Disclaimer: While I hope you enjoy this article, please do not misconstrue any of the information provided below as legal advice; it is merely a personal expression of my interest in the intersection of the law with blockchain technology. Please consult a lawyer and/or financial representative before investing.
Entrepreneurs face a classic chicken or the egg problem. While businesses need capital to function, soliciting investments prior to significant product development may lead to relinquishing vital decision-making authority too soon. Founders must identify the optimal amount of funding to cover expenses yet retain controlling equity to build their business aligned with their vision. Along with continuing to foster growth, balancing these competing interests while seeking an investment remains a nearly impossible task for the nascent start-up.
The crypto decentralization revolution, in addition to challenging incumbent centralized business models, has dramatically recalibrated the fundraising incentives for entrepreneurs. Instead of housing product development, strategy, decision-making, and — most importantly for investors — profits under one corporate umbrella, new blockchain-based projects seek to democratize returns by providing economic incentives to those that facilitate the network rather than those who own it. As a result, distributed networks of workers and adopters earn financial rewards in the network’s “token” based on their participation rather than centralized for-profit structures and passive shareholders.
For example, in light of recent privacy concerns against Facebook, consumers may seek greater control over their data with Internet companies. As such, a decentralized, user-owned social media platform may appeal as a favorable alternative. Instead of Facebook’s users providing their information for free and Facebook’s equity holders absorbing enormous advertising revenues (potentially from questionable state actors), a decentralized social network would compensate those who help facilitate the network (via computing power) and those who offer their data and profile information to potential marketers. The network’s tokens may have a use case on the platform (e.g., the ability to advertise or access certain features) and develop a secondary market for those who crave them.
The passive investor in such a platform must rely on the strength of the network to generate a consumptive or marketable use case for his or her tokens. Entrepreneurs creating decentralized networks no longer need to focus on retaining shares while raising capital since such fundraising models eliminate traditional concepts of equity. Likewise, if a founder maintains a sizable portion of the developed protocol’s tokens (antithetical to the democratized blockchain value proposition), it may stymy user adoption by diminishing the economic incentives for new entrants if the platform remains too centralized. Thus, developers can solicit funding to build platforms, attract new users, and grow networks without surrendering value in a tokenized economy.
Like traditional companies, blockchain-based entrepreneurs can seek funding at any stage of the network’s development, but will often attract an investment as soon as possible through a pre-sale of the platform’s tokens called an “Initial Coin Offering,” or ICO. An ICO often occurs after a developer team publishes a white paper, which describes the underlying technology that will support the network (i.e., the nuts and bolts of the blockchain technology), the team developing the protocol, and the platform’s value proposition (i.e., its use case; when the network is fully established, how it will improve on incumbents — with our Facebook example, perhaps the ability to control and profit from one’s own data). After ICOs raised only $39 million combined between 2014 and 2015, investors injected $256 million into the market in 2016 before pouring in nearly $5.4 billion to blockchain start-ups in 2017. In just over three months in 2018, investors have already eclipsed 2017’s crypto financings with over $6.3 billion funneled into ICOs. Social media platform Telegram alone received an influx of $1.7 billion through two separate $850 million raises in January and March.
If the amount of money invested with so little data or information startles you, it should. Given 2017’s exponential growth embracing crypto-evangelist visions of blockchain technology as a paradigm shifting interdisciplinary marvel, investors would rue missing the next potential king-making opportunity. But with backers dropping millions into projects on the basis of a single dozen-or-so-page document, the ecosystem remains ripe for fast failures and scams. To protect its citizens, regulators across the globe have played catch-up identifying how to classify this new asset class while still fostering the technology’s development. In addition to monitoring money laundering concerns, the defining test in many jurisdictions for issuers and stakeholders remains whether these ICOs amount to sales of “securities” requiring significant compliance with investor protection laws across the world.
