What follows is NOT investment or financial advice and is merely for informational purposes only. Please seek professional advice when making decisions regarding the issuance of securities.
For the uninitiated, an Initial Coin Offering (ICO) is a method used by startups and developers to raise funds from investors in exchange for tokens or custom cryptocurrency. The tokens acquired in the ICO generally grant the buyer some special privilege(s) on the issuer’s platform. The debate of whether these tokens are securities or not and the legality of performing an ICO are almost as old as the practice itself.
Recently, the SEC has been busy issuing subpoenas to firms that conducted ICOs in the past and that the SEC believes may have violated securities laws. With no definitive rules to guide them, startups and developers contemplating raising funds via an ICO may wonder how they can do so and stay out of the crosshairs of the SEC.
Before conducting an ICO the issuer should determine if their token will be considered a security or utility token. Many readers will have undoubtedly heard of the Howey Test and its use in determining if a token is a security or not. Potential issuers are urged to consult professional legal advisors when making this decision. Additionally, it is not in an issuer’s best interest to try and shirk the definition of security by using clever language in a whitepaper or offering document.
If it is determined that the proposed token is a security do not despair and think all hope of conducting an ICO is lost. The SEC has exemptions that can be utilized for entities issuing securities. The remainder of this post will evaluate the exemptions under Regulation D (Reg D) of the Securities Act. This should be taken as an introduction to Reg D and should not be used in place of professional legal advice.
Regulation D provides exemptions for private placement offerings. Typically, these offerings are conducted by smaller companies and can be used to raise capital via either debt or equity sales. The big advantage for many issuers using the Reg D exemptions is that the securities issued do not have to be registered with the Securities and Exchange Commission.
Issuers will still be required to provide prospective investors with offering documents such as a Private Placement Memorandum (PPM). The offerings must also still comply with federal securities laws such as antifraud and civil liability. However, the costs, both financial and in terms of time, associated with a Reg D offering are significantly less than a traditional public offering (IPO). Issuers will also need to consult with legal advisors to determine any requirements at the state level when conducting a Reg D offering.
Exemptions Under Regulation D
Regulation D Rule 504
Rule 504 of Regulation D allows issuers to raise up to $5,000,000 in a twelve (12) month period. Once an issuer first sells their securities they will be required to file Form D with the SEC. This form can be filed electronically and includes such information as the name and address of the company’s promoters, executive officers and directors and some details regarding the offering.
Under a Rule 504 exemption the issuer is not subject to any limit on the number of investors and they may be accredited or unaccredited. One caveat is that, except for limited circumstances, general solicitation is not allowed.
Regulation D Rule 506(b)
Rule 506(b) allows an issuer to raise an unlimited amount of funds from investors; however, the issuer cannot use general solicitation. They are able to sell their securities to an unlimited number of accredited investors and up to 35 other investors so long as any non-accredited investor is considered sophisticated.
Per the SEC, sophisticated means the investor “must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment”.
Similar to Rule 504 a Form D must be filed with the SEC once the issuer first sells their securities.
Regulation D Rule 506(c)
Rule 506(c) allows an issuer to advertise and broadly solicit their offering while remaining compliant. As many issuers are hoping to raise awareness of their product or service in addition to funds during an ICO this may be an appealing exemption.
The freedom to advertise does come at a price. Issuers can only accept funds from accredited investors and the company must take steps to ensure that each investor is accredited. This means reviewing W-2s, tax returns, bank statements and/or other documents to verify the investor meets the standard.
The filing of From D is also mandatory for Rule 506(c) offerings.
While it is not the point of this article to cover Regulation D from the point of the investor, it is worth mentioning that all securities that are issued are considered restricted securities.
Such securities do come with transfer and resell restrictions and must be labelled with a “restrictive” legend. SEC Rule 144 does provide exemptions for holders to sell their restricted securities. These exemptions typically include a six-month or twelve-month holding period. Investors are encouraged to consult an attorney before purchasing restricted securities.
If you are considering an offering of tokens and would like to learn more about Regulation D as an option, then please contact one of our investment bankers. Upon discussing additional details regarding your project we can recommend a strategy to help you achieve your goals and get you back to building your business.