Crowdfunding and ICO – a step in evolution of capital markets
ICO acronym abbreviates to “initial coin offering”. But the practice stems from small capital funding method known as the crowdfunding.
In 2009 a US company called Kickstarter launched and successfully continues today to promote and facilitate funding of creative ideas and products. The idea is to pre-sell some product that a creative team pledge to develop or mass produce and deliver to its backers. The practice had no clear legal foundation back when it started. It was only three years later, in 2012, the US law was amended to regulate the new practice of easier access to small capital ﬁnancing, by adopting Jumpstart Our Business Startups (JOBS) Act 1https://www.sec.gov/spotlight/jobs-act.shtml.
Similarly, ICO phenomenon sprung up from the burgeoning crypto community. The ﬁrst ICO is widely accepted to be the Mastercoin blockchain project in 2013. It set itself apart as the ﬁrst crypto crowdfunding case. The idea was to presell a blockchain coin/token as a service that the team pledged to develop in future. To purchase interest in the project, one was able to pay in bitcoin cryptocurrency. All of a sudden, a new practice was born.
A new use case for cryptocurrencies was forged and started to unfold rapidly. By 2017, not only many new cryptocurrencies emerged, but there were hundreds of ICO projects,
pre-selling their services, often, but not exclusively blockchain-based business applications. Indeed, raising funding in less restrictive way was the prime goal of the practice. Selling a token as interest in the project that had some utility or representation. Hence the new expression – utility token.
By deﬁnition, investing in a nebulous utility token (typically Ethereum EIP-20, also known as ERC-20 compliant) had very loose legal obligations, only those pledged by the issuing entity. The investment was not an equity purchase, nor it was a loan, rather – a voluntary contribution. The attraction was an almost immediate liquidity of the newly minted token. After the initial offering, a bubbling secondary market developed and offered easy entry and exit to all participants. Selling a token was selling a promise of a non-existent yet service, not dissimilar to the age of discoveries of long sea voyage ventures.
Similarly, the beginning of 17th century introduced the ﬁrst permanent joint stock form, where the investment into shares did not need to be returned, but could be traded on a stock exchange. 2https://en.wikipedia.org/wiki/East_India_Company
The crypto investment practice unfolded into a wave of ICO projects, culminating in 2017. Thus many startups and mostly white paper ideas got funded. Most were real projects. Some were bad apples. But the most attractive aspect of the ICO were the returns on investments. According to one source, the ROI yielded in excess of 10x, even if you had invested in both the winners and losers alike over the 2017 year. The whole industry was on a steep upwards pressure, with strong interest from the institutional sector. Such returns are unprecedented in the normal trading environment. Fortunes were made and lost.
The year 2017-2018 went down in history as the ICO hype unfolded. It culminated with several major events that occurred at the same time. One was Bitcoin blockchain forking and the subsequent nose dive of most cryptocurrency value. There were other notable events that coincided and contributed to the overall price fall.
From peak to trough the crypto asset market value was at times suddenly and later gradually reduced from over USD800B to little over USD100B. The so called crypto winter had set in. The bittersweet mass interest receded and an immediate ﬂight away from all things crypto ensued. See chart below. 3https://coinmarketcap.com/charts/
IEO – initial exchange offering
Similarly as with Slack and Spotify exchange listing, there are some ICOs that have listed directly on token exchanges. This way projects can leverage token trading venue client base to showcase their projects directly, without active promotion of the offering through other, often ineffective, marketing channels. This has prompted many token trading venues to start issuing utility token IEOs on behalf of token issuing start-ups.
For the contributors, exchange listing adds trustworthiness, security and vetting, knowing that a reputable exchange, such as Binance will have done certain due diligence before listing an unknown project. Indeed, for utility tokens IEO may prove to be a safe, if not cheap way to gain community trust. It is yet to be seen, however, if the initial listings continue to persist over a longer stretch of time, and what regulatory requirements may be imposed as to listing requirements. This also is a piece of history in the making.
This is part 3 of a 5 part series.
