Security Token ICOs and Compliance: Regulations A, D and Crowdfunding

One of the most contentious issues in the burgeoning token community is how governmental agencies will ultimately decide to regulate the sale and transfer of tokens, specifically with respect to initial coin offerings (ICOs). At present, financial experts continue to go back-and-forth on whether tokens should be treated as currencies, property assets, securities, or their own novel classification for governing purposes. Recent guidance from the SEC suggests that the organization may consider all tokens and offerings of tokens as securities and security offerings. To date, there has not been a clear example of a token offered in an ICO and subsequently traded that would make it through a compliance audit as a security. Understandably, many in the token community are worried by the prospect of security-based regulatory practices tempering the red-hot ICO market that raised a total of $6.3 billion in the first quarter of 2018 alone. However, this would be good news for proponents of token technologies as it would provide much needed clarity and structure to the wild west frontier known as the token economy. While securities regulations are continuously evolving, they have been in place and studied for hundreds of years with abundant data on the effects of different types of regulation. They are clearly defined and in recent years have become more flexible through the offering of registration exemptions which are tailored to alleviate the burdens to smaller businesses of complying with registration requirements. This article examines three registration exemptions that may emerge as promising paths to the successful completion of compliant ICOs.


Regulation A & Reg A+

Regulation A (“Reg A”) was adopted to decrease the burden to small companies of executing an equity offering while holding large company offerings to higher standards. It was subsequently amended as a part of the JOBS Act of 2012 in an effort to modernize the maximum raise limits and further relieve small offerings from certain disclosure requirements. There are two tiers of offerings addressed by Reg A which vary in the obligations placed upon the issuer, the investors included in the pool which is eligible to purchase securities sold in the offering, and the permitted marketing activities associated with the offering. Tier 1 allows companies to raise up to $20 million through the issuance of securities, while Tier 2 (or Reg A+) allows companies to raise up to $50 million. Both tiers allow issuers to market securities to any qualified investor as opposed to only accredited investors, do not automatically require ongoing reporting obligations once an offering is completed, and have a simplified registration form and process. Reg A offerings can be executed by domestic or Canadian issuers that are not subject to 1934 Act reporting requirements or disqualification under “bad actor” provisions of Rule 262. Companies that are not eligible to complete an offering under Reg A include investment companies, blank check companies, and issuers of oil, gas or mineral rights. Asset-backed securities also cannot be offered under Reg A. In recent years, there has been an increase in the number of firms utilizing registration exemptions provided in Reg A to raise capital and satisfy requirements to list on a public exchange. The first example of a company that used a Reg A+ raise to directly list to a major exchange was Myomo, which completed a $5 million raise before listing directly to the NYSE in 2017.

The Process
Raising capital by registering the sale of security tokens with the SEC under the Reg A exemption looks very similar to registering shares of stock in a company under the same exemption. The process for shares of stock or tokens is illustrated in the below diagram. While not as burdensome as a traditional public offering via S-1 registration statement, it still requires a meaningful investment of time and extensive up-front planning for successful execution.

The timeline for Reg A offerings can vary greatly depending on SEC turnaround time, the amount of time available to devote to the process, whether to include the optional “test the waters” step, and environmental factors. However, a reasonable duration to expect is around five to seven months. Once a Reg A offering is qualified by the SEC, it can continue as a live offering for 12 months, during which time it can be paused and reopened again at the discretion of the issuer.


Benefits of Regulation A Offerings


  • Faster and cheaper than a conventional public offering which is not exempt from registration
  • No ongoing reporting requirements
  • Larger maximum raise amounts relative to other exempt public offerings
  • Can sell to non-accredited investors as well as accredited investors
  • Can be used to satisfy public exchange listing requirements


Drawbacks of Regulation A Offerings


  • Longer period prior to initiating the offering than other exempt offerings
  • Aggregate raise amounts are capped unlike registered offerings or certain other exempt offerings
  • More robust disclosure requirements than certain other exempt offerings
  • Not available for certain categories of issuers and types of securities


Regulation D

Regulation D (“Reg D”) was first adopted in 1982 to create an exemption from SEC registration for private placements by usually smaller companies. Reg D offerings are can be completed pursuant to Rule 504, 505, 506(b), or 506(c). Each rule has unique characteristics and restrictions, but the only one that allows general solicitation is Rule 506(c). This allowance only applies if all purchasers are accredited investors and the issuer takes reasonable steps to ensure that this is the case. There is neither a maximum raise amount nor a maximum number of shareholders for Reg D offerings relying on Rule 506(c). Issuers are not required to disclose financial or narrative information and are only required to provide a description of resale restrictions, an opportunity to receive certain other information, and an opportunity to ask questions. Securities issued under the Reg D Rule 506(c) exemption are classified as restricted securities.

