What You Should Know About Venture Capital Before You ICO

Josh Ephraim
Berkeley Blockchain
11 min readFeb 7, 2018


This is part three of a series on UC Berkeley’s CS 294–144: Blockchain, Cryptoeconomics, and the Future of Technology, Business and Law.

You can read part one here, and part two here.

Regulation of bitcoin and other tokens has been a particularly salient topic recently. More people are investing in cryptocurrencies than ever before, and with that, more people are breaking rules, losing money, and even committing fraud. The fact that many people seem to miss is that bitcoin and other cryptocurrencies are already regulated. The existing regulatory regimes in the U.S. are designed in large part to protect the everyday investor. They apply to cryptocurrency just as much as they apply to any other type of investment.

So today in class Adam Sterling walked us through the basics of Venture Finance, as well as the basics of Securities Regulation. We then looked at how it applies to token sales, also known as Initial Coin Offerings (ICO’s).

Venture Finance 101

Adam kicked off the class with a shocking revelation. Adam is bald!

He thought about getting a toupee, but doesn’t want people to know it’s a toupee — such a drastic change from bald to flowing locks would tip everyone off. Other people purportedly have the same issue, and so he came up with a new product — a toupee that grows over time.

Adam named the company HairBNB

At HairBNB, Adam now needs to decide how to raise money to make his idea a reality.

HairBNB can raise money through debt or equity.

Debt financing provides a fixed claim entitling a lender to return of principal, plus interest. Upon insolvency, a debt claim is senior to any equity claims. A loan would also typically require a security interest in something of value from the borrower.

HairBNB isn’t much more than an idea on paper right now, so it’s not a very good candidate for traditional debt financing. The company may have some laptops, chairs, and desks in an office, but that is not typically enough of a security interest to entice a lender.

Equity financing is a much more attractive instrument for an early-stage venture. This type of investment provides no fixed claim in a firm’s assets. Equity is typically a riskier investment, but there is the opportunity for much greater returns for investors. In debt finance, interest rates can be as low as a few percent. In an equity investment, the upside can be much higher. Venture capitalists typically get preferred equity, which has a liquidation preference. The liquidation preference entitles VC’s to a claim senior to common stock upon insolvency, but junior to creditors.

A company’s lifecycle typically starts with the founders exchanging a small amount of cash and maybe some intellectual property for common stock.

Once they start to build a product and get some traction, they look for financing. Debt is out of the question because they don’t have anything of sufficient value for a lender to secure. So they look for investors comfortable with the risk profile of a high-risk startup. This is where the venture capitalists come in!

Priced rounds are a way that VC’s invest capital in a startup in exchange for a piece of the company. A Series A or first institutional investment typically comes with 20–30% ownership in the company. The investment typically comes with new board members as well as control and information rights.

For example, assume a single founder owns all 8,000,000 shares of startup company, and a VC proposes to invest $2,000,000 at a $8,000,000 pre-money valuation:

Pre-money valuation = $8,000,000
New money = $2,000,000
Post-money valuation = $10,000,000

Quick venture math

After the investment, the VC will have a 20% ownership stake. To ensure the VC holds 20% upon conversion of Preferred Stock, price per share is calculated:

Calculating the share price
This is the post-financing capitalization. FDS = Fully diluted shares

You might be wondering where the eight million dollar “pre-money” valuation came from. Sometimes VC’s back into these valuations by determining how much they want to invest (in this case, two million dollars), and how much of the company they want to own. Some other factors that VC’s find important early on are the stage of the company (have they found product-market-fit yet?), competition with other funding sources (are other VC’s competing for the deal?), team (have they built a successful startup before?), size and trendiness of the market, the VC’s natural entry point (do they have particular expertise or a specific investment thesis in the space?), traction, and the current availability of capital or the economic climate.

Venture capital is evolving

In the past several years investors have increasingly used convertible securities. These instruments are lightly negotiated documents, quick to execute, and enable multiple closings (I can invest $20K today, and someone else can invest $25K tomorrow, even on different terms). Convertible securities don’t come with board seats or many investor rights.

A convertible security can be structured as debt through what is called a convertible note. This means there is principle, interest, and a maturity date. The debt then automatically converts to equity at a qualified financing — meaning a priced round that invests more than a certain amount (typically around a million dollars).

