Before Issuing a Token, Here’s What You Need to Know

Is your token offering a securities offering?

When is a token offering subject to securities laws? A securities token offering confers certain rights to investors — — certain equity ownership rights, or a claim in the case of debt issuance. A utility token is typically associated with the provision of a service. The conundrum for issuers is that a utility token may also be a security, which requires compliance with securities laws and subjects it to oversight by the Securities and Exchange Commission (SEC) and state regulators. SEC Chief Jay Clayton remarked in February that “every ICO” he had seen was a securities offering. SEC officials have subsequently walked back this position, but Clayton’s comments should be a warning to issuers who plan to embrace tokenomics.

The Howey test is often cited as the way to judge whether an offering is a securities offering, or an offering of some other kind (personal property, real estate, a commodity). The acid test for whether a particular offering is a security is: “Do I expect the investment to increase in value due to the work of someone else?” Howey offers a starting point, not an ending point, in this analysis. A prominent securities attorney recently remarked in a private meeting: “Twelve months ago, unless you were a securities lawyer you had never heard of Howey. Now you’ve got people in the crypto community pontificating about Howey like it is some kind of bright line. It’s not!”

With the recent crackdown on ICO issuers who have been judged to have conducted illegal securities offerings, scrutiny of all token-related activity is certain to increase. Securities issuers must take care to register their offering (unlikely due to the time and cost) or qualify for an available exemption from registration. The simplest way for a company to issue securities tokens in a compliant offering is under Regulation D, 506(c) of the Securities Act of 1933. This exemption does not require a company to pre-qualify its offering with the SEC, although the company must file Form D within 15 days of the first sale of securities. There are other exemptions from registration that an issuer may rely upon, but the most common and useful one is Regulation D.

Regulation D, 506(c)

Regulation D, 506(c) allows a company to generally solicit for its offering of securities. This means the offering can be publicized through any media platform, including social media, print, radio, and conferences. Although the issuer is allowed to advertise to the general public, only accredited investors are allowed to take part in the offering.

In order to ensure that the investors are accredited, the issuer must verify their income or net worth, through an examination of financial account statements, tax returns, or certification by a qualified third party such as a CPA, licensed attorney, RIA, or broker-dealer. Under Rule 501(a), an accredited investor must have earned $200,000 of income ($300,000 for a married couple) each year for the past two years, or have at least $1,000,000 in net worth (excluding their primary residence). Entities have separate qualification rules. Many issuers rely on third-party services, such as Accredited.AM (a service of North Capital) to verify an investor’s status, under a non-exclusive safe harbor established by the SEC.

Is there an intermediary?

Although utilizing a broker-dealer in an exempt offering is not a regulatory requirement, offerings that have been chaperoned by a registered entity may provide investors with an additional level of comfort. Broker-dealers are required by law to conduct a due diligence review of an offering with which they are associated as a placement agent, and while such diligence is not designed to grade an investment or provide a recommendation, it can help weed out fraud and particularly bad deals. In an environment where many ICO issuers are chasing hot money, cutting corners, and trying to avoid regulation, utilizing a registered broker-dealer is a sign that an issuer is serious and is striving to adhere to securities regulations.

It is important to note that while broker-dealers conduct “reasonable basis” due diligence, this process is not designed to and should not replace investors’ own research. Issuers need to make clear to prospective investors that they should review and carefully evaluate all documents associated with a token offering before investing. In all communications with the public, representatives of the issuer must be truthful and accurate — — no material misstatements, no omissions of material information related to the offering. Hyperbole is profanity when it comes to securities offerings.

Investors need to be aware that companies seeking startup capital, whether from friends and family, through a fundraising platform, or through a token offering, are high-risk investments. Issuers should emphasize this point at every opportunity. The valuations for most ICOs have generally been much higher than industry averages for pre-revenue start-up companies; this is a particular risk that applies to token offerings and should be disclosed. Finally, investors in Reg D offerings will receive restricted securities that are generally subject to a one-year holding period requirement. Restrictions may be built into tokens themselves, or the issuer may have provided for other technical means to restrict token transfers. While there has been much chatter about liquidity and secondary trading of tokens, the fact is that at present there are no legal, liquid, secondary trading venues for securities tokens. The regulatory framework is still in development.

What makes you think the company will succeed?

With many charlatans adding the words “token,” “blockchain,” “ICO,” or “STO” to their corporate name or offering terms, simply to attract new investors or boost their valuation, issuers need to be especially careful how they present their offering. Six questions that prospective issuers should consider:

(1) Have you retained a reputable legal team that will guide you away from common pitfalls? Most issuers know very little about securities regulation and the potential hazards that await them.

(2 ) Does your management team have significant experience in blockchain and crypto? Jumping on the crypto bandwagon to attract investment is generally a poor strategy unless there is a sound, underlying business reason.

(3) Do you have an understandable business plan that is well-articulated and consistently described throughout your offering materials? Investors often shy away from companies with vague, inconsistent or overly complex business plans/models.

(4) Are the securities you plan to issue duly authorized, validly issued, fully paid and non-assessable? See point 1 above. A frequently overlooked item, any securities (whether in token form or otherwise) that are being issued must be in compliance with the law of the jurisdiction where the company is incorporated.

(5) Does your proposed valuation or return to investors align with the company’s development, traction, and potential? As mentioned previously, token valuations have been absurdly high compared to non-tokenized securities offerings, and investors have become more discriminating.

(6) How does the company plan to use the proceeds of its offering? Are you planning to invest in CAPEX, new employees, a new product or service line?

The answers to the foregoing questions do not necessarily define a good or bad offering, but considering them in advance will help you preempt investor questions and address concerns.

What is your risk profile?

Each investment carries its own level of risk, and token offerings of all type— cryptocurrency, ICOs, and STOs — are high-risk investments. If you plan to invest in crypto offerings, you must be willing to lose your entire investment. Investing in startup companies is not for everyone, and it is important to evaluate your investment objectives and risk tolerance prior to investing.

North Capital Private Securities Corporation is a registered broker-dealer, member FINRA and SIPC. Check out our background at broker check here. Private investments are highly illiquid and risky and are not suitable for all investors. Investments in early-stage private companies should only be part of your overall investment portfolio. Furthermore, the allocation to this asset sub-class may be best fulfilled through a balanced portfolio of different start-ups. Investments in startups are highly illiquid and those investors who cannot hold an investment for the long-term (at least 5–7 years) should not invest.