The Process
The process to complete a Reg D offering relying on a Rule 506(c) exemption is fairly straightforward. The time required varies, but securities can begin to be marketed within about a month of beginning the process, and all forms and regulatory filings can be completed within about 45 to 60 days of starting. Unlike Reg A, the offering can continue until all securities authorized to be sold in the offering have been purchased.
As with any offering, the first step is to obtain legal advice and create a plan of attack. At this point, conversations should also begin with any relevant marketing partners. Once a legal service provider is engaged, they will prepare offering agreements and the placement memorandum. Simultaneously, engaged marketing service providers can prepare the marketing materials and strategy. When everything is ready to go, the offering can go live at the discretion of the issuer and the marketing campaign can begin. Any investments received will go into an escrow until it is verified that the pending investor is accredited, at which point the issuer can take the money from escrow. Within fifteen days of the sale of the first security in the offering, a Form D filing must be submitted to the SEC. Once complete, the issuer continues selling the securities authorized to be sold in the offering until fully sold or the offering is terminated.


Benefits of Regulation D Offerings


  • Very fast and cheap compared to registered offerings and other exempt offerings
  • Straightforward process with minimal disclosure requirements
  • No SEC qualification requirement, which removes potentially extensive wait periods for SEC turnaround
  • No maximum raise restrictions
  • Offering timeline is at the issuer’s discretion


Drawbacks of Regulation D Offerings


  • Only accredited investors can purchase securities in the offering
  • Additional obligation of verifying investors’ accredited statuses prior to receiving funds
  • Issuers cannot use the offering as a means of listing directly to a public exchange at completion
  • Significant holding period for the restricted securities sold in the offering


Regulation Crowdfunding

Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012 added Securities Act Section 4(a)(6) that provides an exemption from registration for certain crowdfunding transactions. In 2015, the SEC adopted Regulation Crowdfunding (Reg Crowdfunding) to implement the requirements of Title III. Reg Crowdfunding allows companies to raise up to an aggregate of $1,070,000 inclusive of any funds raised in the past twelve months under a Reg Crowdfunding registration exemption.

The Process
Each Reg Crowdfunding offering initiated by an issuer must be exclusively conducted through one online platform which must be operated by an intermediary which is approved for such activities by the SEC and FINRA. Issuers conducting Reg Crowdfunding offerings are required to file an offering statement on Form C prior to beginning the offering.
In terms of marketing the offering, the SEC has placed limitations on the nature of the materials. According to SEC guidance published on its website, “An issuer may not advertise the terms of a Regulation Crowdfunding offering except in a notice that directs investors to the intermediary’s platform and includes no more than the following information:

  1. a statement that the issuer is conducting an offering pursuant to Section 4(a)(6) of the Securities Act, the name of the intermediary through which the offering is being conducted, and a link directing the potential investor to the intermediary’s platform;
  2. the terms of the offering, which means the amount of securities offered, the nature of the securities, the price of the securities, and the closing date of the offering period; and
  3. factual information about the legal identity and business location of the issuer, limited to the name of the issuer of the security, the address, phone number, and website of the issuer, the e-mail address of a representative of the issuer, and a brief description of the business of the issuer.”

As the offering progresses, an issuer must either provide frequent updates on its progress toward raising its target amount via its offering platform or file Form C-U within 5 business days after reaching 50% and 100% of its target amount. If the issuer elects to raise more than the targeted amount indicated, then it must also file Form C-U to disclose the total amount of securities sold in the offering.
Finally, issuers may be subject to ongoing reporting requirements depending on their size, eligibility for exemptions from the requirements, or other factors. Every issuer should obtain a legal opinion from an attorney regarding which requirements apply to the issuer’s specific situation.