The two main terms of a convertible note are a discount and valuation cap. These mechanisms enable the note-holder (investor) to get shares at a lower price than any new investors upon a qualified financing. The logic here is that they have invested earlier, thus taking on more risk, and they should be rewarded for that.

Y Combinator also created the SAFE, which is a type of convertible security that does not have a maturity date or interest. 500 Startups has a similar convertible security called a KISS.

Securities Regulation 101

For most of the 1920s, the economy in the U.S. was doing great. There were a ton of investment schemes and securities regulation only happened on the state level. However, there was also a lot of shady stuff going on. On Black Friday in 1929, the stock market crashed.

Sound like the crypto advertisements you’re seeing online?

In 1933, Congress passed the Securities Act of 1933. It has also been known as the “Truth in Securities” Act. Two of the main tenets are:

  1. “Require that investors receive financial and other significant information concerning securities being offered for public sale.”
  2. “Prohibit deceit, misrepresentations, and other fraud in the sale of securities.”
FDR signing the Banking Reform Bill in 1933

The ’33 Act is still one of the most important securities regulations in the United States. There are serious consequences if you are in violation.

So how does one ensure compliance? The ’33 Act prohibits selling or offering to sell a security to *anyone* unless you:

  1. File a registration statement; or
  2. Claim an exemption

If you’re thinking option one sounds simple it’s unfortunately not. Filing a registration statement with the SEC means you have to put together a prospectus, which is a “selling” document that must be delivered to each person who is offered or purchases the securities. The prospectus includes information about business operations, financial condition, results of operations, risk factors, and management. It must also include audited financial statements. This means you need a bunch of lawyers, bankers, and accountants to put this together.

The costs are in the millions of dollars. And even if you do this, you are not out of the woods. You’ll need to comply with quarterly filings as well as shareholder meetings. In addition, your company’s value is now subject to the scrutiny of the public market. This isn’t even attractive to several high profile billion dollar companies because of all the hoops you have to jump through.

So if you’re not interested in paying that much and jumping through all of the hoops, you need to find an exemption.

The common exemptions are:

  1. The “Private Offering” Exemption (Section 4(2) of the ’33 Act) — “The sale of stock to promoters who take the initiative in founding or organizing the business would come within the exemption.”
  2. Rule 506 — “Private Offering” Exemption — In general, allows you to sell securities in a private placement if you offer/sell only to people you know personally or who you know with 100% confidence have financial sophistication and can bear the risk of a start-up investment. You also can only sell to “accredited investors.” Accredited investors are individuals or entities that meet certain income or net worth requirements.
  3. Rule 701 — Compensatory Equity Awards — this one enables startups to compensate their employees with equity.

But What Is a Security?

Case law in the U.S. provides some clarity as to what is or isn’t a security.

In a case the Supreme Court decided in 1946 called Securities and Exchange Commission v. W. J. Howey Co., Howey, the defendant, was planting and selling orange groves. In order to raise money, Howey sold tracts of land to people. Howey also offered to mantain the groves for the buyers. Howey basically did everything, and the purchasers shared in the profits from the sale of oranges. The SEC accused Howey of selling unregistered securities.

Howey’s orange groves

The court decided that Howey was in fact selling securities. The court defined an investment contract as any “contract, transaction or scheme whereby a person [1] invests his money [2] in a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party.”

An orange grove in florida

Here, the buyers purchased a tract of the groves to make a profit. The buyers had no interest in farming the lands themselves, and Howey had total control of the business.

What Does This Mean For Token Sales?

Are tokens securities? This is a big question regulators have about tokens. As with many legal questions, the answer to this one is, “It depends.”

So what are tokens?

Blockchain protocol tokens, or simply “tokens,” are digital assets used in connection with decentralized services, applications and communities (collectively, “token networks”) —The SAFT Project: Toward a Compliant Token Sale Framework

As was discussed earlier, the SAFT itself is a security. It is an investment contract in a common enterprise, with the expectation of profits, solely from the efforts of others.

