Pre-Sales and Public Sales
The typical ICO is conducted in two phases. First, there is a “pre-sale” to a small number of sophisticated investors with experience in ICO investments (sometimes referred to as “whales”). The pre-sale is usually conducted when the company has a whitepaper outlining its token but has not yet developed and implemented its full business model. The proceeds of the pre-sale are used to fund the development costs and to complete the implementation of its token and its blockchain-based business. The company then makes a public sale of its tokens to raise a larger amount of capital.
In the U.S., a pre-sale will typically be structured as a private placement under SEC Rule 506(d). The follow-on token sale to the public is usually done in the offshore market under SEC Regulation S. Making a public sale to U.S. investors in reliance on the utility token argument risks having the offering shut down by the SEC. Therefore, we believe that most ICO issuers will have to treat their public token sales as securities offerings, and their compliance options will come down to either registration as a public offering under the Securities Act, a “mini” registration under SEC Regulation A or a registration exemption. These options are discussed in the remainder of this article.
Registration: the IPO Route
The Securities Act has two primary objectives:
- Preventing misrepresentations, deceit and fraudulent activities in the sale of securities.
- Making sure that that investors receive adequate disclosure of financial and other important information regarding the securities being offered for sale.
In order to achieve these goals, the Securities Act requires that any offer to sell securities be registered with the SEC unless it satisfies an available registration exemption.
Registration of a public offering with the SEC under the Securities Act is an expensive and time-consuming process, which is why companies looking to raise capital often seek an exemption from registration. A registration statement, including a detailed prospectus, must first be filed with and cleared by the SEC staff. The prospectus is required to include fully audited financial statements prepared in accordance with general accepted accounting principles in the U.S. Once public, the issuer of the securities will be subject to the ongoing obligations to file financial and other reports with the SEC. These include quarterly reports containing unaudited financial statements (Form 10-Q), annual reports containing audited financial statements (Form 10-K), and an annual shareholders report and proxy statement for the annual stockholders meeting.
The advantage of an SEC registered ICO is that the tokens may be offered to anyone in the U.S., and a secondary trading market can be established on an online portal or even a stock exchange (assuming the exchanges and Nasdaq eventually allow the listing of security tokens).
It is not known at this time what conditions and standards of review the SEC will place on publicly registered securities tokens. Because the registration statement will require the inclusion of audited financial statements, we believe that the registered tokens will not only need to be securities tokens but equity securities tokens–that is, tokens that will be considered equity securities for purposes of U.S. generally accepted accounting principles (GAAP). For instance, the tokens may be structured as a class of non-voting stock having specified dividend and liquidation rights.
Since the 1980’s, firms have been raising capital privately using Rule 506 (which is a part of the SEC’s Regulation D), which provides an exemption from registration for private placements. Billions of dollars are raised each year under this exemption. Key requirements of Rule 506 included limits on the number and sophistication of the investors and a prohibition on advertising and general solicitation.
In 2012, the SEC substantially amended Rule 506. The original part is now known as Rule 506(b); it limits an exempt offering to accredited investors and up to 35 non-accredited investors, and it does not allow advertising or general solicitation. (Accredited investors include individuals with net worth, excluding their primary residence, of at least $1 million, and individuals whose annual net income is at least $200,000 or whose joint net income with their spouse is at least $300,000). Also, each unaccredited investor, either alone or with his purchaser representative, “must have such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.”
In effect, the prohibition on general solicitation and advertising means that a Rule 506(b) private placement may only be made to a private group of investors, family members and friends with which the issuer has a substantial relationship. This often hampers the issuer’s ability to raise capital.
In 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act, which created several new ways for companies to raise capital. In July 2013, the SEC adopted a new Rule 506(c) as part of its implementation of the JOBS Act. It is similar to Rule 506(b) in most respects, but it has three fundamental differences:
- There is no prohibition on general advertising and general solicitation.
- Each investor must be accredited.
- The issuer must independently verify each investor’s is accreditation.
The rule contains four acceptable methods for verification, such as obtaining the investor’s tax returns, bank or brokerage statements or an accreditation letter from the investor’s accountant.
Rule 506(c) is the natural choice for an ICO pre-sale. It is designed for securities offerings to a small group of wealthy, sophisticated investors, which is typically the targeted investor pool for a pre-sale. Rule 506(c) offerings are relatively inexpensive compared to registered offerings, and there is no limit on the amount of money that can be raised under Rule. Also, the Rule 506(c) exemption preempts state securities laws, reducing the cost of blue sky compliance.
Rule 506(c) has some downsides. The ICO issuer must take “reasonable steps” to verify that the investors are accredited. (Many issuers outsource this process to a service like VerifyInvestor.com.) Another downside is that securities tokens sold under the Rule are “restricted securities.” This means that they must be held for at least one year before they can be resold into the public markets, and the number of tokens that may be sold into the public markets thereafter is limited in every six-month period to an amount determined by formula.
