Bringing ICOs out of the shadows

Howard Marks
Aug 28, 2017 · 6 min read
Is anICO an IPOS ?

Bringing ICOs Out of the Shadows

When I founded StartEngine, my mission was to help entrepreneurs achieve their dreams by raising the capital they needed to succeed. As a consequence of this mission, we have democratized capital and allow ordinary investors to participate in the exciting startup industry and invest in brands they care about. Since our launch, we have helped over 50 companies raise close to $40M in capital. According to the StartEngine Index, we are over 20% of the fast growing market for Regulation Crowdfunding offerings.

Last month, I read a very curious new bulletin issued by the SEC. Because our company is a funding portal registered with the SEC, I pay a great deal of attention to what the SEC is telling investors and industry professionals. This bulletin was about ICOs. ICOs are a new type of offering that allow companies to raise capital from people who own either Bitcoin or Ether cryptocurrencies. Why would the SEC care about what is going on with this fast growing segment of the Internet? According to Coindesk, companies have raised over $1B in capital for their companies in the last two months alone. Yes, ONE BILLION dollars. The capital raised through ICOs is greater than investments from the entire VC industry in the same time period.

So why is the SEC concerned? The SEC has three clear mandates:

  • Protect investors
  • Facilitate capital formation, especially for small companies
  • Maintain fair, orderly, and efficient markets

These mandates are very important because fraud is a real problem in the financial industry. From the Enron disaster to the Bernie Madoff ponzi scheme, the number of financial financial scandals could fill several phonebooks. The SEC is responsible for playing good cop and taking these people to justice.

In 2009, Bitcoin was born very quietly, maybe as an experiment to show the world it was possible to create a secure and private means to send money between people. As of today, no one knows the true identity of the creator. But people do know that a single Bitcoin is valued at over $4,300, with a total market cap of over $100B. Bitcoin is a cryptocurrency and companies who help people purchase Bitcoins with real dollars are wallets. Wallets are regulated as money transmitters; bitcoin is money. People who profit from selling their Bitcoins pay taxes to the IRS. Bitcoin is real and it’s growing at unprecedented rates.

A few years ago, a new concept emerged called the Initial Coin Offering or ICO. ICOs are a way for new cryptocurrencies or coins to raise capital in an online offering. The logic behind ICOs is that companies who create new cryptocurrencies do not want to give it away for free, hoping people use it and put a value on it. If these are currencies, then a value must be put on it. This is what an ICO does. It allows a person or a company to sell a set number of coins or tokens to others in exchange for Bitcoin or some other well-recognized cryptocurrency (ie: Ether). An ICO is similar in many ways to an IPO. In an IPO, a company goes public and issues shares. In an ICO, a company issues a limited number of their own coins. With such massive raise numbers, ICOs have been top of tech media for months, and the SEC got wind of it.

On July 25, 2017, the SEC issued a bulletin to explain that some ICOs should register their offering with the SEC because they consider these coins securities. In simple terms: companies must register their offering with the SEC or they are violating securities law. One step further, the officers of the company and anyone involved in the process can be prosecuted for fraud. Not a great addition to the resumé. These charges could include jail sentences and, of course, payment of damages. The downside seems quite large compared the upside of receiving millions of dollars in Bitcoin. If you read the bulletin, the SEC was kind enough to guide those who want to hold an ICO towards means to do so in a legal way. Register the offering with the SEC or use one of the exemptions the SEC rules offer. This is legal terminology for saying either sell to accredited investors and be responsible for checking their status and identity under regulation D 506(c) or use Regulation A+ or Regulation Crowdfunding to sell token in an ICO.

Lucky for these companies, Regulation Crowdfunding, which allows US based companies to raise up to $1.07M per year, is inexpensive and reasonably fast to put in place. The company must select a funding portal and hire a CPA to review the financials (this is only required if the raise exceeds $107k). Once the company passes due diligence, the funding portal files the form C with the SEC and the company can then legally sell securities or coins to the general public. Investors in these offerings must certify their annual income and net worth, because, if their annual income or net worth is less than $107k, they can only invest up to the greater of either $2,200 or 5% of the lesser of their annual income or net worth. This rule allows investors to sell their securities one year after they purchase them. Over 400 companies have raised under this regulation since May 16 of last year, when this new rule went into place.

Regulation A+ is likely to be more exciting for the ICO industry. This regulation permits companies to raise up to $50M per year, however, it requires the company to get a two year audit (or less if the company is younger) and file with the SEC the offering prospectus. This requires an experienced securities attorney to handle the work. This SEC can take anywhere from 30 days to 90 days to qualify (or approve) an offering. So far, over 200 offerings were filed since mid 2015 when the rule went into place. More good news, investors who purchase securities under the Regulation A+ rule can freely trade immediately after the sale. This works well for ICOs because their investors are often eager to capitalize on the demand and sell the coins for more than they paid for.

Both Regulation Crowdfunding and Regulation A+ could be an ideal method for ICOs to legally raise their capital. Raising under these regulations will also allow their investors to feel more secure because the SEC oversees these offerings. In addition, the companies are required to file an annual report which provides investors additional information for their investment.

ICOs are growing very fast, just visit many of the websites that list the companies raising capital. Some of them claim they are not selling securities because the coins are a prepaid service. But why would someone want to purchase a prepaid service when the service is actually not available? Clearly, people purchase them with the hope they go up in value because those coins are in limited supply. The laws of supply and demand also work well in cyberspace. Limited supply and strong demand increases prices. Some ICOs do not allows US investors. However, unless they are strict about verifying the identity of the investor, there is no way to know if someone is not a US citizen. If these companies sell to even one US citizen, they are in violation of securities laws and well… you know now what that means.

I am hopeful the ICO industry is going to mature and become more mainstream because there are millions of people who hold Bitcoin and other cryptocurrencies eager to invest in great new ideas. Imagine if you could invest in eBay or Amazon in 1996. This is what is going on now in the cryptocurrency and blockchain industry. You can find some of the most creative new startups trying to change the world into a better place. Some of the brightest engineers are working on solutions to reduce the cost of banking, insurance and other important services. The world is going to be a better place and the companies who issue ICOs need to do it the right way.

P.S. In case you are interested in understanding if your ICO could be considered a security, then read this analysis by a consortium of lawyers, pundits and investors.

Register for the StartEngine ICO 2.0 Summit on November 10 in Santa Monica.

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StartEngine does not endorse or highlight any individual companies on our website. We prepare a company interview for all new companies our website. Readers should not consider statements made in this post as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:http://startenginebetadev.s3.amazonaws.com/production/pdfs/Disclaimer.pdf

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Howard Marks

Written by

CEO at StartEngine and co-founder at Activision/Blizzard. Raise capital with equity crowdfunding on www.startengine.com

Raising the Entrepreneurial Boom

Words of wisdom about being an entrepreneur, raising capital and winning in the entrepreneurial game written and published by renowned entrepreneur Howard Marks co-founder at Activision and StartEngine www.startengine.com

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