1. Blockchain-Based Start-ups Seeking U.S. Investors Must Comply with U.S. Law Regardless of the Project’s Home Jurisdiction
Despite its extra-governmental ethos, the distributed, global scope of crypto-assets inevitably encroaches upon the legal authority of several nation-states simultaneously. Although many in the community, including the Winklevoss twins and administrative bodies like the U.S. Commodity and Futures Trading Commission (“CFTC”), advocate for the creation of a private, self-regulating enforcement body, states are unlikely to surrender their police powers so long as bad actor behavior remains prevalent against its citizens and private enforcement mechanisms (e.g., freezing coins procured through malicious conduct) prove technologically difficult or ineffective. Thus, developers of new protocols must remain vigilant of and compliant with a variety of regulatory schemes to avoid triggering liability and causes of actions from governments and private citizens.
Even if a developer team establishes an organization that complies with local crypto-favorable laws, certain activities impacting other jurisdictions may implicate that nation’s enforcement regime. Regardless of whether a project originates in a state like Switzerland that welcomes the retailing of certain “payment” and “utility” tokens, the purchase of such an asset may be deemed a sale of a security under U.S. law subject to the reach of the Securities and Exchange Commission (SEC) and state compliance schemes if offered and sold to U.S. investors. Likewise, an issuer remains subject to U.S. jurisdiction if living in the U.S. and/or using U.S.-based facilities (i.e., the Internet), even if he or she incorporates abroad.
According to John Reed Stark, former chief of the SEC’s Office of Internet Enforcement division, “U.S. federal securities laws boldly apply to everyone in the world, with exceptions being available to the extent the person or organization in question does not actually transact in the U.S. or with U.S. persons or companies.”
Unless developers wish to avoid the U.S. market, a prospective offering must (i) be structured so as not to constitute an offer or sale of a “security” under U.S. laws; (ii) comply with U.S. securities laws by filing a registration statement with the SEC and following other disclosure requirements (an expensive process required when conducting an Initial Public Offering, or IPO, of traditional equity); or (iii) fall within federal and state securities law exemptions relieving the registration statement requirement (but nevertheless demanding strict adherence to investor qualifications, transfer restrictions, and/or fundraising limits).
For crypto-entrepreneurs seeking capital to build their platforms, constructing offerings that fall outside the scope of securities laws remains ideal to maximize the pool of potential investors and size of raises; however, considering the broad reach of securities laws, developers should contemplate pursuing a securities exemption to avoid triggering arduous and expensive disclosures required in a full registration.
2. Most ICOs are Likely Securities under U.S. Law, Requiring Compliance with U.S. Federal and State Securities Laws
Industry literature from Coin Center’s Director of Research Peter Van Valkenburgh, Debevoise & Plimpton LLP, Cooley LLP and Protocol Labs’ “SAFT” Project, the Cardozo Blockchain Project, and Perkins Coie’s Conor O’Hanlon have all engaged with the application of U.S. securities laws to blockchain-based fundraising. Although formulated long before the advent of internet technology, the 1946 Supreme Court decision in SEC v. W.J. Howey Co. (“Howey”) provides a malleable framework for identifying whether an unorthodox sale falls under the Securities Act of 1933’s (herein the “Securities Act”) definition of an “investment contract” requiring compliance with U.S. federal securities laws. Howey supplies an “economic reality” four-factor test for an investment contract, considering whether a contract, transaction, or scheme involves: (1) an investment of money (2) in a common enterprise (3) with an expectation of profits (4) solely from the efforts of others.
While the aforementioned research provides an excellent distillation and debate of the Howey factors to guide developers, investors, and participants, the gist of the discussion suggests that the investment of funds into a still-centrally housed project before its tokens possess marketable utility represents a sale of securities. In other words, before a team of developers reaches a distributed global scope (i.e., expanded beyond the original core development team, weakening the “common enterprise” factor) and the asset transforms into a “commodity” whose price primarily depends on market demand rather than the continued work of the developers (the “expectation of profits” and “solely from the efforts of others” factors), the offering likely satisfies the Howey test and subjects itself to U.S. securities regulation. Thus, if a project intends to develop a commoditized platform or even launches a tokenized network, it may not avoid securities regulation until it achieves its proffered purpose and satisfies regulators as a commodity.
The U.S. and more ICO-friendly jurisdictions like Switzerland effectively differ most drastically on this issue of an offering’s timing. While utility token ICOs may proceed at their development’s infancy under Swiss law, tokens must transition from securities to established commodities before a developer team may conduct an ICO to potentially avoid the SEC’s reach. Even so, the SEC nevertheless may deem that a particular utility token offering falls under its jurisdiction.
