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Due Diligence Checklist for Launching an STO

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If you are planning on launching a security token offering there’s an extensive due diligence checklist which should be performed. This checklist will be divided between business and legal compliance. The business aspect is somewhat globally consistent while the legal may vary from jurisdiction to jurisdiction, and this should only be a guide, with full legal-compliance being performed by an attorney.

Business Due Diligence:

This due diligence involves basics which are not unique to tokenized securities, but there are also additional due diligence reviews which cater specifically to cryptocurrencies and STOs.

  • Whitepaper should be reviewed by unbiased third parties which have reviewed these type of documents before. Common mistakes include promising high returns, failure to communicate effectively the technology, or explaining what the company is designed to perform.
  • Tokenized securities should include enough details to actually make sense to investors. If it’s a tokenized real estate fund, are we investing in residential or commercial properties? In what cities? Is the goal to flip distressed properties or to invest in luxury high rise accommodations? These are the types of questions which are important to investors but are often overlooked.
  • Business plan. If it’s a start-up that’s seeking to raise funds via an STO, we need details on what the business is setting out to achieve. Simply being an “AI” or “Blockchain” company is not enough.
  • Profit Sharing – This should be broken down. Investors should understand if dividends will be paid out quarterly, annually, the payout, etc.
  • Does the product or business make sense? Simply tokenizing a business and calling it “AirBNB on the blockchain” is not enough. We need to understand what the business model is, why now, and how the company plans on accomplishing its goals.
  • Differentiating factor – Having reviewed 100s of businesses this is often where business plans, whitepapers, and founders fail completely. It’s a competitive landscape, and this level of competition is simply increasing over time. Explain what differentiates your product/company from competitors and explain this in details. It can be the team, the technology, patents, etc.

Legal Due Diligence:

At its root level legal due diligence is performed to ensure that the corporate entity is formed correctly, with sound corporate governance in place.

It is always significantly more cost effective to be legally compliant from the start, then it is to retroactively change the corporate structure.

Due diligence will ensure that all shareholders and other entities are legally authorized to perform the investment. Additional due diligence may reveal additional risks and liabilities which may not be obvious to someone who does not practice law.

Hiring an attorney to perform due diligence can raise red flags while it is still early enough to take corrective action. This can include discovering undisclosed risks, potential liabilities, compliance/tax issues, litigation issues, or simple contractual issues.

These are what a legal team should be hired to uncover.

  • Background checks of management and shareholders. This includes running them through multiple international watchlists which include OFAC sanctions list, and the exposed persons list which is also known as PEP.
  • Preparation of essential corporate documents which include articles of incorporation, bylaws, minutes of stockholder meetings, partnership agreements, shareholder agreements, fund offering agreements, and capitalization tables, etc.
  • A legal team should review material contracts with partners, management, employees, service providers, and other, which could potentially cause legal issues.
  • Trademark & Intellectual property rights.
  • Compliance review, this includes but is not limited to registrations, SEC form filings, state filings, licensing, and compliance policies.
  • Ensuring that proper KYC and AML is performed for the jurisdiction that you operate in, and based on where investors are headquartered.
  • Whitepaper review to ensure that securities regulations are adhered to. For example, specific returns should never be promised.

Summary:

While this breakdown may offer some clarity on some of the due diligence that should be performed,  SEC regulations are complicated and it is important to hire a legal professional. The information on this page is for entertainment purposes only and is not meant to be construed as legal advice.

Below is a list of companies that are currently assisting STOs with the legal process:

Company:Website:Location:
BX3 Capitalwww.bx3.io261 Madison Avenue New York, NY 10016

Antoine Tardif is the CEO of BlockVentures.com, and has invested in over 50 blockchain projects. He is also the founder of bitcoinlightning.com a news website focusing on the lightning network, and a founding partner of Securities.io

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Recruiting STO Advisors

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Launching an ICO is a complicated process, but launching an STO is even more perplexing. The reason is due to the additional legal compliance that is required, and the necessity to complete proper ongoing KYC and AML on investors.

Businesses, and start-ups should be focusing on what’s important, and that is the success of their business. Learning all of the ins and outs of launching an STO should not be the role that you play. It’s too complicated of a marketplace for beginners, and any accidental error or omission could end up costing the company far more in the future then had things just been done properly.

Below are some of the problems that you will encounter if your STO is not performed according to code.

  • Exchanges will not list any STO which has potential legal issues. Even the loss of one exchange can dilute the future liquidity and value of your brand.
  • The SEC or other government bodies can either slap you with a penalty or in a worst case scenario shut down your operations.
  • Failure to KYC or AML properly could jeopardize future banking relationships, and could result in the confiscation of funds.
  • You could appear to be unprofessional to those in the space.
  • De-optimization of the potential raise amount.

These are a sample of the legal and financial reasons why you should outsource as much as possible. This is not factoring in the lost opportunity cost, of having your staff focusing on the technology of an STO versus running a business. Specialize in what you are good in, which is running your business, and outsource the rest.

