ICOs: The Dual Token Conundrum

It is clear that the SEC is going to do an enforcement action against a number of Initial Coin Offerings (ICOs), and the people who are selling utility tokens to investors for Bitcoin or Ether cryptocurrencies. Most ICOs are conducted by companies that have not completed their proposed services under a Simple Agreement for Future Tokens or SAFT structure.  The companies are issuing their utility tokens using the ERC 20 standard, which was proposed by the Ethereum community. This piece of code is great because it allows the exchanges to list the tokens and trade them between investors.

Being targeted by the SEC in a securities fraud investigation is not fun. The legal costs are great, and the investors could be entitled to a full refund of their investments. Add to this some jail time and it is clearly not worth it. The remedy is quite clear: use one of the SEC’s exemptions to registration.

The question is which one out the different available options?

Below is a list of exemptions from the JOBS Act of 2012:

  • Title II or Regulation D 506(c) permits soliciting capital from accredited investors but the securities are restricted and only tradable to accredited investors.
  • Title IV or Regulation A+ permits raising up to $50 million per year directly from the general public and allows the securities to be freely tradable immediately.
  • Title III or Regulation Crowdfunding permits raising up to $1,070,000 per year directly from the general public with a one year restriction on trading the securities.

Regulation A+ is probably the one best suited for ICOs because it allows a company to raise up to $50 million directly from the general public (everyone) and allows the tokens to be freely traded thereafter. A company choosing Reg A+ needs to hire an attorney and a CPA to conduct a two year audit (or less if the company is younger). The costs range from $100,000 to $200,000 and could be similar or less to what companies are paying today for legal advice on an ICO.

The best way to issue this security token is as a share of the corporation. This share could be common, preferred, or even a revenue share. The SEC needs first to qualify the offering and then the company is free to raise the capital. However, the company may still want to issue a utility token to operate the blockchain service.

But how can two tokens exist?

A two token economy is not as crazy as it seems. The first token is a share of the corporation and the second one is selling a service offered by the company. The owner of the first one is a shareholder and the owner of the second one is a customer. Shareholders and customers can live in harmony as long of their interests are aligned.

So how to make both work and not create any governance issues?

Here is a good example of how to do it:

  • Issue 10 million common shares class B (different than the class A owned by the initial founders and investors) security tokens at $5 each using a regulation A+ offering. This is a total raise of $50M.
  • These security tokens can trade on any exchange that is willing to take securities.
  • Issue 100 million tokens at $1 each. This utility token’s sole purpose is to be used in the context of the service proposed by the company. The company will issue additional tokens as the business grows in popularity. The existing shareholders will receive $50M of these utility tokens, the equivalent of their investment in the security tokens giving them a perk for their initial investment.

The investors who purchased the shares as tokens are able to trade them like normal stock in a company but with full liquidity because regulation A+ permits it.

In addition, they get perks in utility tokens worth the same value of their investments. They can also trade that utility token on other exchanges that only handle utility tokens. This is a win-win for both the shareholders and the investors. The company also wins because they may receive $50 million in capital and a net $50 million in token sales. The company is no longer limited to only 100 million tokens because a year later they can issue more as business growth demands.

ICOs are a revolutionary way for companies to raise capital from the newly minted cryptocurrency crowd and it needs to continue its staggering growth while embracing the JOBS ACT nascent rules.


 

Howard Marks is the CEO at StartEngineCrowdfunding/Capital, the leader in Online Public Offerings.  Marks founded StartEngine with the mission to help entrepreneurs achieve their dreams. Marks is the co-founder of Activision Blizzard and Chairman of Activision Studios from 1991 until 1997.  As co-founder, former Board Member, and Executive Vice-President of video game giant Activision, he and a partner took control  in 1991 and turned the ailing company into the $30B+ market cap video game industry leader. Marks is the 2015 “Treasure of Los Angeles” recipient awarded for his work to transform Los Angeles into a leading technology city.  Marks is also named one of the 500 most influential people in Los Angeles by the Los Angeles Business Journal.  Marks is a member of Mayor Eric Garcetti’s technology council.  Marks has a Bachelor of Science in Computer Engineering from the University of Michigan.  He is bilingual and is a triple national of the U.S., United Kingdom, and France.

 


 

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  • DF

    The core of this article rests on the untested assumption that the SEC would treat the two tokens as two discreet events rather than a single securities issuance – not unlike a bond issued with warrants. Merely labeling it a “perk” is not likely to change that analysis. The proof is that the company wants investors to pay extra for the “perk” because otherwise there is no rationale for the company to provide this perk. Note that this perk is not a free ride for the company – it is a future liability for the delivery of services by the company and will have to be carried on its books as a liability.
    Even in the unlikely case that the SEC does not collapse this issuance into a single securities analysis, the SEC has not issued any guidance for what it will consider a utility token. The Howey test, which the is the relevant test, is difficult to apply to utilit tokens and so there is much uncertainty. However, the Chairman of the SEC recently commented that almost all of the ICOs he is seeing would be securities. Keep in mind that most of the ICOs he is likely seeing claim to be utility tokens.

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