Cutting though the Noise: The nature of start-ups and the SEC-Kik complaint
Earlier this month, the SEC filed suit against Kik, a social media company that sold a new cryptocurrency in 2017. By filing suit, the SEC made public a 49-page legal complaint. The SEC does not allege fraud, but claims that Kik’s sale of cryptocurrency was a sale of securities. On first read, the complaint portrays an unflattering story. However, all good legal complaints lay out such narratives. In this post, we aim to separate out what matters from what doesn’t.
Much of the SEC’s narrative focuses on common circumstances that would apply to almost any startup company. The SEC’s paints a picture that Kik was a venture-capital-backed company desperately running out of money, so it pivoted to what a Kik board member called a “Hail Mary,” to raise new financing and sell a new product.
First, almost every time a startup raises funding, it is desperately running out of money. Read any book about venture capital and you get the basics: VC-backed startups raise money roughly every 18 months, based on milestones. They might miss their milestones or the market might turn, making the next fundraising difficult. If the money runs out, the founders have to face laying off the employees who had faith in them and telling their friends, family, and colleagues who invested that their company — like more than half of VC-backed companies and 90% of new businesses — just won’t make it. Listen to almost any interview with an entrepreneur and you’ll hear about a near-death experience where the company almost went under before raising enough money to live another day.
Second, when faced with limited financial runway, startups often pivot, or sell new products, to survive. Airbnb sold artsy collector cereal boxes at political conventions to raise enough money to keep going. Zipline, recently crowned a “unicorn,” pivoted from little toy robots to healthcare-delivery drones as a “Hail Mary” when it was running out of money. Slack began as a gaming company and sequently became the leading enterprise collaboration app. Twitter began as a podcast platform, then pivoted into social messaging.
We imagine Kik would argue that it simply pivoted towards selling a new product, no different than any of these other companies. It would likely argue that the tokens it sold, called Kin, were products: credits to use on social networks. The new vision was simple, inspired (like many entrepreneurial products) by their own experience. The Kik entrepreneurs realized that new social networks struggle to compete with Facebook and Google, who famously dominate advertising revenue. Kin tokens are designed to create a common pool of “credits” or currency that could be used across lots of smaller social media apps — just as Facebook credits were used as currency on Facebook apps. Indeed, the SEC points to WhatsApp and Snap as successes, but WhatsApp had to sell itself to Facebook rather than remain a standalone company, while Snap remains unprofitable and sells below its IPO price. The challenge of social-media startups is real, and most do fail. There is nothing untoward or illegal about Kik trying to raise money by selling a new vision and a new product.
Third, not only do startups sell new products, they seek a variety of ways to raise capital, often failing to raise funds in one capital market before successfully tapping another. The SEC complaint emphasizes that Kik was struggling to raise an equity-financing round from accredited investors before it began selling cryptocurrency. There is nothing illegal or unusual about failing to generate a market in a security (say, preferred stock) and then seeking some other pathway to raise funds (debt, prepayments from customers, simple agreements for future tokens (SAFT), etc.). Famously, as told in both Ben Horowitz’s classic book The Hard Thing About Hard Things, Horowitz founded a company called LoudCloud that eventually could not sell preferred stock to venture capitalists. LoudCloud then, like Kik, shopped itself for an acquisition but passed when the offers were unfavorable. Horowitz realized that oddly the public stock markets offered LoudCloud the cheapest cost of capital. So the company turned to public investors through a classic IPO. Kik noticed that a SAFT would be its cheapest cost of capital, and that the demand for a digital asset with utility tied to a social-media ecosystem would be stronger than the market for equity. The legal question for both LoudCloud and Kik is not whether one instrument or market had failed previously or was a security. It’s simply whether the subsequent fundraising itself was legal.
So, let’s set aside whether Kik was running out of money, thinking about pivoting, or looking across a range of revenue-generating sales, acquisitions, or other ways to raise money. It’s okay if those things are true, but they don’t really matter and simply tell us what we already know — Kik was a startup.
The question that does matter in this case is simply whether Kik’s token sale itself was legal. The crypto community should focus on this question because, depending on the court’s analysis, reasoning, and decision, this case may have a broad impact on the cryptocurrency community, whether or not Kik wins.