It can be difficult to know where to start. The natural inclination is to seek out an advisor. The wrong approach to finding an advisor is by searching for “STO Advisor” on Google and using the first service that you find. This does not make someone an STO Advisor, it simply makes them someone who is good at search engine optimization.

You should become familiar with the tokenized securities industry. Learn who you can trust in the industry, and who is simply out to benefit themselves. Attend a few Security Token Conferences if you can. Mingle, network, but most importantly learn.

The crypto industry is full of conmen, but what’s more shocking is the high number of people who simply lack any type of business sense. Make sure that whoever you hire as an advisor has experience and is a credible name.

A valuable STO advisor will only sign on with your company if they believe in the project. You do not want an advisor who blindly advises anyone who contacts them. The reason for this is that the most valuable role of the advisor is as someone who introduces you to the right contacts. If an STO advisor attempts to connect junk projects with his existing network, that network will quickly learn to ignore the advisor. This is why the best advisors are very selective on who they work with.

The second most important role of an advisor is as a sounding board. Are you unsure on how the market will react to your business idea? If so, the advisor can be someone that you consult with. A good advisor will be honest with you if they feel that something will backfire and damage your reputation.

An advisor can also perform the following:

  • Introduction to proper legal council
  • Introduction to token issuers
  • Introduction to potential investors
  • Recommendations on jurisdictions to incorporate
  • Optimization of whitepaper/business plan.
  • Connecting at events to discuss project.
  • Recommending changes to planned corporate structure.

How do you compensate an advisor? This can take the form of equity or tokens. It is important that the advisor is actually involved, and is simply not compensated for having his profile on the STOs website. Compensation can be as high as 3%, but this is a little high and it depends on the value of the project, it’s potential to scale, etc. If someone believes in your project they should be willing to be an advisor for 1 to 1.5% in equity or tokens.

What’s important is that you use someone who becomes a business partner. They have your success in mind, and due to this they will do their best in order to ensure your success.

 

 

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STOs – Conducted Under SEC Exemption

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The information below is an opinion piece and should not be construed as legal advice. Please contact an attorney for a full legal opinion. The information is based exclusively on USA regulations.

STOs Conducted Under Exemptions:

With careful review STOs can be structured under one of the following exemptions from registration offered by the US Securities Act.

  • Regulation A+
  • Regulation D
  • Regulation S
  • Regulation CF

It should be noted that even if the issuance of the token is exempted from needing to be registered with the SEC, in order to qualify for this exemption the STO needs to be performed with full compliance of US securities laws.

What are these exemptions exactly?

Regulation A+:

Through Reg A+, a U.S. or Canadian company is afforded the opportunity to:
  • Raise up to $50 million in a 12-month period using a “public solicitation” of its shares and have the offering be exempt from SEC and state securities law registration.
  • Confidentially submit its offering memorandum to the SEC and enjoy the opportunity to “test the waters” before pursuing a mini-IPO/STO.
  • Enjoy a streamlined, expedited review process where the company is required to make its offering memorandum public just 21 days before SEC qualification and the beginning of its roadshow.
  • Combine public funding (through Reg A+) with private funds from venture capitalists to create a larger round of fundraising.

Regulation D:

Rule 504 of Regulation D exempts from registration the offer and sale of up to $5 million of securities in a 12-month period. A company is required to file a notice with the Commission on Form D within 15 days after the first sale of securities in the offering. In addition, a company must comply with state securities laws and regulations in the states in which securities are offered or sold.

The following companies are not eligible to use Rule 504: Exchange Act reporting companies; investment companies; companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies; and companies that are disqualified under Rule 504’s “bad actor” disqualification provisions.

Regulation S:

This regulation implies that STOs must “lock” tokens for a year before trading can commence.

The SEC has written”“Equity securities placed offshore by domestic issuers under Regulation S will be classified as “restricted securities” within the meaning of Rule 144, so that resales without registration or an exemption from registration will be restricted for a one-year period.”

Attorneys are interpreting this statement differently, and you should consult a legal professional.

Regulation CF:

This is the exemption that many STOs are falling under if they decide to raise funds via a crowdfunding platform such as Start Engine.

This is adequate for smaller raises, but may not be adequate for larger raises.

In order to rely on the Regulation Crowdfunding exemption, certain requirements must be met. This includes a maximum offering amount of $1,070,000.

A company issuing securities in reliance on Regulation Crowdfunding (an “issuer”) is permitted to raise a maximum aggregate amount of $1,070,000 in a 12-month period. In determining the amount that may be sold in a particular offering, an issuer should count:

  • the amount it has already sold (including amounts sold by entities controlled by, or under common control with, the issuer, as well as any amounts sold by any predecessor of the issuer) in reliance on Regulation Crowdfunding during the 12-month period preceding the expected date of sale, plus
  • the amount the issuer intends to raise in reliance on Regulation Crowdfunding in this offering.

