Over the last 9 months, I’ve been working with my partners at CityBlock Capital to successfully issue a regulatory compliant digital security under US law. Our goal has been to use digital securities to create greater access and liquidity to venture capital, and throughout this process, I’ve received a lot of questions from people across all sectors about whether or not they should tokenize an asset or equity in their company. I’ve created this overview on digital security issuance to help others understand where the ecosystem currently stands and to bring more focus and prosperity to the industry as a whole.
Background:
Digital securities have the opportunity to upgrade our global financial system by creating efficiencies in capital formation, regulatory compliance, and liquidity via secondary trading. But the realities of the digital security ecosystem of 2018 is just that: an opportunity. The Digital Security Offering (“DSO” or Security Token Offering, “STO”) was pioneered by Blockchain Capital in 2017 as a regulatory compliant alternative to an ICO. In many ways, BCap’s incredible crowdfunding success ($10M in six hours) sent the digital security industry down an ill advised path of shadowing a frothy fundraising trend in hopes crypto investors would eventually migrate toward compliant offerings. As ICOs have gone under intense SEC scrutiny in 2018, DSOs have not been able to capture the same investor momentum because of accreditation standards and vastly different expectations on return potential and liquidity. This context is important for potential issuers because it means throwing around the word ‘token’ does not create new markets for regulated assets and you should have the same target investor today as you did before tokenization existed. If you’re interested in tokenizing an asset because you believe there is value for your company to be a part of a burgeoning industry, it’s important to decouple crowdfunding as a necessary step for issuing a digital security and to take a measured approach on the value you are trying to create by going through this process. As a general rule of thumb, issuing a digital security should not define or distract the value proposition of your core business.
(Pictured: Blockchain Capital’s Brock Pierce) The question you gotta ask yourself is…are you ready for this?
Crowdfunding with DSOs:
As previously mentioned, Blockchain Capital issued the first digital security when they tokenized a venture fund, and they were followed by Science Blockchain Fund, SPiCE VC, 22X and tZero who also took an ICO-style, crowdfunding approach. Crowdfunding is inherently necessary for ICOs and launching decentralized networks, and the Bitcoin and Ethereum networks are vastly more efficient for pooling capital then bank wire transfers, but digital securities are not decentralized networks and crowdfunding will continue to exist outside digital assets (i.e. Kickstarter, Angel List). Make no mistake about it, when crowdfunding works, it’s incredible. There are few things more exciting as an entrepreneur then to have a stranger discover your DSO from the other side of the world, go through a five step application process, instantly transfer cryptocurrency into an escrow account and complete the purchase of a SEC compliant security within 10 minutes (pending KYC/AML). This user experience represents a giant leap in terms of how we might buy and sell assets in a unified global marketplace, but in 2018, consistently capturing the magic of crowdfunding is a mirage in a vast internet desert. If your company or idea doesn’t have a highly engaged crowd today, it’s going to cost you a lot of time and money to create one. To efficiently crowdfund your DSO, you likely need to fall into one or both of the following categories:
- Your offering is backed by highly visible crypto investors, and your raise is tapping into syndicates and networks willing to make an exception from their normal playbooks, particularly your one year lockup period and uncertainty around liquidity. (Ex: Blockchain Capital).
- Your offering has a real viral hook that inspires sharing across the internet or avid communities. Securing a notable advisor, a celebrity tweeting or community managers schilling in telegram groups doesn’t qualify as a viral hook. You need to be selling a security or have a narrative that the media is willing to create millions of impressions around or else be prepared to spend hundreds of thousands of dollars in advertising across multiple channels.
(Pictured: CityBlock Capital meet-up in Tokyo, Japan) Crowdfunding can produce exciting results but there are important tradeoffs to consider.
To execute a compliant DSO crowdfunding campaign with retail and accredited investors, your offering needs to file a Reg A+ exemption with the SEC which can be cost and time prohibitive for early-stage companies. Most private placements over $1M that generally solicit are through Reg D/S exemptions that don’t need to file with the SEC but are limited to 2000 total investors (99 or 250 US in the US depending on the size and structure of the offering) and all US investors must be accredited. Generally speaking, it’s not realistic for a typical Reg D/S offering to rely on crowdfunding as a primary source for capital because of the strict limitations on the issuer’s ability to create a crowd of accredited investors.
Crowdfunding via DSO also presents compliance challenges that need to be considered. In our experience, we’re seeing increased scrutiny on AML compliance if you accepted bitcoin or ethereum as a currency. Simply put, many service providers (ie. banks, escrow agents, insurance providers, fund administrators) aren’t comfortable verifying the source of the funds when you receive bitcoin as an investment. That’s not to say you won’t find vendors who will work with you, but it will be at a premium and any changes to the AML regulations could create an existential threat to your business. FATCA / CRS compliance, which is necessary if you accept international investors, can be cost prohibitive because many vendors quote on a ‘per investor, per year basis’. If your crowdfunding campaign ends up acquiring 1000 international investors, $150 per investor per year to meet FATCA / CRS requirements could easily exceed the value of the investment over the long-term.
