So you want to launch a Security Token Offering (STO)…?
Before I start, a Disclaimer:
- I am not a lawyer. I do not pretend to be a lawyer. Nothing in this posting is legal advice.
- I am not an accountant. I do not pretend to be an accountant. Nothing in this posting is financial advice.
- Lastly, I am not a bot!
Background
What is STO?
A Security Token Offering (STO) based upon blockchain technology can be thought of as a next-generation Initial Coin Offering (ICO). We prefer to think of it as a regulated ICO.
In December 2017, the U.S. Securities and Exchange Commission’s (SEC), Jay Clayton, Commissioner, said, “I believe every ICO I’ve seen is a security.”[1] The SEC has become more proactive about regulating ICOs. [2]
Unfortunately, outright fraud has started to plague ICOs. Where ever there is easy money, the crooks will follow.[3]
This was backed-up by Operation CryptoSweep, with nearly a hundred ICOs targeted for investigation.[4][5]
Frankly, if I had launched an ICO, I would be concerned about who my prison cell mate might be.[6]
Why STO?
The value proposition of https://Knowbella.Tech is crowdsourcing underserved scientists around idle intellectual properties (IP). As the researchers openly collaborate they are rewarded with Helix tokens. Over 50% of the tokens in the issuance are reserved for researchers.
For those scientists who opt-in, we will matchmake them with employers. This is good for the researchers who opt-in because Knowbella Tech facilitates opportunities. The employers benefit by being able to see the researchers in action in real-time. Unlike job hunting platforms in which you only update your profile when you are looking for a job, Knowbella Tech gives employers a window into the real-time collaboration of opted-in scientists and their profiles are dynamic. This will be managed on the blockchain.
As an experienced team with a number of startups and exits over the past 30 years, we suspected unregulated ICOs would come to a nasty screeching halt. Because of that, we decided to consider our Helix token as a security from the start and make it SEC-compliant. Of course we knew this would be time consuming and expensive. Most startups cannot muster the funds and expertise to launch a regulated STO.
Luckily, due to our previous successes, we were able to bring together funds and a team to give a run at launching a STO. We decided to pursue a Regulation A+, Tier 2, Form 1-A filing with the SEC. This is not a cheap proposition. Fortunately, once again, we secured an expert Midwestern law firm charging Midwestern hourly rates. This was less than the rates quoted by law firms on either coast.
As an experienced team we knew sophisticated investors would require Knowbella Tech to actually be a sustainable revenue-generating company focused on providing a multi-bottom-line return on investment (ROI). We also think cryptocurrency investors burned by fraudulent ICOs and those ICOs that simply exploit their user base, would similarly demand a revenue-generating sustainable business. We know our business had to stand on its own without the bluster of buzzwords such as “blockchain”. Yes, we are using blockchain technology, but it is only an enabling technology that supports the business.
It is with this philosophical approach that we decided to give investors and researchers value equivalent to equity. We believe those researchers participating in building the Company, its platform, and its value should not be exploited; rather they should enjoy any ROI realized by their participation.
Tokens as Securities
To this, and inline with our focus on making Helix a bona fide security, we tied Class H shares in the Company to the Helix tokens. As the scientists increase the value of the Company, the value of the H shares increases, and this in turn increases the value of the attached Helix they have earned. This should spill over to the non-scientist holders of Helix on SEC-compliant exchanges.
If the Company achieves an ROI liquidity event such as an Initial Public Offering (IPO), or is purchased, the Helix holders can gain Class H shares for the Helix they hold and enjoy the liquidity of the H shares on a stock exchange. Now the Helix holder has both tokens and stock. The Helix is much sooner liquid than the shares, but the shares require regulatory reporting, keeping both the Helix holders and equity holders up-to-date on the Company’s inner workings.
Process
Okay, with that background, a little bit of insight into the process of the STO.
Step one: Identify a problem in the market that you can solve, presumably with the help of the enabling blockchain technology. Remember, there must be a market for the solution. No one wants to fund research projects with the promise of “if you build it they will come”.
Step two: Answer the question, “who is going to help you launch a company”? You will most likely need a founding team working without pay (“sweat equity”). Securing a team is the most critical step as sophisticated investors back teams, not products. The team will collaborate on building the business plan and executing it. Be sure to secure your legal and financial infrastructure. They will help you grow and remain compliant.
