into Ethereum, one of the first places they will look is the project’s crowdsale, or initial coin offering. In light of that, it makes sense to revisit the way by which the Ethereum team distributed the first 72 million ether (about two-thirds of the 104 million ether currently in circulation) in the early days of the project.

In the beginning

If Ethereum had a birthday, that would be in November 2013. That’s when Vitalik Buterin, the creator of the project, emailed a whitepaper to 15 friends, who then disseminated out to their own networks. Two months later, the project had eight co-founders and a growing army of contributing developers and supporters.

Instead of raising venture capital money, Ethereum bootstrapped. Co-founders Anthony Di Ioro and Joseph Lubin lent their own money to the project. And then Ethereum held a crowdsale by which it raised money selling ether, which it called a “cryptofuel” for its future platform.

Ethereum’s crowdsale tokens were only part of a larger premine. Premine refers to the tokens that exist the moment a platform goes live. This contrasts with Bitcoin, where all of the virtual currency has to be mined. Ethereum used some of its premined tokens for compensating its contributors—those who worked on the project in the months leading up to the crowdsale.

Although, the “Terms and Conditions of the Ethereum Genesis Sale,” refers to those contributors as “volunteers” and their allotment of ether as a “gift.”

According to the Howey test, a security is an investment of money in a common enterprise with a reasonable expectation of profits based on the efforts of a third party.

Did participants in the Ethereum crowdsale expect the value of ether to skyrocket? Many in the crypto space had already witnessed bitcoin’s run up from its pizza days, when one bitcoin had almost no value, to its first price peak of $1,200 in November 2013, the same month Buterin dispatched his white paper.

Morgan Peck, a journalist who was on the ground at Ethereum’s public debut in Miami in late-January 2014, wrote of Ethereum in Backchannel: “I was told it would blow Bitcoin out of the water.”

The crowdsale

Before holding a crowdsale, Ethereum had to officially set up shop.

On February 28, 2014, the project registered EthSuisse (Ethereum Switzerland Gmbh), a for-profit entity in Zug. After Buterin single-handedly pushed through a decision to make Ethereum a non-profit, the project also set up a foundation (Stiftung Ethereum) on July 14, 2014.

At the beginning of June [2014], I had to fire the two people who no one liked working with. It just so happened that these people were among the main instigators of the for-profit idea. I forced through the non-profit. Some people were unhappy, but oh well,” Buterin told Tank earlier this year.

And then on July 22, EthSuisse launched a 42-day crowdsale that ran to September 2. The sale was open to the general public. What’s more, there was no cap on the sale, so you could buy as much ether as your heart desired. The sale was also open to the project’s own employees.

If you want to legally sell securities to U.S. citizens, Section 5 of the Securities Act of 1933 requires you to register with the SEC or else file an exemption, such as a Regulation D, that allows you to sell only to accredited investors, meaning wealthy folks and institutions. Ethereum did not do either, perhaps because it didn’t view ether as a security.

Instead, to avoid running afoul with regulators, Ethereum spent significant resources on lawyers (Pryor Cashman in the U.S. and legal and tax compliance specialist MME in Switzerland) working out the finer details of its crowdsale.

As Lubin told the Financial Post last year, before doing that, his thoughts ran more like this: “We thought it was possible we would land at JFK on a certain day and the FBI would tackle us to the tarmac.” 

EthSuisse raised $18 million in bitcoin during its crowdsale. Sixty million ether were exchanged for approximately 31,000 bitcoin. Participants in the sale paid on average about $0.30 per ether. Unfortunately, bitcoin, which was around $600 when the majority of ether was sold, soon took a tumble. And EthSuisse, having kept its funds in bitcoin, lost about $6 million.

Liquidating a large stash of bitcoin was not a simple thing back then. Bitcoin markets were fragile in 2015. If you dumped a lot of it all at once, you risked crashing the price. The project’s then-CEO Charles Hoskinson (who was pushed off the project just before the crowdsale) wanted to buy $550 strike BTC put options as a protection against bitcoin’s volatility. That may sound like a brilliant idea in hindsight, but there were few places to buy bitcoin derivatives at the time, and BitMEX, one of the largest markets today for trading bitcoin futures, was just getting going.