In fact, the SEC has started to act. Last July, the SEC issued an investigative report against “The DAO,” a crypto-venture fund that sold tokens as ownership shares in its investment vehicle’s profits. Although the SEC refused to pursue charges against The DAO’s promoters for issuing an unregistered security, the report nevertheless declared that such “virtual” offerings triggered SEC scrutiny. By December, the SEC issued its first cease-and-desist order of an ICO against “Munchee,” a tokenized restaurant review platform. The SEC stressed that despite Munchee’s claim that its tokens would possess utility, its promoters not only sold virtual coins before they acquired their alleged use case, but they also advertised the tokens as an investment opportunity in its white paper and subsequent marketing materials. Munchee immediately refunded its $15 million raise to investors.
Further enforcement also appears imminent. On February 6 before the Senate Committee on Banking, Housing, and Urban Affairs, SEC chairman Jay Clayton affirmed the enforcement bureau’s perspective on ICO compliance with U.S. federal securities laws, “To the extent that digital assets like ICOs are securities — and I believe every ICO I’ve seen is a security — we have jurisdiction and our federal securities laws apply.” Despite Clayton’s recent informal comments acknowledging the potential of a security-non-security continuum, his congressional testimony suggests that the SEC may approach the Howey factors expansively or depart from the Howey framework entirely when evaluating whether an ICO falls under its jurisdiction.
Likewise, The Wall Street Journal reported that the SEC has issued at least eighty subpoenas to token issuers, advisors, and investors over the past several months to uncover the mechanics of offerings and their compliance with securities laws. Although the identities of those receiving such subpoenas largely remain unknown, the SEC confirmed it has initiated an investigation into Overstock.com’s $250 million proposed raise for its new tZero platform, as well as “dozens” of other ICOs. Due to such a hazy regulatory climate, distributed video platform Stream halted its token “airdrop” until receiving greater clarity on its legality with securities law, while U.S.-based token exchange Coinbase announced that it will pursue accreditation as a licensed brokerage firm. Even Congress appears poised to intervene.
3. The JOBS Act Provides Potential Effective Securities Law Exemptions for Crypto-Entrepreneurs to Solicit Both Accredited and Unaccredited Investors
Given U.S. regulatory uncertainty, it remains prudent for start-ups to embrace compliance with securities laws and design offerings that satisfy an available exemption to avoid onerous registration and reporting requirements of going “public.” Depending upon their objectives, including (i) the proposed size of the offering; (ii) investor profile (i.e., “unaccredited” and/or “accredited” investors — i.e., individuals with either $1 million in non-residential net worth or three years of annual income exceeding $200,000, or $300,000 for a couple); (iii) number of investors (if considered “equity,” possessing more than 500 unaccredited or 2000 total investors triggers reporting requirements for a company with over $10 million in assets); (iv) liquidity (i.e., “restricted” versus “unrestricted” securities available for re-sale); and (v) financial reporting appetite and accompanying litigation risk, developers may find complying with certain exemption requirements more attractive than others.
The Jumpstart Our Business Startups (JOBS) Act, signed into law by President Obama in April 2012, provides entrepreneurs greater access to capital from both “accredited” and “unaccredited” investors by relaxing previous securities exemption requirements and fostering new legal funding avenues. By combining the Securities Act Section 4(a)(2) private placement exemption, the JOBS Act 506(c) moderation of advertising restrictions, and Section 4(a)(7) and SEC Rule 144 governing re-sales, crypto start-ups can craft private sales to accredited investors to bootstrap their networks. Likewise, the genesis of crowdfunding provides blockchain-based founders the opportunity to capitalize on unaccredited investor excitement and launch a democratized platform by directly targeting diverse users. Finally, the JOBS Act’s revisions to Regulation A and creation of Regulation “A+” offer developers the opportunity to raise up to $50 million in a public round from a pool of accredited and unaccredited investors. Depending on the entrepreneur’s priorities, all three exemptions offer compelling opportunities to elicit funding.