5 Major Takeaways from SEC’s New Investor Protection Rule – Thought Leaders
It seems that the controversies surrounding SEC’s newly adopted Regulation Best Interest rule (Reg BI), would continue to take center stage, even though it goes into effect next summer. The regulation is the culmination of a decade-long process that started in 2010, immediately after the great recession. The Dodd-Frank Act passed that same year authorized the SEC under section 913 to enact a fiduciary standard and best of interest rule to govern broker-dealers and investment advisors when engaging with private investors.
In the aftermath of the introduction of Reg BI, stakeholders, state regulators, investment advisers and broker-dealers have weighed in on various factors that could undermine or aid its effectiveness.
5 Key Takeaways
- Brokers Dealers required to adhere to new “best interest” standard
- Sets up U.S. Department of Labor (DOL) to synchronize rule-making (later this year)
- Big win for broker dealers → even bigger for financial services
- The New Common Reporting Standards (CRS) Says Broker = Advisor → confusion between broker vs fiduciary advisor
- Reverse focus on protecting brokerage role than consumer = more confusion
However, before we highlight these takeaways, let’s first take a look at the substance of the fiduciary standard clarification rule.
The Takeaways from SEC’s Regulation Best Interest Rule
SEC intends to subject broker-dealers, who currently are only required to meet suitability standards, under fiduciary standards.
On one hand, fiduciary standards presently govern the relationship between financial advisors and their clients. And it expects the former to only offer services that are in the best interest of the latter. On the other hand, suitability standards require brokers to ascertain that the investment they recommend suits their clients.
In essence, the rule looks to extend the fiduciary rule on broker-dealers who are increasingly taking up the roles of financial advisors, when their primary duty is to sell an investment product for a stipulated commission. Under the suitability standard, it is legal for a broker to recommend an investment product that avails him a good commission, so long the product is suitable to the customer.
While this is a given, it also presents a conflict of interest. It’s possible that there are cheaper investment products with similar features to the one the broker recommends, but with a less attractive commission. This conflict of interest is what the Reg BI looks to eliminate, as it requires brokers to place the client’s interest above theirs.
To do this, the rule would enforce brokers to explicitly disclose important information such as incentives and commissions that could influence their recommendations. More so, it would, to an extent, ban industry practices, like incentives in the form of vacations, that could spur brokers to betray the interests of their clients.
Knowing fully well that brokers could find a way around this requirement by disclosing conflict of interests with technical terms or in a voluminous document, the SEC also introduced another requirement that could counter such practices. The requirement states that brokers must outline conflict of interests and their compensation structure in plain English and in a concise manner on a document called form CRS.
Also, brokers would document the history of legal or disciplinary actions taken against the firm offering the investment product or its financial professionals. Another vital feature of the rule is Care Obligation. This requirement entails that financial advisors to make sure that they diligently and carefully ensure that their recommendations are in the best interest of their clients.
The last requirement is the Conflict of interest obligation. It requires the management and mitigation of commissions that could represent a financial conflict of interest.
Dissecting the Implications of The Regulation Best Interest Rule
As expected, critics left and right have dissected SEC’s Reg BI, and the prominent argument that many have brought up is the fogginess of the rule. For one, some critics have condemned SEC’s reluctance to clearly define what it means by “Best interest”, the actions that would suggest that an investment advisor is not compliant, and how to mitigate financial conflict of interest.
Chances are that broker-dealers would look to find a way around this rule, at least until SEC starts enforcing disciplinary actions against non-compliant investment advisors. Besides, Reg BI does not seem to have enforcement muscle. It is unlikely that non-compliance would lead to class action lawsuits and litigations.
Furthermore, there is an outcry that SEC’s rule has done nothing to clarify to investors the roles of Investment advisors and broker-dealers. Note that a majority of brokers-dealers are registered with the SEC. Technically, this means that they could assume the roles of Registered Investment Advisors (RIA), and yet, they are not fiduciaries.
More concerning is the fact that the Form CRS requirement would do little to change the status quo. This notion stems from the fact that studies showed that consumers found it difficult to understand the contents of CRS forms.
While responding to many of the criticisms leveled against Reg BI, SEC’s chairman, Jay Clayton stated that “differing views were expressed regarding whether the standard should be more principles-based or more prescriptive — and in particular, whether to provide a detailed, specific, situation-by-situation definition of ‘best interest’ in the rule text.”