Benefits of Regulation Crowdfunding Offerings


  • Non-accredited and accredited investors can purchase the securities sold in the offering
  • Relatively few disclosure requirements
  • Timing considerations are at the discretion of the issuer; as long as required forms are submitted within the times designated by the SEC, it just depends on the experience and resources available to the issuer


Drawbacks of Regulation Crowdfunding Offerings


  • Very low maximum raise amount
  • Requires identification and use of an approved online portal
  • Restricts approved communications between the issuer and investors to only channels housed within the offering portal
  • Strict limitations on permitted content for marketing materials
  • Some prerequisite filings are required to meet disclosure requirements

The uncertainty surrounding the regulation of ICOs will likely linger for the immediate future, but the SEC has been making announcements providing more and more detail. Having a single, definitive set of rules would help to stabilize token markets and promote an equal playing field for all participants. Regulations that govern securities have been heavily studied and have generally been effective at protecting the investing public over the years. Relatively newer registration exemptions provide means of flexibility that avoid penalizing smaller issuers while protecting less sophisticated investors from being taken advantage of by unscrupulous issuers. Regulations A, D, and Crowdfunding are valuable resources that may allow issuers to complete compliant ICOs and alleviate fears of SEC action, bringing ICOs closer to the mainstream and making them safer for investors of all types.


A Study of Blockchain Consumer Adoption: Cryptokitty and Steem

cryptokitty - blockchain adoption

How do you bring blockchain directly to the consumer? Must speculation first be taken out of the equation? After all, even in the dot com boom, high degrees of trading and speculation occurred before mass implementation of the products and technologies were refined and launched. Furthermore, as we saw before the dot com explosion, was the development of the internet with business to business implementations long before there was an individual consumer focus.

 So, fast forward 20 years and here we are, on the brink of an emerging new decentralized technology with significantly more potential than implementation and the playbook is happening just as it did 20 years ago: B2B implementation, heavy speculation, lots of players in the space, and the looming cloud of a crash promising to bring it all to a bitter cold end. But amidst all this noise and predictability, two companies right now are tearing up the playbook, skipping the line and going straight to the consumer. The glimmering light in the vast space of the blockchain multiverse.

The Cryptokitty Go-To-Market Playbook

Crytptokittys is a pier to pier decentralized gaming app (DApp) that allows users to create, alter, sell and trade their virtual Kittys, promising a fun and catchy gaming experience for users on the Ethereum Blockchain. Crytopkitty has also been the first in the industry to successfully scale and showcase the potential utility of the ERC 721 non fungible token, a unique and distinguishable token offering with vast use implications that include personal identity, distinct-individual product capabilities, rare trade applications and, of course, Kittys. Since its inception in Nov. 2017, Crytokittys has added 250,000 users with over 2,100 daily transactions, and has sold almost 400,000 unique kittens totaling in almost $25 Million (44,500 ETH) in over all sales.  

The Launch – A Hackathon 

Less than 6 months ago, Cryptokitty burst onto the scene promising the fun and mindless entertainment that all great current consumer internet products offer. Originally unveiled during a 2017 Hackathon, Cryptokitty quickly became a playful favorite in the block community and attracted outside developers to help bring the product to launch. These developers then became the first Crytokitty user base. Signaling the strength of open source solutions as, both, a development tool and a marketing platform.

Mainstream Adoption – Less Jargon More Fun 

Something in between a Tamagotchi of the 21st century and a Pokemon-Go of the decentralized world, Cryptokitty has lured the attention of casual consumers by simplifying their product, refraining from any and all technical cyrpto-jargon from their site while retaining the core financial incentives of most blockchain platforms that motivates users. All the while, launching a product that is, dare I say, FUN. Cryptokitty is by no means a perfect product. It’s susceptible to market volatility and while the financial incentives proved useful in the beginning to draw consumers, it has proven to be an ineffective form of consumer retention for obvious reasons. If your consumer are wholly attached to the product for its financial movement, then your consumer adoption will have a direct correlation with the movement of the market.

Financial Incentives

Crytopkitty directly lines up financial incentives with user creativity by creating equity in the value of popular Kittys that can be traded and sold by its creators. This creates a clear & easy to understand incentive in the open source initiative and offers a way to bring in talent to improve product. This is a clear example of one of the many reasons open sourcing will be a future of creative company employment and expansion.

