What Every Entrepreneur Should Know about Raising Money Through a Token Offering Startups seeking investment capital cannot ignore this March 4, 2018 headline: “ICOs delivered at least 3.5x more capital to blockchain start-ups than VCs since 2017”. https://techcrunch.com/2018/03/04/icosdelivered-at-least-3-5x-more-capital-to-blockchain-startups-than-vc-since-2017/. The article also noted that “Over the past 14 months, blockchain and related startups have raised nearly $1.3 billion in traditional venture capital rounds worldwide. But for the ICOs Crunchbase has captured, nearly $4.5 billion was raised via ICOs.” However, there have been three very good reasons why startups have avoided token offerings: 1) A large number of the ICOs (Initial Coin Offering) completed to date violated the US securities laws. And there is not a clear path to a compliant token offering. All the talk about the “Howey test”, and utility tokens vs. security token seems so 2017 - before the SEC (Securities and Exchange Commission) weighed in (see below). 2) It was common knowledge that if company completed an ICO, it was unlikely that company could raise traditional venture in the future. 3) The costs associated with an ICO were significant with the probability of success quite low. There are reports that suggest successful ICOs often cost $200,000 - 500,000 to organize and only a small percentage of them were successful. Famous angel investor Jason Calacanis spoke at the recent eMerge conference and said something to the effect that we are not even in the first quarter of the blockchain and crypo-currency game. We are not even yet at the game, but at the tailgate - where there are no rules, just a bunch of drunk adults running around without supervision. The market for token offerings (let’s call it a token offering (a securities offering), rather than an ICO) has evolved radically in the first few months of 2018 to address these concerns. Service providers like Securitize and Coinlist are already working through the concerns with token offerings and a compliant method to issue those tokens (e.g., by starting with a compliant offering and restricting the resale of the tokens). See this Wall Street Journal article (subscription required): https://www.wsj.com/articles/newwave-of-firms-race-to-capitalize-on- ico-gold-rush-1523914537. However, like Jason Calacanis points out, we are still not even ready for kickoff. The purpose of this article is to focus on a compliant, two step-path to a token offering, through which a startup would raise capital under Regulation D convertible note offering, while planning for a compliant token sale at the right time in the future. What’s the Problem with past ICOs? After taking some time to assess the situation, the SEC has come down hard on token (which it may refer to as “digital assets”) offerings. Enforcement actions have been taken and subpoenas issued. The problem, in addition to rampant fraud, is that issuers have used creative approaches to avoid compliance with U.S. securities laws that require the registration of public offerings (or compliance with an appropriate exemption), disclosure of risks to investors, and that bar resale of securities in unregulated secondary markets. Commonly, those creative approaches include claiming that sales of tokens in an ICO are the equivalent to the sale of products of those companies (utility tokens), as opposed to the sale of a security (i.e., an investment). I will not re-hash that debate because it is functionally over. The SEC’s Chief, Jay Clayton said, “every ICO I've seen is a security”, and if you want to take the SEC to court, best of luck. The future could hold a future path or exemption for true utility tokens, but that discussion
is just speculation at this time. What’s the Best Path Forward? The key take-away is to return to basics and find a way to issue your tokens in a manner that complies with securities laws and/or an applicable exemption. At this point, the framework for a securities compliant token offering has not been definitely established. As we’ll explain below, however, Regulation D and Regulation A+ offerings, with controls over resale in secondary markets, are the best option available within the framework of securities laws in effect today. The suggested first step (if you want to start this process in today’s uncertain environment) is to conduct a pre-sale using a traditional private offering exemption. The offering can take the form of a convertible note, a very traditional pre-Series A round instrument. The note would convert into tokens in a future token offering at a discount. The note should also convert into company equity if the company completes a traditional financing round (just like traditional convertible notes). This offers an alternative path to convert the notes if the issuer determines that the token sale process is too expensive or burdensome or that an acceptable compliant offering process is not yet available, and chooses to complete a traditional Series A round instead. Since the instrument is a convertible note, and not tokens, it is easy to control resale just like any other convertible note. The funds from the pre-sale can then be used to prepare the groundwork for the eventual token sale. It is important, however, to disclose this to your investors. Said another way, at this stage, several companies are testing the waters with Regulation A+ filings with the SEC, but none have been approved. We have no clue when the SEC when the will decide to approve such an offering and under what terms. Most businesses are best served letting others first successfully complete a token offering approved by the SEC, and copy that format, the one the SEC finds acceptable. Private Offering Exemptions As discussed above, the SEC considers the sale (or pre-sale) of tokens to be the sale of securities and issuers of course must follow the securities laws when conducting a securities offering. Let’s dive into the options under U.S. securities laws and see what will work. Keep in mind that these laws are complex, so be sure to consult with your attorney before accepting any investments. An initial public offering (IPO) permits the public sale of securities, but it is also an incredibly expensive and time consuming process. Otherwise, an issuer selling securities must use a private offering exemption. The exemptions fall into two basic categories and offer different sets