Issuers of Initial Coin Offerings, ICOs, Initial Token Offerings, TGEs and Accredited Investor Verification
“This ain’t your grandfather’s IPO. Or is it? If the initial offering of a crypto-based token, commonly referred to as an Initial Coin Offering aka ICO, even if framed as a “Token Generation Event” aka TGE, looks like a duck, walks like a duck and quacks like a duck, a right-minded Issuer will need to stay inside both US and other countries’ securities regulation goal posts by conforming to accredited investor verification guidelines.” Paul Azous, CEO, Prospectus.com.
Fact: July 2017 was the biggest month for coin offerings, with 34 projects raising $665 million, or twice as much money as was raised in the first five months of the year combined.
Fact: As of Q3 2017, 46 new coin offerings have been announced and an additional 204 are moving toward fund-raising, according to data from Tokendata.io
Fact: The ‘avalanche of bitcoin-flavored private offerings that map to cryto-centric initiatives resulted in the US SEC issuing formal guidance on July 25, 2017. That statement (see below) included specific guidance with regard to accredited investor verification and compliance with regulatory edicts pertaining to the sale of securities. (To learn who a accredited investor is, click here for the SEC criteria)
Fact: As of August 10, 2017, the amount of money raised by start-ups via so-called initial coin offerings (ICOs) has surpassed early stage venture capital (VC) funding for internet companies on a y/o/y basis.
In Silicon Valley and other “Techland” outposts, those seeking to raise capital have traditionally followed a beaten path. Step 1 is typically comprised of Friends & Family Investors; Step 2 (or “Series A Round”) comprised of Angel Investors; Step 3: Series B Round funded by early stage Venture Capital/Professional Investors; Step 4: Lets Hope : Initial Public Offering (IPO).
Each of the first three aforementioned ‘rounds’ (some of which might be by-passed) are referred to as a private placement. When advanced properly, those private placement offerings will include a private placement memorandum, whereas an initial public offering (IPO) calls for a “final offering prospectus.” Most private placements promulgated via SEC Regulation D Rule 506( c ) and/or Regulation S aka RegS, are offerings that aim to raise money from [sophisticated] private investors. Irrespective of whether those investors are VCs, private equity firms, institutional fund managers (also known as QIBs) or high-net-worth (HNW) investors, the US Securities & Commission has an “axe” of one kind or another with regard to regulating the sale of these private securities, whether they are in form of debt, equity or combination thereof. That interest on the part of securities regulators inevitably leads to “accredited investor” rules, as it is the Issuer’s obligation to take specific steps that verify in advance of a securities sale the investor(s) are properly accredited to purchase said securities.
An accredited investor is an individual person or entity that can purchase securities not registered with financial authorities by meeting specific criteria and/or requirements with respect to income, net worth, asset size, governance status or professional experience.
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It is the Issuer’s obligation therefore to confirm that said investors have been subject to accredited investor verification processes. Generally, the process is straightforward, but it does require information forms to be completed and reviewed by a certified expert. In the event the Issuer does not have an internal process that conforms to regulatory guidelines, the Issuer can engage a third-party accredited investor verification service, or defer to the either of (i) broker-dealer or placement agent, (ii) licensed attorney, (iii) certified public accountant or (iv) investment adviser) to perform this function
Within the context of Initial Coin Offerings (ICOs), Initial Token Offerings (ITOs) and/or Token Generation Events (TGEs) which represent the very latest trend with regard to ‘bitcoin-flavored’ capital raising strategies, traditional private placement memorandums have been displaced by “white papers” published by the Issuer. These documents typically conform to the basic components of a typical business plan, including use of proceeds, but they are often opaque.
As such, in Q3 2017, the US Securities & Exchange Commission (SEC) as well as securities regulators in various non-US jurisdictions addressed the increasing number of crypto-currency and/or distributed ledger-based capital raises via public statements advising Issuers whose underlying business model is based on a cryptocurrency, bitcoin and/or distributed ledger theme and seek to circumvent traditional private placement processes* that said Issuers likely need to conform with long-established accredited investor verification procedures.