Regulation A provides for a “mini registration” under the Securities Act. The issuer files an offering statement with the SEC, which it must provide to investors. The offering statement is like a watered-down prospectus for a registered offering. The requirements for financial statement reviews and audits are less stringent than for a fully registered offering.
Regulation A fell into disuse over the years. However, the JOBS Act required the SEC to update and liberalize the Regulation, and in March 2015 the SEC’s amended Regulation went into effect. (The new rules are sometimes informally referred to as Regulation A+.)
Regulation A+ is a substantial improvement over the old Regulation A. It allows for general advertising and solicitation as well as sales to both accredited and non-accredited investors. Securities offered through Regulation A+ are not restricted and may be freely traded in the public markets.
Regulation A+ distinguishes two tiers of offerings. Tier 1 is for offerings of up to $20 million, while Tier 2 allows up to $50 million. Tier 2 offerings have the advantage of preempting state securities laws, which is not the case with Tier 1 exemption. While the North American Securities Administrators Association (NASAA) has a program to coordinate multi-state filings, the added expense of compliance at the state level is clearly a disadvantage of Tier 1. On the other hand, unlike Tier 1 offerings, Tier 2 offerings require fully audited financial statements as well as ongoing semi-annual and annual reporting requirements. Tier 2 offerings are also limited to (1) accredited investors and (2) non-accredited investors who token purchases do not exceed 10% of their net worth or net assets.
Regulation thus A+ blends aspects of a fully registered securities offering with the less costly and more flexible aspects of a private placement. Most companies making ICO public sales will probably want to use Tier 2, even if they are raising less than $20 million, because of the blue sky preemption. At the time of writing, several ICOs have been filed with the SEC under Regulation A+, and we expect to see many more in 2018 and beyond.
Regulation S exempts offers and sales of securities by U.S. companies solely to non-U.S. persons if there are no directed selling efforts in the U.S. There is also a safe harbor exemption for secondary resales outside of the U.S., and in certain circumstances, after a period of time, Regulation S securities may be resold into the U.S. markets
Many companies wish to avoid SEC regulation of their public ICOs, and thus make them under Regulation S. This of course means that they cannot sell to U.S. investors. However, as the international market for ICOs is large, this has not deterred many ICO issuers. An offshore Regulation S offering must include protections to ensure that the tokens can not be resold into the U.S. in violation of the Regulation.
A Regulation S offering can be done at the same time as another offering to U.S. investors under another Securities Act exemption. For instance, an issuer can make a Regulation S offering to non-U.S. investors alongside a Rule 506(c) or Regulation A+ offering to U.S. investors. However, careful attention must be taken when conducting concurrent offerings under different exemptions to ensure that everything is in compliance with the conditions of each exemption. If you plan to take this route, it would be wise to consult a securities lawyer with experience in concurrent regulation exemptions.
One downside to Regulation S is that it is only a federal exemption, and most state securities laws do not contain a similar exemption. However, most states do not regulate securities sales to purchasers not located in their state, so this is usually not a problem.
Equity crowdfunding is the online offering of securities to investors. In the U.S., there are two types of online equity platforms: (1) accredited investor platforms, and (2) JOBS Act portals.
An accredited investor platform is a website that enables accreted investors to purchase securities from a wide range of offerings listed on the platform. The listed offerings are usually structured to comply with Rule 506(c), which permits general solicitation and advertising, so there is no issue with advertising and promoting the platform or its listed offerings. The securities offerings themselves are structured as separate private placements, and the disclosures that would typically be in a printed private placement memorandum are instead made available on the portal. The portal typically restricts access to accredited investors, but the issuer is ultimately responsible for verifying each investor’s accredited status. Depending on the structure of the portal, its operator may be required to register with the SEC as a securities broker–dealer.
A creation of the JOBS Act, equity crowdfunding became legal for the first time in the U.S. in June 2015, when the SEC implemented its equity crowdfunding regulations. These regulations are modeled on the SEC’s regulations for securities broker–dealers, and requires the portal to register with the SEC as a crowdfunding portal.
The main advantage of conducting a securities offering through an equity crowdfunding platform is that non-accredited investors may participate. As 96% of the persons in the U.S. are not accredited, this opens up the offering process to a much larger number of people. The main disadvantage of equity crowdfunding is that an issuer is limited to raising a maximum of $1 million dollars in any 12-month period.
Several crowdfunding platforms, such as Start Engine, allow tokens to be sold. One innovative use is to use the crowdfunding platform for air-drops, as discussed in our blog article.
For further information, please visit our sister site crowdfundinglawyer.us.
Rules 147 and 147A
Both of these Rules provide an exemption for offerings limited to a single state. We are not aware of any ICO’s being made under these intra-state exemptions, but is conceivable that they could be used for an ICO in a large state such as California or Texas where there is a large investor base.