Published on March 25, 2022
So you have an idea for a blockchain venture, you drafted a whitepaper detailing the company’s value and purpose, and are looking to raise capital for development. The blockchain industry is exploding with innovation and a seemingly endless supply of cash to support entrepreneurs’ ideas. While the prospect of raising millions to fund a blockchain venture can be exhilarating, the process is fraught with regulatory hurdles. The lack of clear regulatory guidance compounds the regulatory issues and increases risk. One notable example is the ongoing litigation between the Securities and Exchange Commission (“SEC”) and Ripple Labs.[1] This article is intended to guide entrepreneurs seeking to raise capital to fund their blockchain startups and build out their utility token’s functionality.
Historically, startups raised capital by selling equity (and often giving up a board seat) to venture capital firms. When entrepreneurs needed more funding, they entered into additional financing rounds, handing away more equity. Unlike equity, which founders are rightfully reluctant to surrender, the nature of blockchain and tokenomics incentivizes wide distribution of tokens and creates new opportunities to raise capital. However, with new opportunities come new regulatory complications.
To avoid a regulatory nightmare, entrepreneurs must first understand what type of token they are selling to raise capital. Broadly speaking, two types of tokens exist, security tokens and utility tokens:
- Security Tokens. Like stock, security tokens represent equity in a company. The SEC regulates security tokens in the same way as stock and requires registering those tokens.
- Utility Tokens. Unlike security tokens, utility tokens have intrinsic value. That is, a utility token’s value is not tied to the value of the issuer but rather to the token itself. The token is valuable because it provides the holder with certain rights. For example, a utility token can represent membership rights or can be used to purchase goods or services from the issuing company at a later date.
Unlike security tokens, which always fall under SEC regulation, utility tokens can be divided into two baskets, pre-functional tokens and functional tokens. Pre-functional tokens lack utility at the time of sale, and funds raised from the sale are used to build out the token’s utility. Pre-functional tokens are securities regulated by the SEC. The sale of functional tokens, tokens with utility at the time of sale, are less likely to be deemed a security and avoid the accompanying regulations. In short, whether your utility token is deemed a security is largely dependent on how developed the token is. To understand why, we must understand how a security is defined.
Definition of a Security
In SEC v. W.J. Howey, the Supreme Court outlined a four-pronged analysis to determine whether a financial instrument is an investment contract:
- there must be an investment of money,
- in a common enterprise,
- with the expectation of profit,
- to be derived from the efforts of others.[2]
If that test is passed, i.e., all four prongs are met, it is an investment contract and must be registered as a security. In other words, entrepreneurs typically want to fail the Howey test to avoid the registration process.
Applying Howey to Utility Tokens
The first two prongs are nearly always met since developers typically raise capital to build out a token’s functionality. Raising capital for your venture requires an investment of money in a common enterprise. The third and fourth prongs require a more thorough analysis.
An investment contract exists when investors purchase tokens with an expectation of profits in reliance on the “undeniably significant” efforts of others.[3] Since pre-functional tokens hold no inherent value, investors clearly rely on others to develop the token’s utility and increase its value. Therefore, nearly all pre-functional tokens meet this prong of the Howey test and are securities.
While pre-functional tokens are securities, all is not lost. The SEC clarified that a token’s security designation is not static.[4] As SEC Chairman Jay Clayton explained in a letter to Congressman Ted Budd, “a digital asset transaction may no longer represent an investment contract, if, for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts which affect the failure or success of the enterprise.”[5] Chairman Clayton’s letter supported the position taken by William Hinman, the former Director of Corporate Finance, who gave a speech explaining that the cryptocurrency Ether became “sufficiently decentralized” and is no longer a security.[6]
In 2014, Ethereum’s founder, Vitalik Buterin, launched the first Initial Coin Offering (“ICO”). In his post announcing the sale, Buterin wrote that “Ether will NOT be useable or transferable until the launch of the genesis block.”[7] At its ICO, Ether clearly passed Howey and was a security. Investors made an investment of money in a common enterprise (the Ethereum foundation) with the expectation of profit derived from the efforts of others (Buterin and other Ether developers).