of hoops you’ll need to jump through. The first category is accredited investor offerings, in which you only take money from wealthy investors (and are the easiest to conduct), and the second are non-accredited investor offerings. Accredited Investor Exemptions Regulation D, under the Rule 506(b) exemption, allows issuers to raise an unlimited amount of money from accredited investors. The most typical accredited investor categories include: (a) individuals who earned $200k or more (or $300k together with their spouse) in each of the last two years, and expects to continue doing so; (b) individuals with a net worth of $1M+ (excluding a primary residence); and (c) entities with $5M+ in assets (not formed just to buy the securities in question) or owned entirely by accredited investors. Rule 506(b). The Rule 506(b) exemption requires: (a) no general solicitation (i.e., “advertising”, including social media)(see below for an exception); (b) that information provided to investors not violate the antifraud prohibitions of the federal securities laws (a private placement memorandum is not
specifically required, although always recommended); and (c) that the issuer be available to answer questions by prospective purchasers. Rule 506(c). An offering may be advertised under Rule 506(c) by (i) meeting the same rules described above; (ii) filing a Form D (simple form describing the offer) 15 days in advance of any advertisement; and (c) verifying the accredited status of each accredited investor (there are companies that help with this process). Non-Accredited Investor Exemptions Regulation CF, Regulation A+ and Regulation D provide an alternative way for issuers to raise money in a manner that’s not limited to accredited investors, but are more costly and burdensome as a result. Regulation A+. This is essentially a mini-IPO that allows issuers to raise up to $20M (Tier 1) or $50M (may increase to $75M)(Tier 2), depending on the type of offering, from non-accredited investors. It is the most expensive option of the private offering options but is less expensive and difficult than a full IPO. To conduct a Tier 2 offering under Regulation A+, issuers must file a registration statement with the SEC (and work through the SEC’s comment process), submit ongoing SEC filings and conduct AntiMoney Laundering checks for investors (the investment amount is also capped for non-accredited investors to 10% of income or net worth (or revenue or assets for a company)). The Tier 1 exemption does not require the company to include audited financial statements and does not have any ongoing SEC reporting requirements, but also does not preempt state law (meaning the investor is required to comply with state law requirements, which complicates and adds expense to the offering, and is only useful if the offer is limited to a small number of states). The Regulation A+ route might be the future for token offerings. Regulation CF. This is the crowdfunding exemption that permits the issuer to raise up to $1M from nonaccredited investors through a registered funding portal (e.g., SeedInvest, Fundme.com). Regulation CF (a) allows a maximum of about $1M to be raised through crowdfunding in any 12-month period; (b) requires reporting and financial disclosures for rounds over $100k, and other ongoing disclosure requirements, including financial statements reviewed by an accountant (audited in some instances); (c) limits investor contributions based on income; (d) limits advertising to the funding portal with limited factual terms; and (e) requires that the issuer be a U.S. company. Rule 506, with Non-Accredited Investors. Under Rule 506, issuers may accept investment from up to 35 “sophisticated” non-accredited investors by providing those investors with the information similar to that required in a Regulation A+ registration statement, along with a host of other information (such as audited financial statements in certain cases) that can make the offer quite expensive. Rule 504. Rule 504 permits the issuer to raise up to $5M in any twelve-month from an unlimited number of non-accredited investors. However, advertising is prohibited unless sales are limited to accredited investors, and the exemption does not preempt state law (meaning the investor is required to comply with state law requirements, which complicates and adds expense to the offering). Regulation S Offerings Regulation S is a series of rules that clarifies the position of the SEC that securities offered and sold outside the U.S. need not be registered with the SEC. However, the rules are complex and not as simple as “selling to non-U.S. residents”. The primary rules are that any offer, sale or resale must be made in an offshore transaction and no directed selling efforts can be made in the U.S. in connection with an offer, sale or resale under the safe harbors.
An offshore transaction is a transaction where no offer is made to a person in the U.S. (including no discussions about the offer in the United States) and where at the time the buy order is originated, the buyer is outside the U.S. Directed selling efforts means any activity undertaken for the purpose of, or that could reasonably be expected to have the effect of, conditioning the market in the United States for any of the securities being offered in reliance on Regulation S. Such activity includes advertising the offer in the U.S. Resale (Secondary Offers) A quick note about resale. All securities received in a private securities offer are restricted securities and are subject to restrictions on re-sale. There are exemptions that apply to the re-sale of securities, just as there are for issuing securities, primarily Rule 144 (which has many nuances, but the most important is a required 1-year holding period for securities issued in most private offerings (although securities sold under Regulation A+ are exempted). One major issue with crypto-currency offerings is establishing controls against re-sale. As mentioned above, there are services currently working on this problem. No issuer should conduct a token offering unless it is comfortable that it can control resale of the tokens. An issuer cannot simply state in its documents that re-sale is conditioned on Rule 144, and close their eyes and let the tokens trade rampantly on various token exchanges. This is one of the main reasons we suggest waiting for a clear compliant ICO process to emerge before conducting your ICO.