In the last decade or two, investing in early-stage companies has been extremely lucrative — for a small group of venture capitalists. But times are changing, and there are few industries where blockchain is such a disrupting force as in investing. After the crazy months of the ICO boom and the burst of the bubble, now it is time to do it right. Let’s take a closer look at how a Security Token Offering works, what is the best country to conduct an STO, and what are the usual mistakes you can avoid.
ICO: A failed experiment
Fundraising is often a long and challenging process that includes developing a solid product-market fit, endlessly pitching venture capital funds, and setting up a legal framework. Blockchain startups, however, have found themselves in a very different situation in early 2017.
The ICO craze, which started around that time, was a once in a lifetime goldrush fueled by speculation and creative interpretation of regulations. Projects raised tens of millions of dollars every week without a valid business model, a competent team, or even a working proof of concept.
ICOs, predictably, attracted con artists, and the majority of ICO projects have never delivered. Hundreds of thousands of ICO “investors” saw their tokens crashing to zero in a matter of weeks after projects folded one after the other. Some projects launched a working product, but in the meantime, they realized they might not need a token after all. While most of these ICO coins were marketed as “utility tokens,” something that can be used as a method of payment when the project goes live, this value proposition turned out to be shaky at best.
By early 2018, the bubble has burst. Many “investors” felt that they were scammed, so retail interest dropped dramatically. Even worse, a few high-profile cases put the industry firmly in the crosshairs of regulators, and ICOs were promptly banned in most countries.
Moreover, many of these “utility tokens,” if put under scrutiny, would be classified as securities. The Howey Test, developed in 1946, is the standard terminology to determine if a transaction should be treated as an “investment contract,” therefore a security. While the test itself is quite sophisticated, its core idea is simple: if “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party,” the transaction falls under the securities law. Most tokens do.
STO: A modern take on traditional fundraising
As the industry matured, serious projects started to look into other ways of fundraising.
Early-stage investing before the ICO boom was very traditional, driven by venture capital and business angels. While this worked reasonably well, in the decentralized world of 2018, it started to look anachronistic: it created an unsustainable concentration of capital mainly in Silicon Valley and China, was anything but democratic and inclusive, and too inflexible to accommodate new concepts like on-chain governance. We needed something better.
As it turned out, the solution was not to create something entirely new, but to modernize the existing structures. If most ICO tokens would probably be classified as securities anyway, why wouldn’t we start issuing them as such?
Marrying securities with blockchain led to the idea of the Security Token Offering (STO). An STO, as the name implies, is a fundraising method when the company issues tokenized securities. Both words are equally important.
These security tokens represent real ownership in the company, with legal protection and shareholder rights. These are time-tested, established concepts in investing.
However, tokenization opens up a whole new world compared to the traditional securities.
First, it eliminates some of the geographical boundaries. Previously, it was notoriously difficult to offer initial shares of a company in multiple countries. While issuers still need to be aware of differences in regulations, tokenized securities can be offered across borders, unlocking a much larger pool of capital.
Security tokens can also interact with smart contracts, enabling features like automatic distribution of dividends, submitting governance proposals, and even electing the leadership and the board by a vote of the token holders.
Tokenization opens up the tightly-guarded world of investing, transforming it from the privilege of the few into an opportunity of the many.
How to structure an STO?
In the legal world, there are easy cases, complicated cases, and then there is international securities law. It is a fascinating but incredibly confusing field, and its practitioners are the most respected and highest-paid lawyers.
In international securities law, every case is unique, and there are no one-size-fits-all solutions. There are, however, a few fundamental concepts we can use to build a mental framework.
Projects considering an STO very often make the same mistake: pitting the cart before the horse, they try to find the friendliest jurisdiction where they can issue their tokens. A far more important question is from which countries they want to solicit investors. A project needs to comply with the securities laws of both the issuing jurisdiction and the investors’ jurisdictions. It doesn’t matter if a company is issuing its tokens in the Cayman Islands or Malta; if it wants to solicit investors from the United States, it needs to comply with SEC rules.
This requirement of “double compliance” leaves projects with a limited number of options.
STO regulations in the United States
The SEC is one of the world’s most heavy-handed regulators. The rules are draconian, and the fines are excruciating. Yet, perhaps counterintuitively, the United States should be on the radar of every project planning an STO for three reasons.
First, the sheer size of available capital and the culture of investing in early-stage companies makes the US very attractive. Additionally, the US has a battle-tested legal framework for securities, including a large body of case law. This is especially true in Delaware, a jurisdiction we recently covered. Lastly, the regulations are not that strict. There are plenty of exemptions and, if structured well, a US-based STO can indeed be very successful.
Every startup based in the US or trying to solicit funds from US investors should use one of the exemptions the SEC offers:
Under the crowdfunding regulation, startups can raise up to 1.07 million USD from non-accredited investors. Reg CF is by far the easiest way to conduct an STO. A million dollars is seed round territory. It is not much, but it might be just enough to kickstart a blockchain project focusing on research and development. Security tokens offered under Reg CF have to be locked and can not be traded on secondary markets for 12 months.
