Initial coin offerings, which have become the ground floor for investing in cryptocurrencies that hope to soar like Bitcoin, raised almost $6 billion last year. In most cases, the issuer had no product — only a white paper jam-packed with business ideas — and said its coins (or tokens) weren’t securities because they’d be used in running whatever venture it was. Regulators didn’t buy that. Some crypto startups are now pitching their digital coins in a different way, by calling them security tokens, ones that can take advantage of exemptions in securities laws.
1. What’s a ‘security token’?
It’s a virtual unit of currency, much like Bitcoin and its competitors. But where Bitcoin’s often-volatile value is entirely dependent on what its adherents say it is, security tokens are promoted as being tied to actual assets, such as equity in companies, real estate or debt. Crucially, that means issuers of security tokens acknowledge being subject to securities laws, and they design their offerings to fit established exemptions from registration under the Securities Act of 1933.
2. Why would a startup go this route?
It’s seen as a way to avoid not only the costly registration requirements that apply to the initial public offering of company stock but — perhaps — also the regulatory scrutiny and legal uncertainty currently enveloping ICOs. The U.S. Securities and Exchange Commission has opened a broad probe of ICOs, concerned that some should be considered securities and that others seek funding for fake businesses. Some ventures that raised money via the ICO may be forced to refund investors’ money, pay fines, or both. Sellers of security tokens hope their extra care at the start means the SEC won’t come looking for them later.
3. How does this work?
Take Spice VC, a venture-capital fund that looked to raise $100 million and said it secured commitments for $40 million of that in a token pre-sale. It followed the terms of Rule 506c of the SEC’S Regulation D, which spells out conditions under which offers of securities are exempt from normal registration rules, and Section 3(c)(1) of the Investment Company Act of 1940, which allows private funds to avoid SEC rules. That meant, in Spice VC’s case, offering sales documents to a maximum of 99 prospective investors, who had to register on its website, certify that they are accredited (read: wealthy), provide proof of identification and respect applicable lock-up periods before selling their tokens. Issuers using the exemptions must check that buyers aren’t laundering funds and disclose operational information to the public on a regular basis after the sale.
4. Why don’t all crypto startups go this route?
Because so much money has been raised, and can be raised, through ICOs, which are open to anybody with an internet connection — no accreditation needed.
5. Where can investors buy these offerings?
Worried about regulatory scrutiny, most established cryptocurrency exchanges don’t yet offer security tokens. That’s given rise to a new wave of companies, with names like Templum, Polymath and tZero, that issue tokens in hopes of becoming token exchanges. Some have launched, and others are in the works. Spice VC’s own venture is a platform called Securitize, which “enables the tokenization of assets to make tokens tradable and increase their liquidity.” Circle Internet Finance Ltd., a startup that lets people make instant money transfers, recently bought digital token exchange Poloniex as part of a bid to break into trading digital assets.