The other important consideration for crowdfunding via DSO is whether or not you want to make investor / community management a core part of your business. Telegram groups, email marketing, social media campaigns and proactive corporate communication are just a few of the marketing initiatives that crowdfunding participants have come to expect to take an offering seriously. These efforts will also bring in people who will publicly disparage your company if they take issue with your offering or if there is a customer service issue. Additionally, you’re likely to attract ‘fast money’ investors, i.e., people looking to flip your offering and get rich quick. Most private placements can take years to generate any meaningful returns so you have to ask yourself if you really want to be spending significant time and resources over the next 5–10 years on a ‘community’ of investors that might be misaligned on the realities of your business.
Asset Ownership with DSOs
If you skip crowdfunding as your part of your DSO, it means you raised money through private networks or you’ve hired a FINRA registered broker-dealer. The primary reason to issue a digital security in this context is to enable secondary trading, but keep in mind, issuing a digital security today is going to create more friction with your investors and / or broker-dealer then just using paper. If you think migrating your cap table over to Carta was difficult, try getting that same investor group to create and use a ERC-20 compatible wallet. Moreover, the SEC regulated secondary exchanges for digital securities are just beginning to go live with startups OpenFinance, tZero, Fluidity and Templum converging with established players Coinbase, NASDAQ and NYSE, but there’s no immediately timeline for these platforms to become fully functional with meaningful trade volume.
11/1/18: we’re still very early in the development of the industry
Even if secondary exchanges for private digital securities progress as planned and you can get listed, it’s important to set a reasonable expectation with your investors of the level of liquidity your asset can generate. Sure, there are late-stage VC and private equity firms that create strong secondary markets for equity in top-tier private companies like Uber, Lyft, SpaceX and Coinbase but your average private company or asset does not create this type of demand and there will always be limited supply based on the number of shareholders. Like in countless industries before it, digital will replace paper and inefficiencies around the secondary trading of private placements will be eliminated from the transaction (brokers, special purpose vehicles, unnecessary legal fees), but the market for these assets will likely operate more like eBay then E-Trade. For example, Fluidity (AirSwap), and their recently launched bulletin board and spaces product, has taken a user-centric approach on compliant discovery and 1:1 conversations which they believe creates the best environment for facilitating private digital security transactions (translation: this is not Binance for STOs). With this in mind, potential issuers have to determine if there is enough real demand from investors for liquidity to justify the current costs of engaging one of the issuance platforms. Remember, just because an asset is structured to be more liquid doesn’t mean there is a market for it.
The last point on asset ownership is that cryptocurrencies and ICOs have created misconceptions about how digital securities should be issued and custodied. Digital securities are NOT bearer instruments, meaning if you lose the private keys for the wallet holding your digital security the issuer can simply create a new one from a centralized ledger. If you lose your private keys for the wallet holding bitcoin or other cryptocurrencies, you’re completely out of luck. This critical difference should be top of mind as you think about executing your digital security issuance strategy because it means no one is going to care about holding their tokens unless they want to sell them which might never happen over the lifespan of the asset. In general, the issuance process will need to become commoditized to a price point and user-experience typical of ubiquitous enterprise SaaS products for digital securities to emerge as the new standard for asset ownership.
Looking Ahead
Digital securities are still in their very early days with a lot of hard work ahead of us. In general, I believe that the sooner we isolate digital security ownership from crowdfunding / ICOs, the quicker we will see broader adoption of the technology. The key is repetition: every issuer that goes through this process will identify new problems, come up with solutions, introduce new vendors and investors to the technology, and overtime, the industry will scale until every security becomes a digital security. Once there is scale, I believe the disruption will be felt most by legacy financial institutions, their back office operations, and eventually the derivatives products they sell, and less so by private issuers. The critical decision for you as a potential issuer is to determine if there is intrinsic value in being part of the building process or if you want to come back in 24 months when things are further along. At CityBlock Capital, we’re investing in equity of digital security infrastructure so going through the issuance process has made us more informed on the opportunities in the industry and we’re in this for the long haul. I’ll leave you with the video below of the CityBlock Capital team discussing what a fully digitized financial system might look like. It’s inspiring to think about, and there is a lot of money to be made in the picks and shovels of this industry, but it’s certainly not happening overnight. If you are going through the issuance process and want to talk shop, feel free to shoot me a note at [email protected].
Disclaimer: The information in this blog post is provided for general informational purposes only and no information contained in this post should be construed as financial or legal advice.