However, by Hinman’s 2018 speech, Ether became “sufficiently decentralized” and no longer fit within the definition of an investment contract. Between 2014 and Hinman’s 2018 speech, Ether’s developers incorporated the planned developments upon which the initial investors had relied. By 2018, Ether was sufficiently decentralized and developed and no longer passed the Howey test.
Critically, development of Ether’s network did not cease. In fact, the token is currently undergoing a considerable network upgrade known as the consensus layer.[8] A significant feature of the consensus layer is the process of permanently removing circulating tokens from the total supply, called “burning.” Burning Ether, in conjunction with stable or rising demand of the token, clearly increased its value. Additionally, developers are adding features to Ether which will increase the token’s efficiency.[9] Since the upgrade decision, Ether has surpassed its previous all-time high, and although development of the consensus layer upgrade unquestionably increased Ether’s value, the token is not a security since it remains sufficiently decentralized and developed. In short, although the upgrade increases Ether’s value, the third-party efforts do not “affect the failure or success of the enterprise.”[10]
The Howey analysis provides some critical insights. First, a pre-functional token is treated as a security because purchasers rely on the efforts of others to increase its value. Second, while a pre-functional token is a security, a token’s security status is not static.[11] Rather, development and decentralization can shed a token of its security designation. Finally, third parties can continue to develop a token’s utility without the token obtaining or regaining its status as a security.
SAFT Agreement
Since the SEC’s “sufficiently decentralized” test is murky at best, entrepreneurs must take special precautions to avoid burdensome and costly mistakes when raising capital. Enter SAFTs.
Simple Agreement for Future Tokens (“SAFT”), which is modeled after Simple Agreements for Future Equity (“SAFE”), is a great tool for entrepreneurs raising capital to fund the development of a utility token.[12] Companies raise capital from accredited investors, who, in exchange, receive the right to future tokens at a discounted price. SAFTs are investment instruments that must be registered with the SEC. Since the investors are all accredited, companies can utilize Regulation D, which requires minimal registration and information.
Once the utility token is developed, the company distributes tokens to the SAFT investors while simultaneously releasing tokens to the public at large. Since the token is sufficiently developed and decentralized, purchasers “no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts.”[13] Buyers no longer expect future profits in reliance on the significant efforts of others. As a result, it is unlikely that the token is a security. Additionally, the original SAFT investors are free to sell on the secondary market without restrictions imposed on private securities, thus making the initial investors highly liquid.
Next Steps
As you consider the options available to finance your blockchain venture, you must be aware of the regulatory hurdles associated with the multitude of options. Be wary of initial coin offerings and understand the registration requirements when raising capital from investors. Finally, remain up to date on the onslaught of new regulations, regulatory proposals and executive orders that can affect your business.
[1] SEC v. Ripple Labs Inc., et. al. 2021 WL 5336970.
[2] SEC v. W. J. Howey, 328 U.S. 293 (1946).
[3] Sec. & Exch. Comm’n, Framework for “Investment Contract” Analysis of Digital Assets, https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
[4] Letter from Jay Clayton, Chairman, Sec. & Exch. Comm’n, to the Tedd Budd, Congressman, (March 7, 2019), https://www.coincenter.org/app/uploads/2020/05/clayton-token-response.pdf.
[5] Id.
[6] William Hinman, Dir, Div. Corp. Fin., Sec. & Exch. Comm’n, Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418.
[7] Vitalik Buterin, Launching the Ether Sale, Ethereum Foundation Blog (July 22, 2014) https://blog.ethereum.org/2014/07/22/launching-the-ether-sale.
[8] Jeff Benson, Ethereum Foundation Kills ‘Eth 2.0’ in Favor of ‘Consensus Layer’ Rebrand: The Ethereum Foundation Goes from Eth 2.0 to Eth 2.0 No, Decrypt (Jan 24, 2022), https://decrypt.co/91149/ethereum-foundation-kills-eth-2-consensus-layer-rebrand.
[9] Id.
[10] Letter from Jay Clayton, Chairman, Sec. & Exch. Comm’n, to the Tedd Budd, Congressman, (March 7, 2019), https://www.coincenter.org/app/uploads/2020/05/clayton-token-response.pdf.
[11] Id.
[12] An example of a SAFT Agreement can be found here: https://www.sec.gov/Archives/edgar/data/1693656/000110465919039476/a18-15736_1ex1a3hldrsrtsd1.htm.
[13] Id.