* those who rely on various regulatory edicts that govern the issuance of non-public securities to investors, including those that may or may not depend on or include a role played by a licensed broker-dealer, underwriter or placement agent(s), but do require a regulatory compliant offering memorandum.
Many entrepreneurs creating virtual currencies have argued that they are not securities because they are intended to be used as the internal method of payment in the software that the entrepreneurs are creating. Those folks can argue as much as they want, and those who are advancing capital raising initiatives via ICOs or similar offerings will likely have be provided the opportunity to defend their argument—when they are confronted with subpoenas by the SEC or securities regulators within the domicile/regions that govern the Issuer and/or protect respective investors.
Below extract from July 25, 2017 US SEC investor alert partially qualifies the SEC’s view:
Virtual coins or tokens are created and disseminated using distributed ledger or blockchain technology. Recently promoters have been selling virtual coins or tokens in ICOs. Purchasers may use fiat currency (e.g., U.S. dollars) or virtual currencies to buy these virtual coins or tokens. Promoters may tell purchasers that the capital raised from the sales will be used to fund development of a digital platform, software, or other projects and that the virtual tokens or coins may be used to access the platform, use the software, or otherwise participate in the project. Some promoters and initial sellers may lead buyers of the virtual coins or tokens to expect a return on their investment or to participate in a share of the returns provided by the project. After they are issued, the virtual coins or tokens may be resold to others in a secondary market on virtual currency exchanges or other platforms.
Depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold may be securities. If they are securities, the offer and sale of these virtual coins or tokens in an ICO are subject to the federal securities laws.
Prospectus.com can be engaged to perform accredited investor verification services. Whether in advance of a private placement, an Initial Public Offering (IPO), an Initial Coin Offering (ICO), Initial Token Offering or Token Generation Event (TGE).
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The full SEC NOTICE re ICOs JULY 25 2017 via this link: https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings
*SEC v. W.J. Howey Co… the Supreme Court defined “investment contract” as a contract, transaction or scheme in which (i) a person invests money in a common enterprise; (ii) with a reasonable expectation of profits; (iii) to be derived from the entrepreneurial or managerial efforts of others.
Background:The term “ICO” is often used to describe Ethereum token launches. But coins and tokens are two very different things.
ICO — Initial Coin Offering — is a term created to describe the many bitcoin clones and other “coin” clones that erupted over the years. Bitcoin is basically a distributed ledger that performs best as digital money But you can’t build much with it. Ethereum can do what Bitcoin does. It can be digital money too, but unlike Bitcoin, Ethereum is highly programmable — it’s designed to accommodate the construction of complex applications. Bitcoin produces “coins”. Ethereum generates “tokens”. A “Token Launch” is an Ethereum phrase. An “ICO” refers to a bitcoin/altcoin offering. (The currencies inspired by Bitcoin are collectively called altcoins)
Bitcoins only have one application or utility— to act as simple stores of value with limited-to-no other functionality; value not represented or manifested through a variety of dynamic functions. Tokens, on the other hand, are a completely different strain all together. Tokens can store complex, multi-faceted levels of value. Ethereum tokens are spawned by a Smart Contract System (SCS), are highly programmable and have multi-functionality because of it. They rise above being just a coin, and through their assortment of functions become something much more — “tokens”. Technically speaking, tokens are not “offered”, they are “generated”. Probably the most accurate phrase of what’s going on during an Ethereum token launch is to describe it as a “Token Generation Event.”Nevertheless, a coin does one thing, and a token can do many things.