a. The JOBS Act’s Relaxation of Prohibitions on General Solicitation Combined with Securities Act Re-Sale Safe Harbor Rules Provide a Viable Private Offering Opportunity for Blockchain-based Start-ups
Prior to the enactment of the JOBS Act, most start-ups struggled to attract securities exempt private funding given a restricted investor pool (i.e., only wealthy or “sophisticated” individuals) and prohibitions on public advertising. Entrepreneurs relied upon the Securities Act Section 4(2) “private placement” exemption, now Section 4(a)(2), which, as constructed, offers little guidance for issuers and investors by simply authorizing transactions “not involving a public offering.” Common law precedents and SEC no-action letters have defined the contours of the exemption by limiting it to purchasers who can “fend for themselves” either as a “sophisticated investor” or through access to the kind of information available in a traditional investment prospectus for a registered offering. Section 4(a)(2), by not providing a disclosure requirement for issuers, supports the concept of caveat emptor — buyer beware — for such eligible investors. Given the fuzziness of the term “sophisticated investors,” the SEC established Regulation D Rule 506(b) in 1982 to provide a Section 4(a)(2) safe harbor for offerings attracting 35 or fewer unaccredited investors who nevertheless possess financial sophistication and awareness of the investment risk.
Further limiting the breadth of potential backers, the Securities Act forbids the “general solicitation and advertising” of such Section 4(a)(2) or Rule 506(b) sales. Likewise, investors receive “restricted” securities ineligible for re-sale absent (i) a Rule 144A sale to “qualified institutional buyers” (i.e., institutions holding more than $100 million in non-affiliates); (ii) another limited exemption (such as Section 4(a)(7) or Rule 144, discussed below); or (iii) a full share registration.
For the blockchain-based start-up, Section 4(a)(2) and Rule 506(b) provide limited utility. Designed to protect unaccredited investors from salacious marketing, the pre-JOBS Act Section 4(a)(2) exemption rejected advertising in print, broadcast, or similar media — highly problematic for entrepreneurs developing platforms embedded and reliant upon the Internet. Recognizing the challenge facing founders seeking to efficiently raise capital in the digital age, the JOBS Act authorized the SEC to create a new private exemption allowing the general advertising and solicitation of capital raises. Now, issuers may rely upon Rule 506(c) to publicly market their offerings, provided that all purchasers are accredited investors and the founders take “reasonable steps to verify” each person’s accredited status. The new private placement exemption offers entrepreneurs the freedom to reach beyond their pre-existing relationships for funding, which not only increases investor competition, but may also connect developers with better strategic partners. For the crypto-founder, Rule 506(c) enables him or her the opportunity to release a white paper, advertise an interest in raising funds to build a platform, and attract investors from the United States.
While Rule 506(c) liberates start-ups to raise an unlimited sum, relying on the Regulation D private placement exemption nevertheless possesses certain downsides for a blockchain-based project, particularly considering the ethos of the crypto movement. Unless combined with another securities exemption, a 506(c) financing remains limited to accredited investors. Instead of empowering users and fostering a democratized distribution, wealthy investors retain the spoils of a successful platform; potential unaccredited users cannot buy in to a project early absent an alternative financing or distribution scheme.
Regulation D issuances also remain subject to limited censorship and disclosure requirements. For example, Regulation D offerings must exclude or disclose certain “bad actor” issuers and other “covered” persons, and must comply with anti-money laundering (AML) and know-your-customer (KYC) regulations under the Bank Secrecy and USA Patriot Acts. Founders also cannot completely avoid disclosing information to the SEC like they can under Section 4(a)(2); Regulation D sales require filing an electronic “Form D” with the federal enforcement bureau within 15 days after the first sale relying upon the exemption. Fortunately, Form D disclosures remain minimal and pale in comparison to Regulation Crowdfunding reporting, Regulation A information sharing, or the disclosure requirements of a full registration. Still, disclosing information to a centralized agency may deter certain potential token issuers.
