If you thought 2017 was a wild year for ICOs, strap yourself in. 2018 is set to get more exciting as we’re going to see the true power of this financial innovation unleashed for startup and corporate fundraising. And, unlike 2017, it will come with legitimacy, transparency, and trust. While many of the 2017 ICOs were based on nothing more than the vapor and fluff of a white paper, the overwhelming trend for 2018 will be toward regulated security tokens (there are 30+ in the pipeline at Wilson Sonsini alone). For some companies, it represents a hard fork in startup and corporate fundraising and will change the size and frequency that companies will need to raise. I will outline how these regulated ICOs work as well as their wider potential impact.
THE ICO GAME PLAN THUS FAR
Thus far in ICO-land, most companies have been trying to define their tokens as a utility token in order to not be considered a security by triggering the Howey test tripwire, as reiterated by the SEC this past summer. However, in most cases the utility definition doesn’t fit and what’s being sold is in fact a security under the law. In life, I’m all for begging for forgiveness over asking for permission, but when it comes to being subject to a SEC enforcement action, you may not receive much forgiveness. The penalties are steep, ranging from fines, forced return of the capital raised, and even prison. A few ICOs have opted to be regulated (eg. Science) and, in most cases, have relied on the exemptions in Rule 506(c) of Regulation D (“Reg D”) which allows for an uncapped raise provided it’s limited to accredited investors. The problem with that approach is that you cannot raise from a broad enough base as those earning under $200,000 or with assets under $1,000,000 are locked out. This stifles the ICO’s financial innovation potential. Furthermore, Reg D security tokens are restricted securities and are subject to a minimum one-year lockup period, thereby suppressing their immediate liquidity. With the poor fit of Reg D, and the looming threat of regulation, some erroneously concluded that the ICO was therefore “doomed to fail”. That outlook is both uninformed and lacks vision.
HOW REG A+ CHANGES THIS
Enter Regulation A+ (“Reg A+”). Thus far it has been the lesser known cousin of Reg D. But that is going to change because this exemption, which was initially conceived to handle the more vanilla crowdfunding innovation of yesteryear, allows your company to raise up to $50,000,000 per year from accredited and non-accredited investors (see below) located anywhere in the world. Reg A+ security tokens have no lockups and are immediately tradeable (unless you include a contractual lockup). You are also not subject to advertising and solicitation restrictions, other than not lying and providing a few disclosures. This lets you blast your ICO marketing campaign through social media, podcasts, Reddit etc. Furthermore, Reg A+ has a novel feature called ‘testing the waters’ which permits you, while your offering is in the pre-qualification stage with the SEC, to market and promote the ICO in order to gauge investor sentiment. This differs from the current ICO pre-sale concept since you are prohibited from asking for or accepting any money. It does, however, allow you to lay the early groundwork for the campaign and energize your investor base. Reg A+ comes in two flavors: Tier 1 and Tier 2. Tier 1 is limited to raises up to $20,000,000 while Tier 2 allows raises up to $50,000,000. We’re going to focus on Tier 2 here, largely because it is exempt from US state blue-sky laws as well as caps on the number of participating non-accredited investors.
To be eligible under Reg A+, your company must be organized and operating in the United States or Canada (international subsidiaries are permitted). You also need to have the offering qualified by the SEC. And this is the catch. Although not as cumbersome and expensive as an IPO, qualifying will still require reporting, disclosures and audits. These include disclosures of the company, the offering, the material risks, distribution plans, use of proceeds, business operations, financial conditions, disclosures about directors, executives, and key employees, executive compensation, beneficial security information, related party transactions, two years of financial information, material contracts, agreements and corporate records. Your company must also be independently audited and be subject to ongoing reporting on an annual or biannual basis. As you can probably gather, it’s not exactly cheap (easily in the six-figures) and it will take about 2–3 months to clear the SEC (and longer if for some reason the SEC is not satisfied).
SHORT TERM PAIN, LONG TERM GAIN
Naturally, some have balked at what they consider to be onerous requirements, and intend to geofence their way into a large ICO. But I would propose that complying with Reg A+ is arguably a better path for many companies and the ICO ecosystem as a whole. Companies will not be able to create a scammy vapor-token by waving that mirage-like white paper that promises everything and delivers nothing. Reg A+ infuses trust and transparency, both of which are fundamental tenets of the blockchain.Furthermore, since most of the large economies (where in all practicality the vast majority of your ICO investor base resides) have either already, or soon plan to, regulate ICOs (and in some cases ban them completely), good luck raising enough from the remaining states. You need to play ball with the regulators since that opens up the broadest geography for your investor base.
Moreover, the math could be pretty damn good for your company. If it costs you roughly $500,000 in legal, audits, accounting, and marketing, to establish credibility, but in exchange you could get up to $50,000,000 in return, you’ve made 100x — all with no equity dilution, no hat-in-hand VC pitches, retaining your board seats, avoiding shareholder battles and activist investors, not being subject to the same quarterly earnings headache of a public company, and creating a token that could further rise in value (thereby improving the company’s overall valuation). That sounds like a pretty sweet deal.
IT’S A HARD FORK FOR STARTUP FUNDRAISING
And this is where the startup fundraising hard fork occurs. Many startups find themselves locked in the endless fundraising loop. As soon as your seed round closes, you are building in anticipation of your Series A. Once you hit that mark, you are looking out towards the Series B. One of the frequent things that executive teams complain about is how distracting and expensive (both in hard costs, opportunity costs and just sheer exhaustion) the months of wooing, pitching, negotiating and closing investment rounds are. With a sizeable Reg A+ raise, you could capture well into the 8-figures in a legal and transparent manner. It could set you up with a very long runway for your team to freely develop, innovate and scale your product. But since there are substantial costs associated with Reg A+ qualification, and the fact that the disclosures are quite detailed and broad (creating a high hurdle for vapor-tokens to receive qualification), early stage startups may be best positioned if they first raise a seed round that allows them to develop their product and cover the cost of qualifying.
And, as with all startups, an ICO does not get you out of having a real product, with a legitimate token, that serves an addressable market. You can’t just bolt a token onto your existing startup idea in the hope that you can cash in. The token must be organically woven into the fabric of the product so that it supports long term adoption and use. It is in both the company’s and investor’s interest for the demand and value of that token to rise. It won’t sustain if you have a phony token and your product stinks.
THE MISSING PIECE IS COMING
Lastly, security tokens do require some additional infrastructure and it looks like this is coming in 2018 too. One of the missing pieces is an exchange. I mentioned earlier that with Reg A+ you can raise from non-accredited investors. There is a small catch here. The amount the non-accredited investor contributes is limited to 10% of their annual income or their net worth, unless the token will be traded on a national security exchange. These are SEC and FINRA regulated exchanges that must be created specifically to trade regulated security tokens. These exchanges are on their way, with tZERO(largely owned by Overstock) being the first out of the gate. With the regulator’s blessing, trading your token on such exchanges will allow you to raise from non-accredited investors without income/net worth caps, will provide liquidity for the tokens, and will probably be the moment that ICOs go mainstream. From all accounts, this could be the beginning of something quite extraordinary, and very soon your Uber driver will not be gabbing about the price of Bitcoin, but about some ICO you haven’t yet heard of.