SAFT is dead. Long live SAFTER
Over the past six months, SAFTs have become a popular way to help ICO issuers comply with securities laws. However, SAFTs are now obsolete. They should be replaced by similar securities that more cleanly separate the security from the utility token, and give issuers and buyers more ways to work together.
Update: We posted a more fully evolved replacement for SAFT here.
What is a SAFT?
A SAFT is a way to fund a coin offering with a legal sale of a private security. It’s a paper agreement to deliver utility tokens (blockchain coins) sometime in the future.
The buyer of a SAFT wants unregulated utility tokens, because they are easy to trade and they often go up in value. The seller wants to sell unregulated utility tokens, because it’s easy for people and computers to move them around to organize a community, buy compute resources, and incentivize behavior. Also, they need the money for software development.
A US-based seller doesn’t just sell the coins directly to finance software development, because that would violate securities laws. It’s pretty clear that this initial purchase is an investment. The buyer is investing in a development team for the purpose of increasing the value of the token, and making money. That qualifies it as a security, and it can’t be freely traded in the US. So, the seller sells a SAFT to fund software development.
Typically the SAFT is sold in a Reg D/ Reg S private offering. Buyers have to be accredited (with more than $1M net worth), and they are restricted in how they can resell the security. Their intention is to hold the SAFT until it converts to unregulated tokens, and then sell the tokens.
There is a theory that goes with this. The theory is that when the coins are actually used as mining fees, or gas, or payment for file storage, they will no longer be securities. They will be a type of product. Later, the seller will release the software, and start using the tokens as a product. At that point, they can convert the SAFT and give their investors the utility tokens.
There are a lot of SAFTs out there, and most of them have not converted. So, we don’t actually know how this will work out.
The Filecoin SAFT
A lot of people have pointed to the Filecoin SAFT as a role model.
From the point of view of the crypto community, Filecoin is a very good project. It comes from the developer of IPFS, which is open source software for distributed file storage that has become relatively established through several years of community work. Filecoin is essentially an accounting and incentive system for the public use of IPFS. Professional investors eagerly bought the SAFT, and it was sold in several rounds with escalating prices. Protocol Labs reported that “The sale was a resounding success! We raised over $205M in USD, ETH, BTC, and ZEC.”
So that is where Filecoin has left it. They have a crapload of money, which is far more than enough for them to build the Filecoin software. The investors have what is essentially a paper agreement, that they cannot resell, that will convert at an unknown date, to a token with vaguely defined rights, which may or may not be usable because of its status as a security. If anything derails the planned development process or token economy, they have no official rights to go to the issuer and work out a new solution.
From cool to uncool
The Filecoin SAFT was designed by lawyers at Cooley, most notably Marco Santori. Cooley and many other law firms have been promoting SAFT as a financing mechanism for coin offerings. This pipeline has left dozens of ICO issuers with SAFT presales that are hanging out there, waiting for conversion. There are hundreds more in the pipeline. The legal fees on each deal range from $50K to to $200K. Some law firms have 80 or more deals in the pipeline, representing a pipeline value of more than $10M, paid to a small team of lawyers.
Recently, this pipeline to profit has been disrupted by the SEC. I have no idea what the SEC has been communicating to law firms. I do see that there is a timeline.
- On January 18, I went to the Miami Bitcoin Conference and saw Marco Santori promoting ICO’s. To his credit, he has a genuine interest in building community value with open source software.
- On January 22, SEC Chairman Jay Clayton came out with a “stern” smackdown on ICO lawyers, which you can read here. He was clearly frustrated after six months of insisting that ICO issuers comply with securities laws. During this time, lawyers saw that the SEC wasn’t doing much enforcement, and they largely ignored the statements.
- On February 6, Marco Santorini announced that he was leaving Cooley and taking an in-house job as President and Chief Legal Officer of wallet startup “Blockchain”. He stated that “I did not get into this to do ICO’s.”
- This just in: A Cooley lawyer sent this to one of my friends: “…we are generally advising companies that there is a high degree of regulatory uncertainty in the U.S. right now, and that it is generally advisable to delay any form of public sale of tokens until there is more regulatory certainty. Specifically, U.S. regulators are currently very skeptical of the notion of a ‘utility token’ and the bar to achieving the level of functionality necessary to achieve that status is extremely high (if it is even achievable). For companies that continue to see the value in crypto currencies and distributed ledger technology (DLT), we are encouraging them to develop their software with cash-on-hand or via traditional equity investments or very limited SAFT sales to potential users of the network with a very long runway to achieve functionality.”
So... Issuers have put over two billion dollars worth of SAFTs out there, including last month’s $850M offering from Telegram. Investors have bought them, eager to receive their utility tokens. A rumored 800 more are in the pipeline. And, now lawyers are advising them that the whole game won’t work. What happens to the SAFT holders? Obviously, we cannot control the changing tides at the SEC. But, we can design more adaptable agreements.