According to data from the crowdsale, more than 40 percent of the ether sold went to the top 100 purchasers. And the three largest purchasers, went home with roughly 1 million ether each. Some critics thought the sale was dominated by even fewer people.

“In my view, most of the ether sold in the 2014 token pre-sale in exchange for Bitcoin may have been paid out to one person or, more likely, a handful of close associates working in concert,” Preston Byrne, a English securities lawyer, wrote in a blog post.

A graph of the amount purchased by purchase size shows the distribution.

As for the crowdsale funds, EthSuisse used them to pay off nearly $2 million in back expenses—which included $300,000 in legal fees and $210,000 in interest on loans—and to fund the development of the platform.

What about the other premined tokens?

In addition to the 60 million ether sold in the Ethereum crowdsale, another 12 million coins were premined. Where did they go?

  • Three million of them went to the Ethereum Foundation as a long-term endowment.
  • Six million ether were distributed among 85 contributors who worked on the project in the five months leading up to the crowdsale. Many of them had worked for no pay, and they understood that the tokens could be worth potentially nothing, if the project failed for any number of reasons
  • Another 3 million ether became part of a “developer purchase program” that allocated the right to purchase ether at crowdsale prices (2,000 ether for 1 bitcoin) to roughly 50 people who worked at the Ethereum Foundation between September 2014 through March 2015. (This sounds similar to how companies grant stock options to employees, giving them the option to buy company stock at a set price at a later date.)

In all, roughly 100 contributors, either through the contributor allotment, the developer purchase program or both, received ether in compensation for their efforts on the Ethereum project.

The largest beneficiaries of the contributor allotment were the project’s co-founders. Seven of them received about 300,000 ether each. Lubin, who went on the found ConsenSys, a 1,200-employee incubator for Ethereum-based projects, is also rumored to have been the biggest investor in the ethereum crowdsale.

The biggest payout, 550,000 ether, went to Buterin. While that may sound like a lot now, at the time of the crowdsale, it was only worth $160,000. In a recent tweet, Buterin, who is still battling rumors that he is a billionaire, posted a link to his digital wallet, which now holds about 360,000 ether. Today, that amount is worth $30 million.

Market observers think Ethereum’s co-founders were paid the most ether because they were part of the leadership team. But in an email to The Block, Buterin explained that the “reward” distribution was egalitarian. A set amount of ether was divvied up each month among those working in the project at the time, based on a whether they worked a quarter time, half time or full time. The co-founders just happened to be the project’s earliest employees.

“I was basically the only one working on the project in November [2013], and it was the leadership [team] that was [a big] part of the project in much of December and January, so naturally these people got higher awards,” he said. “I don’t think anyone imagined that basically everyone on that premine list would [potentially] become a millionaire.”  

“We had an idea that Ethereum might be useful obviously, we believed it would be, and we knew bitcoin was worth money, but not for a second did anybody expect the kind of growth we saw,” Mathias Grønnebæk, an early Ethereum contributor told The Block

Number go up

Nearly a year after the crowdsale, the Ethereum platform went live on July 30, 2015. When trading opened on third-party exchanges on August 7, the price of ether went to $2.80 but quickly dropped to under $1.00, where it stayed for the rest of the year. The following year, ether hovered around $10—still a 30x return on investment, if you bought during the crowdsale.

What the project needed to push the price of its token even higher was actual use cases for the platform. And Ethereum’s biggest use case, as it turned out, was launching more crowdsales. An ERC-20 token standard made this particularly easy. All you needed to raise the equivalent of millions of dollars via an ICO was to cut and paste some code and come up with a white paper.

One of the best known Ethereum applications was an investment fund known as the DAO (short for decentralized autonomous organization)., the German company behind the project, promoted the DAO as a leaderless corporation where contributors could vote on what Ethereum-based startups they wanted to fund, while smart contracts enforced the rules of the game.

In late April 2016, the DAO launched what was to be the largest crowdfund in history at the time. The project raised $150 million in ether in DAO tokens from 11,000 investors. The effort was so big that 14 percent of all ether was in the DAO. And the publicity was so effective that people bought ether simply to invest in the DAO. This pushed ether to nearly $14 in May.

