But harder doesn’t mean impossible. In fact, some might argue raising millions for (let’s face it) risky ventures should be hard. Despite the challenges that crypto entrepreneurs now face, startups continue to have an array of options to raise capital at their disposal.
Opinions will vary as to the best way to proceed, and this is in no way intended to be interpreted as legal or financial advice. Seriously. We cannot stress this enough. Step one, before you do anything else, is to go get yourself a good crypto lawyer.
And with those indemnifying, obligatory disclaimers out of the way, let’s make it rain:
1. Raise cash by staying out of the United States.
This isn’t necessarily the best of options, and we’re certainly not encouraging anyone to take to the sea a la John McAfee. But it’s a good place to start.
If your company doesn’t need to be registered in the United States—or cater to U.S. consumers—then one way to avoid running afoul of American laws is to simply keep out. As Preston Byrne, a partner at the law firm of Byrne & Storm, PC, told Decrypt last November, entrepreneurs can still avail themselves of the “offering and trading rules of other jurisdictions, such as the UK or Singapore, whose requirements for token sales are generally thought to not be as strict as those in the United States.”
It’s no wonder that blockchain companies have traditionally “flocked” to the more crypto-friendly regulatory environs of places like Malta to set up shop. Yet, as Byrne admitted, this strategy isn’t exactly foolproof, since the “U.S. is known to exercise extraterritorial jurisdiction.”
It nevertheless appears to be the preferred method of big players like Binance, whose token launch platform (the Binance Launchpad) specifically excludes investors from the United States (as well as a laundry list of sanction-riddled countries).
The innovation has caught on, spawning the birth of a brand new three-letter fundraising mechanism: the IEO (initial-exchange offering). Binance's IEO platform has been so successful at shilling tokens and raising cash that a number of other exchanges, such as such as Huobi, OKEx, and KuCoin, have followed suit.
For example, the TRON Foundation (established in Singapore) raised $7 million on the Binance Launchpad when it unloaded nearly 24 billion BitTorrent tokens (BTT) during a public sale in a matter of minutes. In late February, the UK-based Fetch.AI raised $6 million in “about 10 seconds,” according to Binance CEO Changpeng Zhao.
Pros: The glory days of the unadulterated ICO can still be had (for now)—just as long as they’re kept far, far away from the prying eyes of U.S. regulators.
Cons: By excluding U.S. investors, you cut out one of the largest cryptocurrency markets in the world and limit your potential upside.
2. Raise cash by getting a no-action letter from the SEC.
So you’ve decided to stick with the good ol’ U.S. of A, have you? Good on you. Have we mentioned recently how important it is to get a good lawyer?
The problem with public token sales in the United States is that no one—not even the regulators themselves—have a firm grasp yet on what the rules are or ought to be.
When the ICO craze happened, the issue was that these people got boatloads of money, and so they were really not interested—or they didn't have too much incentive—to really try to make sure their consumers were having a really good experience. Cesare Fracassi
When the ICO craze happened, the issue was that these people got boatloads of money, and so they were really not interested—or they didn't have too much incentive—to really try to make sure their consumers were having a really good experience.
Is an ICO token a security? Or is it the sale of the token and how it’s packaged and marketed that’s the security? Can you structure the token and its sale in such a way that effectively proves the token is “sufficiently decentralized,” useful, and not an investment contract? It’s all very complicated.
But while regulators at the SEC have shown—both through public comments and enforcement actions—that they intend to treat all ICOs and their related tokens as securities, they have left the door open for you to try and convince them that they really aren’t. And that’s where no-action letters come in.
“Generally, where there are unclear fact patterns, the SEC has had a long history of assisting market participants, engaging with them, and if they can reach kind of a meeting of the minds, the market participant writes a letter to the SEC,” says Lewis Cohen, an attorney at the blockchain-focused DLx Law LLP. Cohen explains that incoming no-action letters to the SEC can be anywhere between five to 20 pages long and are used by a company to describe to the Commission exactly what it’s doing, why it’s doing it, and why it thinks its business should be exempted from enforcement action.
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There is a “standing offer for people to come in for so-called no-action relief in connection with a particular token or project,” SEC Commissioner Hester Peirce said in a speech earlier this year, echoing comments made by Director William Hinman last June.