As such, after careful consideration, the agency concluded that the principle-based approach adopted for the rule “is a common and effective approach to addressing issues of duty under law, particularly where the facts and circumstances of individual relationships can vary widely and change over time, including as a result of innovation,”
Judging from the details of Reg BI discussed above, there is no doubt that the rule has elements of the fiduciary rule that the Obama administration proposed through the Department of labor. The difference is that the latter was looking to classify all investment professionals as fiduciaries. In other words, a client could decide to sue his investment advisor or broker once he notices any discrepancies that would suggest that his interests were not best served by the actions of his investment manager.
Recall that this rule hit a roadblock under the present administration, as the securities industry challenged its viability in court. And while DOL has also indicated that it is pushing for a new fiduciary rule, there is no guarantee that its future proposal would have the same grit as the previous one. This assertion is probable, considering the likelihood that Eugene Scalia, the attorney that led the case against DOL’s previous fiduciary rule, would emerge as the new Labor Secretary.
Also, it is important to note that the Certified Financial Planner Board of Standards plans on enforcing an ethics code that would entail that its 84,000 members adhere to fiduciary standards, irrespective of the regulatory frameworks that govern them. Interestingly enough, this code’s implementation date coincides with that of Reg BI’s.
More importantly, some states are contemplating on taking matters into their own hands by imposing separate fiduciary rules that would correct the apparent flaws of Reg BI. For instance, New Jersey’s security bureau has released a rule proposal that explicitly classifies brokers- dealers as fiduciaries. Other states that have taken a similar path are Nevada and Massachusetts.
In response to this development, SEC’s chairman, Jay Clayton, stated that “I and many others believe a patchwork approach to the regulation of the vast market for retail investment advice will increase costs, limit choice for retail investors and make oversight and enforcement more difficult. I am hopeful that our regulatory colleagues will continue to work with us to minimize inconsistencies and maximize the effectiveness of our collective efforts.”
However, regardless of the loopholes of Reg BI, and the controversies that spurred responses from state regulators, I believe that the SEC’s proposal is a step in the right direction in order to protect investors.
For investors, it is a matter of asking the right questions:
- Who pays your broker’s commission?
- How much he gets paid for encouraging you to buy an investment product.
- Are you a fiduciary?
- How does a broker apply investor protection rules?
The information provided here is personal opinion and provides only a subjective opinion of the rules and regulatory guidance provided by the SEC. It should not be read as legal or compliance advice. Consult with your compliance professional for further details.
Top 5 Equity Crowdfunding Websites – Opinion
Crowdfunding has been around since 2008 with the launch of indiegogo, followed by Kickstarter which launched in 2009.
The early crowdfunding websites offered users free perks, and goods in exchange for funding their business venture. Most of these start-ups fizzled out after a few months but some of these were widely successful. One of the most notable success stories is the virtual reality headset Oculus which raised over $2.4 million on Kickstarter in a campaign that also caught the attention of Mark Zuckerberg. Shortly thereafter Oculus was acquired by Facebook for $3B. This was a monumental acquisition for a start-up with a great vision and zero profits.
Unfortunately, while the Facebook acquisition of Oculus was life changing for the Oculus team, the early backers of the project on Kickstarter received nothing, as no equity was offered for their initial backing of this project.
In 2012 the JOBS Act passed which opened the doors to crowdfunding websites offering early investors equity. Now investors from all over the world have the opportunity to support start-ups who are too small to access traditional venture funding.
These equity crowdfunding websites serve an important purpose as they are directly responsible for nurturing entrepreneurs while offering investment opportunities to investors who are not based in Silicon Valley.
Below are in my opinion the top 5 equity crowdfunding websites. As a disclaimer, I’m an equity owner in 3 of the companies listed below (WeFunder, Microventures, StartEngine).
#1 – SeedInvest
SeedInvest differentiates themselves by focusing on only having handpicked start-ups in upcoming industries. If you want to invest in the future of tech this is one of your best options. The industries that are often featured include:
- Augmented Reality
- 3d Printing
- Artificial Intelligence
- Space Technologies
They’ve helped over 150 companies raise capital, and the team is great at filtering out most companies that apply, to offer investors a curated list of world class companies to invest in.
#2 – Microventures
This website is different than the rest of this list as they offer two different focuses and they target accredited investors only.