The SAFT leaves us with a number of avoidable problems.
- It’s goal is to convert to a utility token (not a security), so that it can move freely between machines. It’s not clear that you end up with a utility token when you start with a SAFT. Regulators such as the SEC are now saying that if you started by selling it as a security, it stays as a security as long as it is designed to be sold at a profit. One of the main problems is that a SAFT often requires a public sale to price it and convert it — “a bona fide transaction or series of transactions, pursuant to which the Company will sell the Tokens to the general public in a publicized product launch.” It’s this launch that is most likely to violate securities laws, both in the letter of the law and in principle. Many good crypto launches don’t do a launch sale, and instead start up their community with earn-ins (mining), a fork, or an airdrop.
- It leaves the buyer in a bad situation if anything goes wrong with the plan — and things are going wrong. The only right that the buyer receives is the right to receive a utility token if everything goes according to plan. It is likely that the SEC will block the conversion to utility tokens. SAFTs are sold for startup projects, and the majority of startup projects fail. A few projects do well enough to pay for everything and more (as the Ethereum ICO has done), but most projects fail. ICOs may be even more likely to fail because many of them come from teams without a history of making software deliveries, and rely on unproven economic assumptions. Normally, startup investors can participate in some sort of workout or pivot if the original assumptions are invalid. SAFT buyers get none of these rights.
- It creates mind-bending tax and accounting problems. Originally, we sold a security, which leaves us with a liability in the capital account, and is not taxable. Then, we convert it to a utility token, which is a type of product that gives us taxable revenue, and a tax liability. We can “defer” the revenue until we deliver the product, but a lot of these coins are designed to be outstanding forever as currency and stakes. They are the product and they would be taxable. It’s hilarious to hear the “tax partner” argue with the “ICO partner” about this. The only real solution is to incorporate in a jurisdiction like the Cayman Islands with zero corporate tax, where they don’t care how screwed up your accounting is.
A Better Way
We can fix these problems. We can create a class of stock that receives utility tokens as a dividend. It starts out similar to a SAFT, as a Reg D / Reg S security which entitles its owner to a nice distribution of tokens. However, it lives on after the dividend, it gives the issuer and investor more ways to work together, and it fixes the accounting. I’ll dub this SAFTER (SAFT Equity Replacement).
SAFTs are designed to convert to tokens and disappear. Making them disappear was important six months ago, because there was no good way to trade and use the Reg D / Reg S private securities like the SAFT. Now, we have new technology that enables us to trade these securities in an “international tradeable private exempt” market. This allows us to create a better security, and a better ICO process.
- We fix the accounting problems by separating the capital transaction from the delivery of the token and product revenue. Capital stays as capital, and token sales are revenue.
- It’s obvious how the utility token is different from the security.
- We aren’t required to do a big public launch sale in order to price and convert the SAFT. We have the option to do a launch sale. However, we also have the option of staying away from laws governing the sale of securities, and building our community in other ways, such as forks and airdrops.
- The buyers can receive ongoing security rights, possibly even stock rights such as governance, dividends, and liquidation cash. This makes it possible to fix failed assumptions and adjust to new circumstances.
- We have more ways to interact with our utility token economy. We can issue different types of dividends to the security holders. We can run governance with the security holders. We can pay royalties from the utility economy to the security (as Sia does).
A new and improved coin offering
These securities can fund a new and improved ICO process that eliminates conflict with laws governing the sale of securities, because they don’t actually sell the coins. A lot of projects have slipped into this method by selling out their presale, so they do not need to go to a public sale. Instead, they “fork” an existing blockchain, and give away their new tokens to the holders of the forked coins. Or, they “airdrop” tokens and give them away in a marketing blitz to selected community members. Or they ask community members to earn-in with services such as mining. These tactics allow them to build value the crypto way, by engaging a community that is committed to a crypto coin and uses it. And, they can keep some coins, dividend some coins, and never sell anything that looks like a security.
This fork/drop tactic takes us back to the original way that cryptocurrencies gained value. Bitcoin was never sold in an ICO. Every bitcoin was earned by mining. The majority of crypto projects by value have come up through this community building technique.
We are working on even more interesting variations on this technique that add value to existing projects and communities with forking and airdropping, and comply with securities laws, while getting issuers early access to unregulated coins and funding.
- SAFTs are an early structure for investing in companies (as opposed to open source communities) that develop blockchain software and economies. They leave us with a number of problems.
- We can fix those problems with a similar security that receives tokens as a dividend, rather than as a conversion. This cleanly separates the security from the utility token, and it gives us more ways to work with our investors.
- These “presale” securities can be tokenized into an international, tradeable, private, exempt securities market. The follow-on coin distribution can build amazing community value, while not touching on rules governing the sale of securities. Contact Aboveboard to find out how to use these new structures.