Further, Regulation D sales represent “covered” securities, which, while preempting state securities laws on their initial sale, nevertheless must comply with such state “blue sky” laws and the SEC’s enforcement scheme on re-sales. Under federal law, restricted secondary sales may not occur absent a Section 4(a)(7) private exemption, Rule 144 public exempt re-sale, or a Regulation S international trade. Signed into law by President Obama in December 2015, the Fixing America’s Surface Transportation (FAST) Act promulgated the new Securities Act safe harbor, Section 4(a)(7), codifying the previous lawyer-made “Section 4(a)(1½)” exemption for private re-sales to fellow accredited investors made at least 90 days after the initial purchase, provided that the transaction remains compliant with other information requirements. Unlike an initial issuance under 506(c), however, such secondary sales cannot result from general solicitation or advertising. After a minimum of one year, a non-company-affiliated investor may also utilize the Rule 144 public re-sale exemption to sell to accredited and unaccredited investors alike in the U.S. Thus, three months after an ICO, a private market may develop for a network’s tokens before welcoming a full exchange (subject to certain individual volume limits) nine months later.
While such lock-up periods may foster the development of more technologically sound platforms by encouraging longer-term investment decisions, it extends the minimum time required for utility tokens to develop their commoditized use case and attract a network of users. Given the SEC’s expansive jurisdictional reach on ICOs, however, it remains unlikely that a project can escape the definition of a security within such a time frame. Absent a legal opinion from counsel, purchasers of tokens via Regulation D should assume that any subsequent sale must comply with securities re-sale rules.
Ultimately, Rule 506(c) offers entrepreneurs an attractive option to fund the development of their platforms with American investors. Compared to other security exemptions, 506(c) benefits from offering a potential limitless issuance, fewer disclosure requirements, and reasonable re-sale opportunities. 506(c)’s greatest downfall, however, remains its limitation to accredited investors, the antithesis of the crypto movement. To reach a potential network’s ultimate end users, founders could seek to capitalize on another champion of the JOBS Act: Regulation Crowdfunding.
b. Regulation Crowdfunding Offers Crypto-Entrepreneurs the Opportunity to Bootstrap Networks By Directly Appealing to the Average Consumer
While Rule 506(c) loosens restrictions on marketing and discovering investment opportunities for accredited investors, the JOBS Act’s greatest achievement in fostering entrepreneurship remains the enactment of “Regulation Crowdfunding,” a securities law exemption allowing any investor the ability to support a nascent project and share in its successes. Prior to the JOBS Act’s modification of Securities Act Section 4(a)(6) with “Regulation CF,” unaccredited investors unable to qualify for the Section 4(a)(2) Rule 506(b) safe harbor solely relied upon the public markets to appreciate their capital. Designed to protect unaccredited investors otherwise lacking financial sophistication from risky investments and sensational advertising, the pre-JOBS Act securities regime prevented unaccredited investors from accessing potentially the most lucrative investment opportunities. Now, Regulation CF provides such unaccredited investors the chance to invest a limited sum in compelling early-stage projects.
Spawned from successful digital non-profit fundraising platforms like Indiegogo, entrepreneurs recognized the opportunity to leverage crowdsourcing to finance for-profit endeavors. Unlike non-profit donations, however, altruistic financiers participating in for-profit crowdsourcing often receive rewards for supplying capital. For example, sites like Kickstarter provide tools for new businesses to court investors by offering their supporters the finished product of a successful financing. Much like how many backers of crypto-based networks expect to receive commoditized tokens for supporting an ICO, for-profit crowdsourcing in this manner avoids the definition of a security by more closely resembling the purchase of a good or service rather than an investment with an expectation of profits. Upon receiving the completed good or service, the relationship often ends (unless, of course, the original backer formally invests in the accelerating business). For most crowdsourced token issuances, however, it remains unlikely that its digital coins will have reached a commoditized equilibrium with a genuine consumptive utility at such an early stage in its development. Thus, crowdfunded token sales more aptly fit under the final category of crowdsourced fundraising efforts: crowdfunding for equity.
Unlike philanthropic crowdfunding or donations to for-profit entities with limited compensation, many financiers crave equity to benefit from the long-term success of the company. President Obama’s signing of the JOBS Act ushered in the creation of equity crowdsourcing platforms, beginning with Fundable and made more popular since by AngelList, which allow any investor to contribute to a start-up pursuing a Regulation CF offering and obtain a share of the business.