In April, the SEC made good on this offer by issuing the very first no-action letter for a blockchain startup to TurnKey Jet, a U.S.-based air carrier and air taxi service that uses its TKJ token as a type of pre-paid gift card for service.
And we can presume, then, that other companies with plans to raise cash through token sales are similarly seeking no-action recommendations from the SEC.
Pros: There is perhaps no better way to make sure your business is safe from SEC enforcement action than to get it in black and white. While not legally binding, assurances don’t get a whole lot better than this.
Cons: No-action relief is extremely facts specific and not intended to be broadly relied upon. And unlike the more optimistic Comissioner Peirce, the SEC’s “crypto czar” Valerie Szczepanik warned last June that no-action letters for ICOs would likely be “rare.”
3. Raise cash by calling your project a security and launching an STO instead.
Another option that crypto entrepreneurs have recently begun taking advantage of in greater numbers is the oft-discussed but seldom-understood “security token offering,” or STO.
In truth, there are a number of different kinds of token offerings used to raise startup capital that are often lumped together under the STO banner. To simplify this discussion, we’ll limit the term STO to offerings that actually include the sale of a bonafide security token—a blockchain-based, tradable financial asset that grants the token holder tangible value, such as a share in equity, debt (bonds), or returns based on revenue distribution.
In the United States, an offering of securities must either be registered with the SEC or qualify for an exemption. “The idea is that buyers of securities have the right to certain disclosures and disclaimers and have the right to be informed about their purchase,” says Drew Hinkes, co-founder and general counsel of Athena Blockchain, and an adjunct professor at the NYU School of Law.
Hinkes explains that there is a special class of securities that can be sold called “exempted securities”—often referred to as private placements—that a business can sell without registering with the SEC and becoming a public-reporting company. And that’s where STOs fit into the picture.
All STOs are conducted pursuant to one of the various registration exemptions that companies are afforded under federal law. Depending on the exemption that you use—Regulation D, Regulation S, Regulation A+, or Regulation CF, to name the most common—you’ll be limited in how you can legally market your token sale and to whom you can sell. To qualify for the exemption, you will need to file the appropriate form with the SEC (for example, Form D if filing a Reg D exemption) and make certain disclaimers and disclosures public for your investors.
It is important to note, however, that in practice, STOs are almost always restricted to accredited investors: an individual who either has a net worth of over $1 million or a yearly salary of $200,000 for two years and expects the same of the next year.
The exemptions to this rule include Regulation S (often used in combination with the more common Reg D), which would all you to sell to non-accredited investors outside of the United States. Regulation A+ “threads the needle,” says Hinkes, and would allow you raise up to either $20 million or $50 million (depending on if you choose Tier 1 or Tier 2) from both accredited and your average, mom and pop investors. The catch is that Reg A+ exemptions must be reviewed by the SEC before the sale. To date, not a single Reg A+ STO has made it out of the SEC’s review process.
Regulation CF also allows you to sell to non-accredited investors, but only through a licensed crowdfunding platform, like Start Engine or Republic Crypto, and at a maximum limit of $1.07 million. Reg CF also lays out a very specific formula that determines how much each of these non-accredited investors can buy based upon their individual income and net worth.
For a more complete explanation of each of these exemptions, how to execute an STO, and reasons why it might be the right move your business, read our Decrypt Guide to security tokens and STOs.
Pros: An STO will enable your startup to potentially raise millions in startup capital while offering your investors a tangible stake in your company’s future. Best of all, it is one of the more straightforward ways to remain in compliance with U.S. securities laws.
Cons: There is a lot of compliance involved, and the process can be prohibitively expensive for some startups (up to $1 million in lawyers fees and other costs is not unheard of). Additionally, security tokens cannot be easily traded; transactions must follow very strict rules, such as requiring the use of a broker-dealer or an alternative trading system (ATS). Finally, depending on the nature of your token and how it functions within your business, an STO may not be the best way to go.
4. Raise cash via a “security-wrapped” ICO (Introducing: SICOs).
Let’s say you want to do business in the U.S. and raise money from American investors, but you don’t necessarily want to sell a token that is itself a security (the token doesn’t represent a stake in your company or guarantee investors any specific rights)—can you still run an ICO?
