In the summer of 2017, as blockchain DApp and Protocol projects rushed to write white papers and harness the power of the ICO (initial coin offering) to raise non-dilutive funding from ‘contributors’, there was a sudden need for documents to support these efforts. With millions of dollars being raised prior to product development or often incorporation, project leaders and their advisors sought methods to short-circuit the expense and time-consuming processes that had preceded the ICO era. Enter the SAFT (Simple Agreement for Future Tokens).
The SAFT White Paper is a modified version of the existing SAFE (Simple Agreement for Future Equity) construct for initial token sales and is – effectively – a form of a convertible note. It reworks the SAFE capital raising mechanism to define tokens as utilities rather than securities.
Under a SAFT or Simple Agreement for Future Tokens, a company raises funds from accredited investors pursuant to a Regulation D offering. So far so good. The project then uses the money it has raised through the sale of a SAFT to develop the underlying project and at some undefined point in the future, the SAFT allows for the production and distribution of tokens at a discount. The SAFT White Paper argues that the tokens purchased by exercising that right are non-security, utility tokens that are freely tradable on unregistered exchanges/ Alternative Trading Systems and unconcerned as to whether the subsequent purchasers are accredited or not, or who the secondary buyers of the tokens might be.
With exchanges ready to trade utility tokens springing up all over the world, and fund-raising becoming perhaps the alpha use-case for the Blockchain, why shouldn’t innovations extend from the realm of the technology to the realm of governance? After all, Tezos had just raised more than $200 million dollars. If you were planning on raising funds for your project using what some have derisively called ‘Magic Internet Money’ why not use a magically brief document for your raise?
Perhaps because the Chairman of the SEC doesn’t think it’s a good idea? Chairman Jay Clayton said earlier in 2018, “(I)n any event, the crypto community is now on full notice that the SEC will focus on prior token and SAFT offerings that did not comply with the federal securities laws; and it can generally seek disgorgement and money penalties for such misconduct that occurred within the last five years. The SEC also will insist that all token issuers comply with applicable federal securities laws as they develop their platforms and token markets.
Despite some raising major concerns about this method in the prior quarter, the SAFT is apparently still so popular that Coindesk, in its recent ‘State of Blockchain Q2 2018’ report, reported over $300 million was raised using this document for 37 ICO projects. It’s not a geographic phenomenon either, North American projects from Toronto to San Francisco, Austin and Grand Cayman continued to harness the magic, despite warnings from some quarters.
SAFT is like magic except things don’t work that way under the U.S. securities laws. The SAFT may be the original sin of ICOs. Perhaps they should rename the construct a ‘Simple Agreement for Future Trouble’.
While I am an attorney with several decades of securities and derivatives experience under my belt, please don’t just take my word for it. If you have spent any time paying attention to crypto news, you have heard of SEC Chairman’s sworn statement in the U.S. Senate: “I believe every ICO I’ve seen is a security”.
Some project leaders have taken great solace in a June 14, 2018 speech by William Hinman, the SEC’s Director of the Division of Corporation Finance, in which he offered a more nuanced take on why Bitcoin and Ether are not securities. Hinman’s June 2018 analysis focuses on a point in time when a “network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts” as the point at which a token may no longer represent a security. That’s great but it doesn’t really help an issuer that is looking to raise capital via a token offering. That issuer is generally touting its own skills, technology and ability to deliver profits. That issuer needs another way to offer tokens in compliance with U.S. requirements.
Luckily there is an established way to do raise funding via a token. There are well-defined and time-tested exemptions that allow U.S. companies to sell tokens (that are considered securities) without registering. The “big three” exemptions are Reg D and Reg A (both for issuances in the U.S.) and Reg S (for issuance outside of the U.S.).
One of the most tried and tested ways to raise money without filing an S-1 or going through the lengthy SEC registration process is through an exemption from registration called Regulation D. The majority of VC-funded raises are performed under Reg D and it is easy to find competent counsel to assist. Under Rule 506(b) or 506(c) of Reg D, a company can hold a private security token offering and raise an unlimited amount of capital from accredited investors inside and outside of the United States. Accredited Investors are generally defined as people who make $200,000 a year and have a net worth of at least $1 million. Such investors are issued restricted securities that can only be traded with the issuer’s consent and be held for a period of up to one year before they become more freely tradable under Rule 144.
So, in the world of tokens, an issuer needs to 1) do KYC/AML checks on its investors, 2) be satisfied that the investors are in fact accredited investors, 3) work with an issuance platform that has the technical know how to “lock up” tokens so that they can not be traded in the first year without the issuer’s consent, and 4) maintain a registry of its holders so that it can communicate with its investors.
Assuming you want to raise money quickly by relying on a private placement exemption such as Reg D but also want the tokens to be tradable and usable on your network in less than a year’s time, you may want to avail yourself of Regulation A right after you complete your Reg D fundraise. Regulation A allows an issuer to raise up to $50 million a year and, while it is not cheap, it is much cheaper to do than an S-1 filing used for traditional IPOs. Any investor can buy your tokens – not just accredited investors. Reg A filings will be reviewed by SEC staff and an issuer will know about any perceived deficiencies before putting the tokens out to the public thereby avoiding tail risk from the SEC and plaintiffs’ attorneys later on. While Reg A is an option, there have been no token offerings that have earned approval. It may be a year before any Reg A token offering is approved, but at that time it may become a popular way for post-product and post-revenue token projects to raise funding.
If an issuer wants to sell its tokens to non U.S. investors, it can also do so under Regulation S. In addition to taking U.S. laws into account when selling to foreign investors, the issuer will obviously need to employ competent counsel in the countries in which it is selling into to comply with the laws of those countries. While Reg S does not require the issuer to lock up its foreign investors for a year (like it would have to do under Regulation D) it may still desire to do so to keep the U.S. and non-U.S. investors on a level playing field. When doing a Reg S and Reg D offering at the same time, the issuer needs to avoid advertising of the Reg S deal in the U.S. This is a very important but nuanced marketing approach where an issuer would benefit tremendously from input from competent legal counsel.
Given the prevalence of these exemptions and the technological know-how now available to issuers, we feel that U.S. regulations offer adequate methods for issuers to issue tokens in and outside of the U.S. In light of the SEC’s and state securities regulators’ pronouncements and enforcement efforts directed at unregulated securities offerings such as SAFTs, one is hard-pressed to find a rational reason for not availing oneself of the regulations and exemptions described above. Unless you want to plan for years of defending yourself instead of developing your product.
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About the Author
Gautam S Gujral is a Co-Founder and General Counsel of Vertalo. Previously, Gautam was a Managing Director at Credit Suisse. Prior to his tenure at Credit Suisse, Gautam was Special Counsel at the U.S. Securities and Exchange Commission and a recipient of the SEC’s Capital Markets Award