Under Regulation Crowdfunding, businesses may currently raise up to $1.07 million over a 12-month period from accredited and unaccredited investors provided that any such investors limit their annual investments over all Regulation CF issuances to (i) $2,200 or 5% of the lesser of net worth and net income (if under $107,000); or (ii) 10% of the lesser of net worth and net income (if over $107,000), up to a maximum of $107,000 over the course of a year. Likewise, the sale must be conducted through an SEC approved intermediary (i.e., either a broker-dealer or crowdsourcing platform registered with the SEC and FINRA). Further, bad actors, public companies, and foreign entities cannot pursue a Regulation CF private placement. The company must also disclose certain financial and shareholder information to potential investors via a “Form C,” and may have to provide annual reports on a “Form C-AR.” Like Rule 506(c), Regulation Crowdfunding shares qualify as “covered” securities and remain susceptible to re-sale restrictions. Unlike 506(c), however, issuers utilizing Regulation CF cannot advertise the offering other than a general notice that directs individuals to the funding platform.
Regulation Crowdfunding issuances ultimately mirror 4(a)(2) private placements, but welcome unaccredited investors. Compared to Rule 506(c), however, Regulation CF maintains several disadvantages. First, Regulation CF departs from Rule 506(c)’s acceptance of general solicitation and advertising. Likewise, crowdfunded offerings may only accept slightly more than $1 million compared to an unbounded potential raise through Section 4(a)(2), Rule 506(b), or Rule 506(c), despite increased costs for a lengthier disclosure process via Form C (compared to the electronic short Form D) and supplemental annual reports. Crowdsourcing must also be completed through a regulated broker-dealer or portal. Material misstatements to unaccredited investors may also result in strict liability for the issuer. Finally, if more than 500 unaccredited investors provide capital and the company eventually possesses more than $10 million in assets, it must begin providing costly public disclosures. Despite such drawbacks, however, crowdfunding remains attractive for blockchain-based entrepreneurs given the appeal of reaching a distributed audience, which not only more closely embodies the crypto ethos, but may also more effectively foster a successful network.
Creatively crafted raises, however, may enable developers to pursue both a Regulation CF offering to kick start a network with a large base of unaccredited investors before utilizing a Regulation D issuance to provide additional funding and accelerate the platform’s growth. Under the concept of “integration,” two offerings conducted in close proximity may effectively be considered a single offering under U.S. securities laws, which may threaten the issuer’s reliance on either securities exemption if the combined issuance violates the SEC’s requirements. For instance, a Rule 506(b) reliant offering with 20 unaccredited investors may be in jeopardy if the business utilizes and advertises a Rule 506(c) sale shortly thereafter.
Securities regulators may treat multiple purported exemptions as a single issuance by considering several factors including (i) the offerings remain part of a single plan of financing; (ii) the issuances involve the same class of securities; (iii) the offerings are made at or about the same time; (iv) the business receives the same kind of consideration for their sale; (v) the capital raise is made for the same general purpose; and (vi) the offerees remain among the same class or character. Like the Howey test for securities, however, analysis of these factors remains fact-intensive. Fortunately, Rule 502(a) provides an integration safe harbor for issuances conducted at least six months apart. If a blockchain developer wants to carefully avoid liability, he or she should initiate a Regulation CF crowdsourced round and wait six months to solicit accredited investors via a Section 4(a)(2), Rule 506(b), or Rule 506(c) private placement.
Considering that an entrepreneur may be seeking to target two different classes of offerees — unaccredited investors with a Regulation CF issuance and accredited backers via another private placement exemption — waiting six months may not be necessary. Further, in the context of Regulation CF issuances, the SEC has determined that such offerings avoid integration with concurrent Regulation D sales, so long as “each offering complies with the requirements of the applicable exemption that is being relied upon for the particular offering.” In other words, a developer may generally advertise and solicit a Rule 506(c) financing at the same time as pursuing a Regulation CF exempt raise if he or she ensures that any such Regulation CF investor did not access the raise via general solicitation and advertising. Thus, an entrepreneur can pursue a simultaneous bifurcated offering utilizing Regulation D and Regulation CF to attract capital from both accredited and unaccredited investors.
c. Raising Regulation A’s “Mini Registration” Maximum Raise from $5 Million to $50 Million Presents Developers the Chance to Launch Active Networks with Both Accredited and Unaccredited Investors
Another, traditionally less popular, pre-JOBS Act means of funding includes the small business-geared Regulation A “mini IPO” for U.S. and Canadian companies promulgated under Section 3(b) of the Securities Act. Prior to the passing of the JOBS Act, a Regulation A offering permitted a public raise of up to $5 million; now, entrepreneurs can use the funding mechanism to obtain $50 million over a 12-month period from accredited and unaccredited investors alike via the modified “Regulation A+” abbreviated public offering.