The answer is yes. But there’s a catch. You still need to follow essentially the same rules as those listed above for an STO.
Sure, there are crypto projects currently in the market—like the Canada-based messaging app Kik—that are trying to make the case to regulators that their networks are “sufficiently decentralized” and therefore intrinsically exempt from securities laws (the same logic that apparently led to the SEC declaring Ethereum not a security, despite its own ICO in 2014). We’ll see how this plays out, but at present, most lawyers in this space will likely recommend the “better safe than sorry” approach.
To do that, your token offering will still need to be conducted in accordance with one of the registration exemptions listed above. But that doesn’t mean that your token needs to offer tangible value to your investors—you can still sell a consumptive “utility token” for your business while following securities rules.
Hinkes calls these sales “security-wrapped ICOs” or SICOs. “The idea here is that you’re selling some kind of network asset, which is not itself inherently a security. But it is offered pursuant to exemptions legal wrapping,” he says. “So you can sell it without violating the law for its issuance.”
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But here’s the rub: selling a “utility token” in a way that is compliant with current U.S. securities laws means that they can generally only be sold to accredited investors. This is problematic, since it makes little sense for a network to only be accessible to high net-worth individuals.
Therefore, in order to get your network token into the hands of U.S.-based, non-accredited investors, your token sale will need to make use of either Regulation A+ or Regulation CF registration exemptions. However, these exemptions carry significant limitations as described above—either submit to an SEC review process from which no crypto startup has yet surfaced, or be content with a $1.07 million maximum raise.
Generally, where there are unclear fact patterns, the SEC has had a long history of assisting market participants, engaging with them, and if they can reach kind of a meeting of the minds, the market participant writes a letter to the SEC. Lewis Cohen
Generally, where there are unclear fact patterns, the SEC has had a long history of assisting market participants, engaging with them, and if they can reach kind of a meeting of the minds, the market participant writes a letter to the SEC.
Pros: It’s still possible to run an ICO, sell a utility token that has a consumptive purpose on your network, and do so in a way that follows the rules laid out by the SEC and U.S. securities laws.
Cons: This has all the drawbacks of an STO (compliance costs, limitations in the way the asset can be traded, etc.) and none of the benefits. The only practical way to execute this currently is to use a licensed crowdfunding platform.
5. Take a trip down to Sand Hill Road and do it the old-fashioned way.
Here’s a crazy concept: why not forego (or, at the very least postpone) a token sale, take your business idea to a venture-capitalist firm or angel-investor network, and raise some cash the old-fashioned way?
That’s the advice of Cesare Fracassi, associate professor of Finance at the University of Texas at Austin and director of the school’s Blockchain Initiative. According to the professor, while ICOs might have been great for the early-adopting entrepreneurs and their individual bank accounts, they’re generally bad for business.
“When the ICO craze happened, the issue was that these people got boatloads of money, and so they were really not interested—or they didn't have too much incentive—to really try to make sure their consumers were having a really good experience,” Fracassi tells Decrypt.
The result is a fundraising model that encourages founders to “exit before they enter,” raising tens of millions of dollars before establishing a customer base or demonstrating a product-market fit, he says, and the industry has suffered as a consequence.
The professor advocates for a return to basics. And while that may not be what you came here to hear, there’s something to be a said for the discipline required in traditional fundraising methods that have stood the test of time: “In entrepreneurship, when you go and raise funds through an angel network or a VC, they're not going to say, ‘Here's $50 million, come back in two years and let me know how you do.' They don't do that. They tell you, 'Here's $100,000; this is going to keep you up for the next 2 or 3 weeks. Come back and tell me what you've done after 3 weeks and then we'll maybe give you some more.’”
But that isn’t to say that ICOs and other token sales should be chucked out the window altogether as a lost cause. After all, blockchain systems that depend on their native tokens as the software that powers their networks must still get these tokens into the hands of their users. And in some instances, it’s the token itself that is the product, so finding creative ways of selling them is a perfectly legitimate way to generate revenue.
The question then becomes: at what stage of your business is it the right time to launch a token sale? It’s a question that more and more crypto entrepreneurs will be asking themselves as the industry grows and matures in the years to come.