The main focus is on Late Stage companies. Some of the late stage companies which have been featured include:
- Honest Company
This offers the easiest possible route to investing in phenomenal late stage companies which are often only a few years away from going IPO. The minimum investment is often in the $5000 to $50000 range, with the minimum depending on the interest level and the company.
They also offer investment opportunities in Early Stage companies with minimum investments in the $3000 to $5000 range. These companies are often in Fintech, robotics, 3-D printing, etc. The quality of these Early-Stage companies is high and is also handpicked.
#3 – WeFunder
They were responsible for helping to write the JOBS Act, and are one of the oldest companies in the crowdfunding space. There’s been some huge success stories on this website.
In April 2013 Zenefits raised at a $9M valuation, and only 2 years later in May 2015 they raised an additional $500M and were valued at $4.5B. This means if you had invested $10000, you would have received a cool return of $500,000 in a 2 year period.
WeFunder came out of the Y Combinator accelerator program, which is the most famous and successful accelerator program in the world. Some success stories from here include AirBNB, DropBox, Stripe, coinbase, etc.
The reason this is important is that Y Combinator companies support each other in what is a giant ecosystem. Many of the start-ups on WeFunder are Y Combinator graduates (such as Zenefits).
#4 – Fundable
One of the oldest platforms on this list, Fundable launched on May 22, 2012. Since then they have been offering access to a notable list of companies in every industry that you can conceive of. I’ve seen everything from solar power fields to revolutionary 3D printed prosthetics.
Fundable is a crowdfunding website which offers an extensive live of companies to choose from.
#5 – StartEngine
Over 90M has been raised by 265+ companies. They even recently successfully raised a$10M STO for themselves.
While this is a great platform they are not as selective as the rest of the equity crowdfunding websites on this list, so you do have to be more careful and perform extreme due diligence in who you invest in. That being said there are some gems to be found. Hackernoon recently successfully completed a $1.07M raise. I do find that they have too many companies listed, which makes perusing the list a bit exhausting.
These are the top 5 crowdfunding websites which I believe offer investors the best access to investment opportunities. You should always perform proper due diligence, and understand that Early Stage investing is high risk, and that you are more likely than not to lose access to all of your capital. You should also expect that it takes 7 to 10 years to earn a return on any of these investments.
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How to get an STO approved by German regulators – Thought Leaders
After over 130 security token prospectuses were submitted to BaFin, the German regulator, it was the Bitbond STO that was the first to be granted approval.
In 2016, Bitbond became the first blockchain business to be regulated as a financial institution in Germany. The next logical step was to crowdfund our growth – compliantly – with a bond issued on blockchain technology.
As the first, we had no guidelines to follow, but we learned a lot in the process that followed. Rather than keep these insights to ourselves, we want to share them, in the interests of growing the whole industry and encouraging adoption.
What makes an STO an attractive option?
The institutional mismanagement of money that triggered 2008’s global financial crisis has had profound effects on investor appetite for alternative products. Crowdfunding and micro-lending have been growing, which has enabled a new frontier: decentralized financial products.
Relying on no bank or centralised authority, decentralized finance encompasses cryptocurrencies and blockchain-powered financial products that are decentralized, relying on less middlemen or intermediaries.
Security Token Offerings (STOs) – where a company creates a digital asset that represents a tradable stake or asset, which it sells to investors in return for capital – have been a natural progression from the crowdfunding boom launched by Kickstarter in 2009 and crowdlending movement initiated by Topa and LendingClub.
The sale of a digitized version of a security, STOs have become an onboarding point for non-crypto investors to learn about digital assets. At the same time STOs are a cheaper, and more efficient tool for businesses to fundraise, with the added benefit of a compliant structure to adhere to.
So, what does it take to launch a regulated STO?
Step One: Get your business, and your story, in order
Obtaining regulatory approval for any financial product is not easy. It shouldn’t be. With emerging technology like an STO, the barriers become even steeper.
Before embarking on the road to regulation, you need to clarify your motivations within your business. What makes an STO the most efficient method of fundraising for your goals? How will a diverse pool of international investors offer more value to your business than a smaller pool of sophisticated investors or experienced VCs?