Unlike the Section 4(a)(2), Regulation D, and Regulation CF private placement exemptions, a Regulation A+ offering involves a public sale of an issuer’s securities to investors. As such, start-ups relying on Regulation A+ must disclose substantial financial information to the SEC for qualification before supplying them to potential backers. Depending on the type of Regulation A+ issuance pursued (“Tier 1” allows a maximum raise of $20 million while a “Tier 2” issuance may reach $50 million), entrepreneurs may have to provide audited financials with management discussion and analysis (“MD&A”) of such figures (Tier 2), file annual, semi-annual, and current event reports after the offering (Tier 2), or register the issuance with offeree states according to relevant “blue sky” laws (Tier 1). If the company elects to list on a national exchange, it must adhere to any additional requirements proffered by the listing agency to access its platform for greater liquidity. Businesses must also begin traditional public information reporting required by the SEC (i.e., 10-Ks, 10-Qs, 8-Ks) upon reaching certain business thresholds, including exceeding 2,000 shareholders or 500 unaccredited investors, but may reduce certain obligations by qualifying as an “emerging growth company,” another JOBS Act design aiding accelerating businesses. Like private placements, the JOBS Act also rejects bad actor issuers from utilizing Regulation A+ for capital formation.
Despite such increased disclosure requirements, Regulation A+, particularly Tier 2 offerings, provide certain benefits over pursuing other financing schemes. While Tier 1 issuances must comply with state “blue sky” laws, federal law preempts state securities regulations for Tier 2 offerings like Regulation D and Regulation CF. Unlike the private exemptions, however, Regulation A+ represents a public sale, allowing purchasers of such “unrestricted” securities the ability to re-sell their shares immediately. Especially if a company lists its shares on a national exchange, stockholders obtain far greater liquidity for their purchased securities than in private placements, which require waiting a minimum of three months for private re-sales and at least a full year for a public market in the United States. Regulation A+ also benefits from allowing an issuer to “test the waters” and publicly advertise an offering, which even a traditional IPO disallows. Regulation A+ effectively offers two middle ground approaches to raising capital that select the best features of both private and public placements (accredited and unaccredited investors, immediate re-sale opportunities, and substantial yet not overly burdensome disclosures). If entrepreneurs remain concerned with increased disclosure costs present with a Tier 2 offering, they may sacrifice federal preemption and replace a maximum $50 million raise with a $20 million capped issuance.
Drawbacks to pursuing a Regulation A+ issuance include caps on issuances and the costs and risks associated with pursuing a public market. Compared to a simultaneous Regulation CF and Regulation D financing, Regulation A+ cannot raise an unlimited sum while building an accredited and unaccredited coalition. Regulation A+ may only raise $20 million or $50 million depending on the issuer’s appetite for disclosure. If an entrepreneur remains wary of beginning an extensive reporting process, a $20 million Regulation A+ issuance may be attractive, but nevertheless places a ceiling on a raise that otherwise does not exist with a Rule 506(c) private placement.
Immediate re-sale opportunities may also harm a nascent network by attracting investors seeking a quick return rather than long-term, strategic believers in the platform. Successful distributed tokenized platforms require both time to develop technologically proficient protocols and evangelists to foster network effects rather than speculators distorting the mission of the technology too soon. Finally, public reporting also increases litigation risk against an issuer for materially misleading statements or omissions under Section 12(a)(2) of the Securities Act, which, according to 1995 Supreme Court case Gustafson v. Alloyd, do not apply to private sales.
Practically, certain blockchain-based start-ups may also not be able to properly coordinate relevant disclosures required to complete a Regulation A+ offering. Although most projects begin centralized with a limited pool of developers, if a project transitions into a distributed network, consensus coordination to complete financial disclosures may be impossible. If power returns to individual users rather than a centralized corporation, traditional financial reporting may not be applicable. Although this issue also remains relevant for private placements, coordinating on consistent and detailed reporting requirements for Regulation A+ offerings may be too difficult for certain structures.