Example of Initial Token Offering aka ICO Mainstreet Investment Fund
Below discussion extract profiling initial token offerings courtesy of Quartz.com
“Token offering can be viewed as a hybrid between a Kickstarter campaign and a stock market floatation. On one hand, the launch lets customers reserve a product or service before it’s completed and ready for the market—that’s the Kickstarter part. On the other hand, it also gives those customers a stake in the future of that product or service; if the service gains in popularity, the token should rise in price, enriching the original users, making it a lot like getting in on a hot IPO. However, one of those analogies puts token issuers squarely in the sights of securities regulators, so the distinction is crucial. More on that later when we discuss the legal gray area that tokens occupy.”
Like the rest of the cryptocurrency industry, token offerings rely on a basic circular logic: A token has as much value as its users bestow on it, just as bitcoin rises in price so long as demand outstrips supply. But token boosters say their units of digital currency are different from bitcoin in one critical respect: they are programmable, and have been coded to perform various useful functions.
Tokens issued today are built atop ethereum, the second most valuable cryptocurrency on the market. Ethereum is like bitcoin because it is a tradable digital currency, which is called ether. It’s unlike bitcoin because it was designed with its own programming language—a significant departure from, and its creators say, an upgrade over, bitcoin. This language allows people to write “smart contracts” or automatically executed agreements on ethereum. A bond, for instance, might automatically pay out its coupon, without the need for an intermediary or paperwork.
It turns out that ethereum’s programming language is powerful enough that coders can write smart contracts that issue new units of digital currency, bound by their own rules. This is what the tokens offered today are: a series of complicated ethereum smart contracts. The ethereum network itself is being used as a giant token-issuing machine. “Right now ethereum is a token factory,” says Muneeb Ali, co-founder of Blockstack, a startup working on building tools for a decentralized internet.
An ethereum-based token is to ether as a concert ticket is to a US dollar, Peter Van Valkenburgh, director of research at the Coin Center think tank, suggests. “In the real world, we often use all sorts of items rather like we use cash,” he writes. “We use tickets, coupons … and a variety of bearer instruments because they entitle the holder to different things.” These customized tokens can be traded on secondary markets, like exchanges, and have their own value, independent of the price of ether.
Per New York Times Aug 7 2017 coverage by Nathaniel Popper:
“…Nick Morgan, formerly a lawyer in the S.E.C.’s enforcement division, said that the security label was likely to apply to any coin that an investor buys with the expectation that it will increase in value as a result of the efforts of the entrepreneurs who created it….That definition could be a problem for many coins because the excitement around initial coin offerings has been driven almost entirely by investors who have bought coins in the hope that they will become more valuable over time as the underlying software is improved…
Importantly, the SEC did not go so far as to categorize all tokens as securities and therefore subject all ICO issuers and the related exchanges to the applicable registration requirements. Instead, it noted that the determination depends on the particular facts and circumstances and economic realities of the transaction.
SEC Regulation D Rule 506c: Per accredited investor verification expert Jor Law, co-founder of Verifyinvestor.com, “With the new Rule 506(c), companies can now generally solicit and advertise their capital raise to anybody so long as they verify that the only people that actually invest are accredited investors – the rationale being that accredited investors either can better comprehend the risks of their investment and/or be able to bear a loss of their investment. Verification has to be done by taking “reasonable steps.” In the final rules that became effective on September 23, 2013, the SEC outlined what would constitute reasonable steps. You may access the final rules through the following link: http://www.sec.gov/rules/final/2013/33-9415.pdf From time to time, the SEC issues interpretive releases that give additional insight into how to properly verify accredited investors.
Many companies have been advised by their lawyers to not verify investors themselves. It’s too tedious of a process, requires specialized knowledge of the securities laws, and carries too high of a liability if done incorrectly. Instead, companies are recommended to outsource this function to third-party verification providers – but not just any random third-party. It’s important to choose a verification provider that is qualified and one that will protect the confidential nature of the information they will receive in order to conduct the review. In fact, the SEC indicates that a company may rely on a third party verification provider only if it “has a reasonable basis to rely on such third-party verification.”
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