Metrics – The Rise and Fall 

During its meteoric launch, Crytopkitty reached an average daily active user count of 14,000 in less than two weeks. The transactions accounted for anywhere between 11%-25% of all Ethereum transactions at any given time during that period, singlehandedly slowing down the Ethereum network. However, with a primary reliance on financial incentives and a lack of forward movement of the actual product, Cryptokitty usage has fallen even faster than the value of the market. With a peak of 14,000 active daily users in Dec. 2017 and a current daily usage of just 600, Cryptokitty has seen a usage decline of 95%. Proving to be even more volatile than the over all crypto market valuation, with a decline of 60% in the same period. With current total users at 250,000; daily active users make up for less than 1% of their total ecosystem. Cryptokitty has, still, proven to be a profitable product. The company keeps 3.75% of all breeding and selling auctions. To date, there have been almost 400,000 kitty sales with an average price of just over $65, making the company an estimated $1,000,000 in just 6 months. A huge feat, on the blockchain platform, from a perspective of revenue that comes purely from product movement between consumers rather than coin liquidation.

Moving Forward, The Customer Always Matters

The success of Cryptokitty, as a consumer product, exists in the fundamentals of any successful consumer product, whether decentralized or not. A Smart, simple, fun product, that is easy to understand and that connects with consumers. The limitations of Cryptokitty as well as other blockchain consumer products may lie in the current limitations of the industry. Low consumer knowledge, low consumer adoption, and slow transaction times. Pokemon-Go, a centralized consumer product on a much bigger stage accounted for just 5% of app daily active usage, yet has retained 90% of its American consumers in this past year with 80% of users making in-app purchases, resulting in revenue of over $200 million dollars. It’s clear that the potential for consumer products in the DAPP world is relevant, however the potential must be met with higher overall consumer applications of DAPPs, smarter connectivity with consumers, better marketing, and a consumer retention plan that is equally as strong as a consumer capture plan.

The Steem Playbook

Introduced in March 2016, Steem is a unique Blockchain that works as a platform for its flagship decentralized social media platform, SteemIt. Initially launched as an open source crypto message board, SteemIt has evolved to a full-fledged social media platform reaching almost 1,000,000 total users, 200,000 daily posts, 2,100 new accounts added daily and a current market cap just shy of $800 Million.

The Open Source Community 

Like Cryptokittys and most companies on the blockchain, SteemIt offers strong financial incentives to users for providing the social media community with strong, quality content. Even in the 3rd month of its inception, Steem distributed 10% of its market cap ($1.3 Million at the time), as rewards to its committed users. A giveaway program that was unprecedented at the time and offers glimpses into the current utility value of drivers such as airdrops as a new launching platform. This incentive has proven strong in the world of social media. Even in the centralized business world, companies like Youtube, provide assistance to influencers on their platform. Steem has also stayed true to their community first philosophy, having implemented one of the strongest uses of open sourcing in the ecosystem. From tech development, to user acquisition, Steem has not been shy about reaching out to its community to build a stronger product. As the old saying goes, 2 heads is better than 1, and a decentralized platform has, embedded in it, the ability to scale that to the thousands. This utopian stance has been what has allowed SteemIt to scale up to an almost 1,000,000 person user base with 70,000 daily active users.

Value = User Growth 

Steem has seen its fair share of market volatility, however the correlation between market volatility and users is far more detached than that of Cryptokitty. With a 70% decrease in coin value since December, yet 5x user growth in the past year with strong daily active user retention. Currently the daily active user rate of 7%, compared to a 15% daily active user rate from the centralized parallel company, Reddit, it’s clear that SteemIt is already detaching itself from pure cypto and lining itself up for major growth and mainstream usage.

Building a Crypto Moat – Thinking Long Term

According to a post by Steem, on their flagship website, SteemIt, last year; Steem is focused heavily on user growth with a plan to further open source their platform with a three tier goal of building Communities, Effortless Onboarding, and the implementation of a Mobile App. They are also implementing a plan to attract other decentralized social media sub categories on to their block, positioning themselves to be the umbrella platform for decentralized social media, further widening their moat in this space. With the combination of great incentives, high retention rates, steady user growth (that can be handled steadily in their block), a focus on their product, direct connectivity with their community and a plan to deepen their place in the decentralized social media space, it’s clear why Steem is a favorite in the race to consumer facing applications in the decentralized ecosystem as the ecosystem, itself, continues to grow.

In Conclusion

What Cryptokitty and Steem are both succeeding in, are the fundamentals that most companies in the crypto ecosystem are falling short in (in one way or another) when it comes to making great consumer products: creating consumer content that is easy to understand and easy to use, utilizing creative ways to attract a great developer network, and focusing on consistently building regular users to generate revenue. With the extensive use of open source implementations, and the shift from crypto-centric jargon to mainstream user face adoptions, it’s clear to see that Crytokitty and Steem are quietly paving the way for how companies will build future consumer products and how individuals interact with this promising new technology.