For Bitbond, it made sense to launch an STO to the public, as the core product is about creating access to finance for underserved demographics, in a compliant way.
Similarly, when Blockstack, a decentralized computing ecosystem, was looking to raise money in a decentralized and accessible way, it made sense for them to make use of the SEC’s crowdfunding regulation, Reg-A+.
When a business is built on the idea of decentralization, using a fundraising method that encourages wider participation and access is the logical route to take.
Step Two: Talk – and listen – to regulators
In Germany, regulators have defined cryptocurrencies and other blockchain-backed tokens as units of account, so they have to be treated as financial instruments. This means any kind of service for third parties in relation to cryptocurrencies or crypto tokens must be authorised by BaFin.
Whilst they judge on a case-by-case basis, any token or cryptocurrency project looking to facilitate the issuance, exchange or other services around tokens must make their case to BaFin.
When BaFin are presented with a prospectus, they must give feedback within 20 days, which is a short time, even when they are assessing a product they already know.
With emerging technologies, a different tactic is needed: the blockchain industry needs to talk to the regulators, not just on the products we’re building, but on the ecosystem at large.
In April 2018, Bitbond reached out to BaFin, to present a legal framework of the Bitbond STO. By opening the conversation with something tangible to build from, we could tailor our prospectus around their concerns.
Over the next months, we went back and forth with the regulators; much of conversation centred on how blockchain transactions work, what additional risks and opportunities stem from them, the unique features of the Bitbond offering and how the proof of ownership in the security works if there is no central clearing.
We took things back to basics, when talking to BaFin to provide a crash course in the fundamentals of blockchain. We answered numerous questions on how the blockchain works, what Ethereum and Stellar are and how transactions work on these protocols.
This gave them the language to interrogate our project – and helped us identify the main areas of concern and the risks BaFin wanted to see addressed in a prospectus.
By teaching them the context, including the fundamental pillars of blockchain technology, and the way tokens facilitate the use of that technology, we can help regulators make more informed decisions, and ask better questions.
Step 3: Prepare a prospectus that addresses concerns and regulations
They may bring administrative hassle, but regulators play an important role in the financial ecosystem. They hold businesses like us to account to maintain the stability of the financial system and protect consumers.
In Bitbond’s case, the idea for the STO came in February 2018, conversations began with the regulator in April, a prospectus was submitted at the end of October, with approval being granted in January 2019: nearly a year later.
This took longer than a standard securities application, but that was because the concept we were presenting was so new – there was nothing the regulators could compare it with.
Investing this time was worthwhile, as we now have the first mover advantage with the first regulated STO in Germany.
More than that, we have the privilege of paving the way for more German and European businesses to launch compliant STOs.
An STO remains a more efficient way of fundraising than going through a private VC fund or accredited investors: there is only one prospectus to prepare, rather than having to tailor many proposals to individual institutions or investment banks.
This prospectus must cover all conceivable risk factors that exist for investors. These range from unexpected rises in transaction fees reducing the profitability of the bond, through to the tax risks associated with holding an emerging asset class that is subject to legal changes.
Projections must be made, and justified. Assets and liabilities must be declared and broken down in a balance sheet. The target market must be identified, and characterised.
An extensive history of the issuer and its business activities must be laid out, in language that the investors will understand.
Once all the details have been laid out, there are far fewer intermediaries needed between the business and investors, which makes the raising process significantly leaner, more efficient, and easier to manage.
With these future savings, educating the regulators is a worthwhile investment.
Conclusion: Education and open-mindedness will improve access to alternative forms of finance
It is in the interests of all stakeholders in this space – from regulators to businesses to customers – for emerging technologies to operate within a compliant structure. We have already started working with other companies looking to gain the regulator’s approval and use our technology for the issuance process.
As well as a fundraising method, an STO has become a vehicle to teach investors about digital securities.
It is exciting that the process of getting approval for a prospectus can become an extension of this educational process, which can act as a catalyst for regulatory engagement.
BaFin’s willingness to interact, and learn from the industry is an exciting opportunity for Germany to step up as world leaders of innovative financial services and products.
If the industry continues to invest time and resources to educate and work together with regulators, we can create a framework for compliant STOs, which in turn provides a welcoming environment for the next generation of compliant digital securities.