Governmental or credible self-regulation may be prudent to establish new reporting standards unique to the industry and decentralized organizations. Nevertheless, creative incentive structures within a network itself may allow for certain token holders on a protocol to head such reporting required by the U.S. securities system. For networks that can successfully coordinate disclosure efforts, Regulation A+ provides an enticing capital raising scheme for entrepreneurs seeking to publicly advertise and attract a significant raise from accredited and unaccredited investors.
Conclusion: Compliance with U.S. Securities Laws Will Allow Blockchain-Based Start-ups to Innovate with Legitimacy
Blockchain technology’s evangelized disruption not only represents a potential paradigm shift in how entrepreneurs may consider raising capital and forming companies, but also in data privacy and ownership. With the pervasiveness of hacks and other nefarious uses of individual data, people may crave market solutions less reliant on centralized corporate structures. Although in its infancy, blockchain technology offers the potential to provide greater security and allow a network’s users to share in its collective successes.
As more minds gravitate to the field, regulators should pursue a measured approach to protect investors yet foster innovation and capital formation. Switzerland (and potentially others like Malta) offer entrepreneurs favorable regulations to those creating and enabling distributed utility-based systems while the United States’ federal and state securities regime requires careful compliance to avoid triggering governmental and private liability if engaging the U.S. market.
While credible self-regulation or federal legislation preempting state law specifically for crypto platforms remain attractive, the 2012 JOBS Act provides frameworks to effectively raise money and grow distributed networks. Regulation D Rule 506(c), for example, provides entrepreneurs the opportunity to raise an unlimited sum from accredited investors in a private placement and appeal to those beyond their networks through general solicitation and advertising. Likewise, Regulation Crowdfunding provides a novel mechanism for unaccredited investors to access potentially lucrative venture opportunities. Blockchain-based founders may also seek to reach both accredited and unaccredited investors by completing dual Regulation D and Regulation CF private placements. Finally, entrepreneurs could capitalize on dramatic changes to Regulation A and conduct a public Regulation A+ offering to attract any investor, raise up to $50 million, and provide investors immediate access to liquidity. Depending on the priorities of issuers among (i) the idealized size of their token issuance; (ii) the type and (iii) number of investors they may wish to recruit; (iv) the urge to provide investors liquidity; and (v) their willingness to comply with costly and lengthy disclosure requirements, certain issuances may be more appealing to crypto-platform developers.
Fortunately, exciting developments within the industry may ease the process for developers to deal with a litany of complex regulations not only in the U.S., but also across the world. Harbor’s R-Token seeks to provide a blockchain solution for crypto-start-ups by providing additional lines of code to complete securities, AML, KYC, and tax checks on the initial and re-sale of securitized tokens directly on the protocol. Other platforms like CoinList, StartEngine, Prometheum, tZero, and Templum also dramatically streamline registration, assist start-ups seeking to complete securities compliant offerings, and provide “alternative trading systems” for secondary sales.
As with any nascent technology, exciting advancements also breed exceptional risk. While the industry waits for tailored legislation to provide clarity for issuers and investors, by complying with U.S. securities laws, entrepreneurs not only may limit their personal liability, but may also foster credibility for themselves and the industry. To create truly revolutionary distributed global systems, entrepreneurs must continue to decrypt blockchain technology to the masses through compliance with the law.
Thank you for reading! If you made this far, I would love to hear from you. I encourage any and all feedback either in the comments, via Twitter (@presbarclay), or email (email@example.com).
In addition to the incredible writers and thought leaders whose work I have cited and linked to above, I owe a special thank you to Daniel Budofsky for his thought-provoking comments and insights during the drafting process. I must also thank Howard Marks, Sara Hanks, and Scott Purcell, whose ICO Webinar with CoinDesk inspired many details discussed herein. Any crypto-enthusiast should also follow the work of Coin Center’s Peter Van Valkenburgh, whose policy research papers not only remain must-reads for lawyers, but also anyone interested in the regulatory health of the industry. Finally, stay tuned to the latest developments in the blockchain ecosystem with CoinDesk, Token Economy, and The Daily Bit my favorite news and analysis sites for all things crypto. Please reach out to continue this discussion.