Step three: Leverage your business plan and team to raise capital, most likely from high networth accredited investors. Again, in the U.S., this type of capital raise is governed by State and Federal regulations. Your “high-speed, low-drag”, law firm should be involved from the start of your company building process. In this step, you better know the team, product, market, and proposed ROI forwards and backwards. Be sure someone on the team can tell the story in an honest, non-embellished way. There are a number of books that can help you. My favorite is Guy Kawasaki’s “The Art of the Start 2.0: The Time-Tested, Battle-Hardened Guide for Anyone Starting Anything” (Guy Kawasaki, @GuyKawaski, 2015).
Step four: After securing funding try to gain a minimal viable product (MVP). Funders are becoming increasing wary of funding research projects that cannot be sustainable.
Step five: With a MVP, proof of honest and frugal financial stewardship, a focus on generating an ROI, consider launching a STO.
Step six: Pick either a Regulation D (Reg D) offering or Regulation A (Reg A) offering. The Reg A is significantly more expensive and takes much more time to file than a Reg D. A Regulation S (Reg S) will enable one to conduct an international STO and take both accredited and non-accredited investors in those jurisdictions indicated in the Reg S filing.
A Reg D only allows raising capital from U.S. accredited investors. If you want to gain non-U.S. investors, add a Regulation S (Reg S).
A Reg A allows raising capital from both accredited and non-accredited investors, domestically and internationally. This is the regulation that Knowbella Tech chose to pursue under the expert guidance and leadership of our law firm.
Which is cheaper: The Reg D/S or Reg A? Depends on the variables such as doing a roadshow, networking with investors who care about your story, and the amount of work required to achieve the filing. Generally speaking the Reg D route is the cheapest, followed by the Reg D/S combination, and most expensively the Reg A. The Reg A is generally more expensive because it requires nearly the same amount of cost as an IPO. As such, Reg A is frequently known as a “mini-IPO”[7]. As usual, ask your big bad law firm which is best for you. If you use a Midwestern law firm and your company is not too complex, expect around $100,000.00.
Step seven: Assuming you gain permission from the SEC to do an STO, recognize other regulatory requirements including interstate money transfer, taxes, and state securities authorities.
Step eight: Do not sleep. You are working for your investors, customers, and token holders.
Other Considerations
If you are not committed 100% to your business and willing to give up holidays, weekends, relationships, and your sanity, do not undergo launching a business, let alone a STO regulation filing. Most of your investors do not care about your sacrifices. They care to gain a ROI. Regardless, under the Regulations in which you raise capital, you are required to be a good steward of capital with a fiduciary responsibility to the equity holders.[8]
You should know yourself. Know your strengths and weaknesses and fill the weaknesses with those who are stronger than you. Try to tuck away ego.
Do not worry about dilution. Own a fraction of something instead of a 100% of nothing.
Conclusion
The complexity of the STO cannot be boiled down into a few blog posts. After all, many books of regulations exist that govern securities and there are constant updates. Again, your law firm is a critical team member to ensure you are compliant and remain compliant.
In the near future we will discuss the execution of the Knowbella Tech STO…
Citations
[1] Stan Higgins, SEC Chief Clayton: ‘Every ICO I’ve Seen Is a Security’, https://www.coindesk.com/sec-chief-clayton-every-ico-ive-seen-security/, 06 Feb 2018.
[2] Jay Clayton, Statement on Cryptocurrencies and Initial Coin Offerings, https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11, 11 Dec 2017.
[3] Gareth Jenkinson, Unpacking the 5 Biggest Cryptocurrency Scams, https://cointelegraph.com/news/unpacking-the-5-biggest-cryptocurrency-scams, 18 Apr 2018.
[4] North American Securities Administrators Association (NASSA), State and Provincial Securities Regulators Conduct Coordinated International Crypto Crackdown, http://www.nasaa.org/45121/state-and-provincial-securities-regulators-conduct-coordinated-international-crypto-crackdown-2/, 21 May 2018.
[5] Jay Clayton, Statement on NASAA’s Announcement of Enforcement Sweep Targeting Fraudulent ICOs and Crypto-asset Investment Products, https://www.sec.gov/news/public-statement/statement-nasaas-announcement-enforcement-sweep-targeting-fraudulent-icos-and, 22 May 2018.
[6] Dan Mangan, ‘Pharma bro’ fraudster Martin Shkreli: I want to serve prison in a minimum-security federal camp, https://www.cnbc.com/2018/03/14/martin-shkreli-asks-to-serve-fraud-sentence-in-minimum-security-camp.html, 14 Mar 2018.
[7] Dylan Lewis, What’s a Mini-IPO?, https://www.fool.com/investing/2017/10/03/whats-a-mini-ipo.aspx, 03 Oct 2017.
[8] Legal Information Institute, Fiduciary Duty, https://www.law.cornell.edu/wex/fiduciary_duty, July 2016.