Back to HairBNB. Assume Adam posts a White Paper. He proposes that potential “hairheads” acquire the right to HairBNB tokens through a donation to the HairBNB Foundation. He expects the HairBNB platform to be operational in early 2019, and once live, hairheads will be able to obtain tokens at a 20% discount. Proceeds from the “donation drive” will be used to build the platform.

100 hairheads acquire HairBNB tokens, but they aren’t yet functional. Hairheads are able to exchange/sell/trade the tokens.

Are these tokens securities? In order not to be considered a security, a token should have some use (in other words — giving a possibility to do something, like provide access to a system) and not solely represent a speculative source of profits from owning.

Adam left this question open in class. It’s not black and white, but I think it is a security. Just because the hairhead token will one day have a consumptive use, it doesn’t remove it from security status beforehand. Before 2019 and the launch of HairBNB, there is nothing you can do with your token except hope that it appreciates in value.

Others may argue that it is just like an API key or a Kickstarter pre-sale. All the token provides is access to a service at a future point in time. I find this argument a bit less convincing, but the SEC says they’ll evaluate it on a case by case basis.

One high profile example of a token that was deemed a security was The DAO, or Decentralized, Autonomous Organization. The project developers noticed that there were a bunch of decentralized projects that didn’t have a way to get funded. So they sold a token. In exchange, token holders received the profits that were made from any of the projects The DAO invested in. This lined up pretty neatly with Howey, where Howey worked the land and sold the oranges, while the people who bought the orange groves reaped the profits. In both cases, the SEC said it was a security.

Other Regulations to Consider

There are a whole lot of other regulations to consider if you’re thinking about doing a token sale or “ICO.” There are Money Transmitting Business regulations, federal tax laws, state laws, commodities and futures (CFTC), fraud, and regulation of exchanges. Looking forward to learning more about this!

For Further Reading…

The professors assigned the following:

  • The Laws That Govern the Securities Industry: SEC.gov summary of the Securities Act of 1933, Securities Exchange Act of 1934, Trust Indenture Act of 1939, Investment Company Act of 1940, Investment Advisers Act of 1940, Sarbanes-Oxley Act of 2002, Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Jumpstart Our Business Startups Act of 2012, as well as Rules and Regulations
  • SEC v. Howey Co., 328 U.S. 293 (1946): Under the Securities Act of 1933, a contract involving the investment of money for the purpose of gaining a profit due to the acts of the promoter or a third party is considered a security.
  • Opening Remarks at the Securities Regulation Institute: SEC Chaiman John Clayton on expectations for market professionals, particularly when dealing with new products or new forms of old products, and the SEC’s approach to remaining Dodd-Frank rulemaking mandates.
  • FinTech Update January 2018: ICOs: Adding a utility feature to a token does not necessarily make the token a non-security if the token can still appreciate in value based on the token sponsor’s efforts in creating a utility for that token. Chair Clayton said that whether utility tokens are securities depends on the characteristics and use of that particular asset.
  • FinTech Update December 2017 : SEC Freezes PlexCoin ICO
  • The SAFT Project: Toward a Compliant Token Sale Framework: VCs invest in a project in exchange for a set amount of the tokens it sells in a future Initial Coin Offering (ICO). Sometimes the SAFT offers a discount to the initial investor for providing capital at an earlier stage than other token purchasers. The SAFT itself is a security.
  • Not So Fast — Risks Related to the Use of a “SAFT” for Token Sales: The Cardozo Blockchain Project outlines some risks associated with the SAFT, including (1) that it may blur the true test of how tokens will be analyzed under U.S. federal securities law, (2) it increases the risk that a token will be treated as a security by emphasizing the speculative nature of the investment, and (3)incentivizes early investors to flip their holdings instead of supporting enterprise growth
  • The threat of tough regulation in Asia sends crypto-currencies into a tailspin: Asian countries have played a large role in crypto growth, so new regulation would have a big impact on the market.
  • Here’s how the U.S. and the world regulate bitcoin and other cryptocurrencies: MarketWatch and Perkins Coie put together a nice chart of the U.S. regulation as well as the regimes for other countries.
U.S. Regulatory Regime — Credit: MarketWatch.com



Josh Ephraim
Berkeley Blockchain

legal counsel to startups and VCs, jd-mba, former investor at Dorm Room Fund