An issuer does not aggregate amounts sold in other exempt (non-crowdfunding) offerings during the preceding 12-month period for purposes of determining the amount that may be sold in a particular Regulation Crowdfunding offering.

Investors are subject to the following limits:

Individual investors are limited in the amounts they are allowed to invest in all Regulation Crowdfunding offerings over the course of a 12-month period:

  • If either of an investor’s annual income or net worth is less than $107,000, then the investor’s investment limit is the greater of:
  • $2,200 or
  • 5 percent of the lesser of the investor’s annual income or net worth.
    • If both annual income and net worth are equal to or more than $107,000, then the investor’s limit is 10 percent of the lesser of their annual income or net worth.
    • During the 12-month period, the aggregate amount of securities sold to an investor through all Regulation Crowdfunding offerings may not exceed $107,000, regardless of the investor’s annual income or net worth.

Spouses are allowed to calculate their net worth and annual income jointly. This chart illustrates a few examples of the investment limits:

Investor
Annual Income
Investor
Net Worth
Calculation
Investment Limit[4]
$30,000
$105,000
Greater of $2,200 or 5% of $30,000 ($1,500)
$2,200
$150,000
$80,000
Greater of $2,200 or 5% of $80,000 ($4,000)
$4,000
$150,000
$107,000
10% of $107,000 ($10,700)
$10,700
$200,000
$900,000
10% of $200,000 ($20,000)
$20,000
$1,200,000
$2,000,000
10% of $1,200,000 ($120,000), subject to $107,000 cap
$107,000

 

Summary:

While this breakdown may offer some clarity on the subject, as can be seen SEC regulations are complicated and it is important to hire a legal professional. The information on this page is for entertainment purposes only and is not meant to be construed as legal advice.

Should you choose to launch an STO you may choose to fall under one of the above exemptions, or structure your STO in a different legally compliant way.

Below is a list of companies that are currently assisting with this process:

Company:Website:Location:
BX3 Capitalwww.bx3.io261 Madison Avenue New York, NY 10016

 

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Whitepaper Review

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A whitepaper serves multiple goals, it’s your roadmap, it highlights your team, it details your project, and it outlines your vision.

The whitepaper is a document that will be combed through carefully from investors, to partners, to the SEC. This is why it’s important that there are two bodies that review this document.

Business Review:

This is the review from an STO advisor, or some other type of associate that you trust. They will review the business plan to ensure that it makes sense. If at all possible you should have someone review the whitepaper who is familiar with your industry. For example, if you are launching an autonomous vehicle having someone from Tesla or Alphabet’s Waymo review the whitepaper makes the most sense.

You want the person reviewing the whitepaper to be ruthlessly honest about potential assumptions, omissions, mistakes, lack of clarity, technical errors, etc. You want to catch all potential issues early. This will enhance the whitepaper, and will save your team money.

The whitepaper should always serve first and foremost as a business plan. The technology should always be secondary to the business. The exception to this is if it’s a very technology focused business, where the entire business landscape and success is based on the viability of the technology.

What investors want to know are the following:

  • Why the market needs your product or service.
  • Why now? Are you too late, or too early for the market?
  • Do you understand the competition? And how will you overtake them?
  • If it’s fractionalization of real estate, venture funds, etc. How will the real estate/funds be managed?
  • Specifics are important. We’ve reviewed many whitepapers for companies tokenizing real estate, and there is often a failure to discuss the type of property, location of properties, expected holding period, etc. Just because real estate investors are buying a tokenized fund, doesn’t mean that they are not first and foremost viewing this from a real estate investor mindset.
  • Unrealistic projections. Telling us the market size, but not disclosing actual competition, marketing budget, etc just makes the entire project look amateurish.
  • Sell your team. If they went to ivy league schools, disclose that information. Also disclose any other business they have been involved in.
  • Presentation is important. Hire someone to format the information with crisp graphics and charts. The difference this makes in how your company is perceived is monumental compared to the initial cost.

 

Legal Review:

The most important thing that should be reviewed is that no false promises are made. Never promise specific returns. Remember, while the whitepaper may serve as a marketing tool, in a court of law it also  serves as a piece of evidence.

There is no going back and editing the whitepaper once its posted online, as a version of it will always exist somewhere. It needs to be fully legally compliant prior to publication.

You should hire a law-firm that is familiar with the tokenization of securities and that has a track record of working with different STOs. Research the clients the law firm has worked with to ensure that you are working with a credible law firm.

Legal is one aspect of your business that you should not try to save money by hiring a low rent law firm. Hiring the right legal team will save you money and future grief.

Since this website does not dispense legal advice, we urge you to contact an attorney in the space. If there is anything that you should take from this article, is that you should absolutely have a licensed attorney review your whitepaper prior to publication or the launch of the STO.

 

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