The DAO did not last long. On June 17, a hacker took advantage of a weakness in the code to drain the contract of one third of all its assets. The blockchain was supposed to be immutable, meaning that once a transaction was recorded on the ledger, that was that. You could not undo it. In 2014, Ethereum co-founder and lead developer Gavin Wood spoke about “allegality,” the idea that a system “cannot care” whether its actions are legal or not legal. “Decentralized software as a service has no operator,” he said.

But after some deep soul searching, the Ethereum Foundation, some of whom were curators of the DAO or had personally invested in it, decided to “roll back” the entire Ethereum blockchain to return the lost funds. In July, Ethereum issued a type of software upgrade known as a hard fork, which made it as though the DAO never happened. Although, disagreements over the immutability of a blockchain, resulted in a split in the community and a competing project known as Ethereum Classic, where the DAO hack still lives on. 

Ethereum seemed determined not to let the DAO fork serve as precedent for rescuing faultily coded smart contracts. After Wood left Ethereum in January 2017, he founded a company called Parity that launched an Ethereum software wallet of the same name. A month after the DAO hack, when Parity lost $30 million worth of ether due to a bug in its code, Ethereum did not fork. And those 150,000 stolen ether remained lost. 

The DAO hack was a setback, but not enough to deter thousands of other ICO projects from launching on Ethereum. Many of those projects never took off.

In March 2017, as the ICO craze lurched into full swing, the price of ether began to climb. By June, one ether was worth nearly $370. The price toppled when then SEC issued a report that deemed the DAO tokens to be securities. The SEC did not take action against, because all the investor funds had been returned, but the report contained a clear warning that ICOs needed to comply with securities laws: 

“In light of the facts and circumstances, the agency has decided not to bring charges in this instance, or make findings of violations in the Report, but rather to caution the industry and market participants: the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”

Another warning to ICOs came in December when the SEC halted Munchee, a million dollar Ethereum-based project for securities violations. Like many ICOs, Munchee was trying to sidestep securities laws by claiming its token offered a utility function. According to the SEC order:

“Even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security. Determining whether a transaction involves a security does not turn on labelling – such as characterizing an ICO as involving a “utility token” – but instead requires an assessment of “the economic realities underlying a transaction.” All of the relevant facts and circumstances are considered in making that determination.”

Despite the regulatory backlash, the ICO market was still going full tilt in 2018, with fundraisers shifting their focus to investors outside of the U.S. In January, ether hit its all time high of more than $1,300, before heading back down again. Today, one ether is less than $100.

Are we decentralized yet?

What is ether? Is it a utility token, a commodity, an investment, or some combination?  

The U.S. Commodity and Futures Exchange (CFTC), has determined that bitcoin is a commodity, but it has fallen short of issuing a clear determination on ether. The CFTC recently issued a request for information to learn more about Ethereum and how it compares to bitcoin.

Meanwhile, the SEC has said that it believes current offers and sales of ether are not securities due to the network’s “decentralized structure.” That means that ether would have had to transform from a security to something other than a security at some point in time.

“I kind of don’t think this is going to work,” former CFTC chairman, Gary Gensler told a crowd at a blockchain conference at MIT in April. “I don’t think there’s any precedent in the law for a security to transform to be something else.”

SEC chairman Jay Clayton explained his view at Consensus Invest last month with an analogy:

“Let’s say you’re the producer of a new play and you get 15 people to invest in that play and you say, ‘Your interest in this play is going to be a suite of tickets. You’re giving them tickets in exchange for their interest in the play—those tickets are securities. They’re taking those tickets back, waiting for the profits. It’s like taking 10% of the play. But when the play gets done and everybody has their tickets distributed and all you can exchange the tickets for is going to see the play, that’s decentralized.”

Until a judge steps in to settle the matter and takes a look at the Ethereum crowdsale and how the network is currently operated, the issue is open to debate. And Ethereum, along with the thousands of other projects that held ICOs, will have to wait and see to find out with certainly what laws they are supposed to comply with. 

Correction (December 18, 2018, 7:30 p.m. EST): A previous version of this story listed the current supply of ether as 130 million. It is actually about 104 million.