Reg D offers three exemptions for startups.
Under Rule 506(b) companies can raise an unlimited amount, and they can accept funds from both accredited and non-accredited “sophisticated investors” (the latter is capped at 35 participants). Rule 506(b) does not allow general solicitation, so funds have to be raised through personal connections.
Rule 506(c) is a similar exemption. It allows general solicitation, but it is open for accredited investors only.
Rule 504 is one of the most flexible options. Investors do not need to be accredited, and general solicitation is permitted with certain limitations. The catch is the annual offer limit at 5 million USD — but this should be enough for many startups.
All Regulation D exemptions put a restriction on resale, so these tokens cannot be freely traded on secondary markets.
Reg A+ is catering to established startups, as one of the requirements is submitting two years of financial statements to the SEC. There are two tiers of the Reg A+ exemption. Under Tier 1, companies can seek funding up to 20 million dollars, and there are no investor requirements. Under Tier 2, the limit is 50 million dollars, but non-accredited investors can invest only a limited amount.
Tokens issued under Reg A+ have no resale restrictions and can be freely traded on the secondary markets.
Reg S provides a way for US and non-US startups to solicit capital outside the US. There are no limits on how much money the company can raise, and investors don’t need to be accredited.
It is not required for the company to be registered in the United States to use Reg S. Indeed, startups conducting an STO elsewhere might want to apply for a Reg S exemption with the SEC anyway. The US, being the de facto policeman of the world, reserves the right to exercise jurisdiction over any company if there is reasonable suspicion that even a single US person has invested in it. Applying for a Reg S exemption is an insurance policy.
STO regulations in offshore jurisdictions
All that glitters is not gold. Conducting an STO in an offshore jurisdiction like the Cayman Islands or the British Virgin Islands comes with considerable limitations — and a few undeniable advantages. Projects need to weigh carefully if the end result is positive.
The upside is clear: these countries usually do not have any securities laws, so there is nothing to comply with. Companies can get as creative with their STO as they want. There are no taxes, either, and no filing requirements. However, the good news ends here.
Projects need to comply with the securities laws of the jurisdictions where they solicit investors, and there is rarely enough capital in these offshore countries to conduct a successful STO. A Cayman Island entity still has to deal with the SEC if it seeks funding in the US, or with the European, Japanese, Singaporean, etc. regulators.
For very large STOs, where the possible tax savings can justify the legal costs, this might make sense. In these situations, the offshore entity is often just a temporary vehicle. After the funds have been raised they are usually transferred to a foundation in a more reputable jurisdiction. Very few, if any, projects settle with a Cayman or BVI entity for the long term.
STO regulations in the EU
The European Union is not generally known as going light on regulation. Securities are indeed tightly controlled, both on the EU level and on the level of the member states. The good news is, rules are not nearly as strict as you might think.
On the European level, startup fundraising is governed by the new 2017/1129 Prospectus Regulation. The law allows companies to conduct public offerings up to 8 million EUR under a simplified scheme. Europe wouldn’t be Europe if this didn’t come with a dozen of asterisks. First, for cross-border offerings (i.e., a company incorporated in Malta soliciting funds from other EU countries), the limit is considerably lower, 5 million EUR. Second, member states can attach additional requirements. Malta, Estonia, and Lithuania are the three countries rolling out the red carpet for STOs, and conditions in these states are the easiest to fulfill.
The most significant advantage of conducting an STO in an EU country is the common regulatory framework. Once an STO is cleared in Lithuania or Malta, it can solicit investors from all the European Union. The EU is a market of half a billion people, and while it does not have the same culture of investing as the United States, there is ample capital and a developed legal system. The only serious disadvantage of Europe is taxation, but this can be mitigated with the right company structure.
STO regulations in Asia
You might be surprised we have not mentioned Asia so far — there is a reason for that. Security Token Offering is banned in China and South Korea. Japan and Taiwan are experimenting with STO-friendly legislation, but both are way behind the US and the EU.
Singapore should be a perfect country to issue security tokens. Taxes are reasonable, the Monetary Authority of Singapore is one of the most innovative regulators in the world, and exemptions are quite generous. Companies can raise up to 5 million SGD per year without even filing a prospectus.
The problem with Singapore (and with Hong Kong for that matter) is its small size. If a company wants to solicit investors from the US or the EU, it needs to comply with American and European laws anyway. In this case, it is often easier to conduct the STO in the US or Europe.
The first steps to launch an STO
If you are an early-stage startup with a world-changing idea, a viable roadmap, and a solid business plan, it’s time to raise funds! As you’ve seen, offering tokenized securities is a fantastic opportunity, but the road is winding, it is full of traps, and mistakes can be quite costly.
Let us help you!
Schedule a free, 30-minutes exploration call, and let’s talk about the best solution for your specific case.