Could broadening the investor base help growing companies, save ICOs?01.24.18
2017 saw an unprecedented amount of activity in the initial coin offering (ICO) space with almost $6 billion raised in total, including $3 billion in the fourth quarter alone, according to Token Report.
This growth was accompanied by increasing scrutiny from regulators.
In September, the Securities and Exchange Commission brought its first enforcement action related to an ICO. And in December, the SEC issued its first cease and desist letter to one company in the middle of an ICO. (SEC Files Fraud Charges Against ICO Organizer)
The SEC Commissioner then issued a personal statement, stating that ICOs “can be effective ways for entrepreneurs and others to raise funding” while also noting the SEC’s position that “longstanding securities law principles” are used in determining whether an ICO constitutes a security offering and, most importantly, offers sufficient protections for investors.
JCOs: The next generation of ICOs?
The JOBS Act Crypto Offering (JCO) appears to be the the latest idea to comply with U.S. securities laws while expanding access to crypto-investments to non-accredited investors. (What is the JOBS ACT?)
The enforcement actions and guidance provided by the SEC indicate its willingness to apply existing securities laws to ICOs in order to promote investor protection.
Before the idea of the JCO, ICOs launched in U.S. seeking to comply with such securities laws were primarily done either under A) Regulation S of Securities Act of 1933 (Reg S) or B) through Simple Agreements for Future Tokens (SAFTs).
A) Reg S exempts offers and sales of securities that take place outside of the U.S. This exemption is most often used when all of the offer and sale takes place entirely offshore and to non-U.S. persons. The Reg S exemption only applies to federal securities laws; a state exemption would likely be required as well to avoid state securities liabilities.
B) SAFTs were constructed based on the classic Simple Agreement for Future Equity (SAFE) agreements typically used by venture capitalists.
In a SAFT, accredited investors enter into investment contracts for the right to receive tokens that will be issued in the future instead of taking equity in a start-up company. In a SAFT agreement, no tokens are exchanged in return for capital - only the promise of future tokens or product. The investment contracts underlying a SAFT qualify as a security, making them subject to SEC regulation and only practical for fundraising from accredited investors or venture capitalists.
A new option for companies
Responding to the desire to make crypto investments available to non-accredited investors, a blockchain company named Finova Financial is the first company to announce that it would issue tokens that are U.S. securities law-compliant and available to both accredited and non-accredited U.S. investors.
Finova’s idea was to create a hybrid offering that would look and run like an ICO but would have the structure of a mini-IPO under the amendments to Regulation A in compliance with the JOBS Act (Reg A+).
The mini-IPO under Reg A+ allows for a general solicitation of both accredited and non-accredited investors in an offering up to $50 million. This offering preempts state securities registrations, but does require filing, review, and qualification by the SEC.
The underlying premise of a JCO is that a company issues securities or tokens to the general public in exchange for cryptocurrency or other funds (including cash) in compliance with existing SEC regulations. The tokens are linked to a share of equity in the company and are accounted for in a distributed electronic network or database that is maintained by the company.
Since they are linked to equity, the tokens would have the ability to directly transfer dividends to the virtual wallet of a tokenholder.
Tokens can also be listed on Alternative Trading Systems (ATS) that comply with Regulation ATS under the Securities Exchange Act of 1934, as amended, such as the tZERO ATS joint venture proposed this past year and due to come online in 2018. Importantly, listing the tokens on an ATS could create liquidity in the tokens if traded by the public.
While Finova’s JCO has not yet been completed (or even qualified by the SEC), this method of fundraising might serve as a more economical alternative to existing means of conducting an ICO or going through the costly process associated with an initial public offering.
If you are interested in discussing JCOs and how one might be structured for your company, please contact one of the attorneys in Waller’s blockchain technology team for more information.