Private equity or venture capital funding
When you are just starting out, it is yourself or/and the proverbial triple FFF (friends, family and fools) and perhaps business angels that contributes to the birth of your startup business morphing from an idea in to a company. Then, you begin to look around for more seed or growth funding. Typically these are venture capital or risk capital funds that are eager to jump on the opportunity of the next uber-big venture. Their proﬁt expectations are usually in the range of 20-30% per annum. Whereas, if they hit it big with your great idea, they may even touch 2-20x return, depending how well you do on the exit. Attracting venture capital is generally applauded and celebrated as an achievement. There are some disadvantages however worth mentioning.
One such disadvantage is a possible oversized loss of equity. An equity investor may require anywhere from 10% to 90% of your company. Depending on the shareholder agreement, any milestones or strict targets, even the most benevolent investor may turn out to be a vulture preying on your company. It is important therefore to always weigh all pros and cons about letting in a new equity holder with special requirements. As the saying goes, investors invest in people, not projects. When deciding on an investment option, the same should be said about startups accepting funding: you should seek out long-term partnerships with people, not just the money, at any perilous cost. 1https://www.youtube.com/watch?v=sTzfkvjBtyM
The other disadvantage of attracting venture capital or private equity investor is the diminished management control. When a serious ﬁrm or individual bring in a substantial amount of funding to a startup, it typically comes with a requirement of management and expenditure control. It is understandable for someone who puts up large amount of money on a promise alone to want to actually see and control the way the money is spent. The easiest way to yield control and oversight is to require a seat at the management or supervisory boards of the company. Once a controlling seat is given, with it comes a diminished executive power for the top management. It becomes harder to push through major decisions, and expenditure amounts that exceed those stipulated in the shareholder agreement. Each major decision gets to be questioned and not always by the most quick minded likes of people. It may, of course, turn out to be a blessing than a curse. For startups that lack experience or clear vision. But it is usually a hindrance and not a boon.
To sum up, private equity or venture capital investor may very well be of beneﬁt to the young startup founders. But, the disadvantages of oversized loss of equity and a certain loss of management control may be the reasons for seeking other options.
Another way of ﬁnancing a business is taking a loan, or issuing a convertible loan against future equity. If you are an established company, for short-term purposes you may issue other forms of debt, such as mezzanine, or you may get long term ﬁnancing in the form of debenture.
A loan is given by a private, or an institutional investor, such as a bank. A loan however ideally is given against a collateral. A loan is basically a credit. However, credit is something you have to earn ﬁrst. Taking a loan therefore is usually reserved to companies that already have revenue streams, or have high potential for earnings. Taking a loan to spend on a startup is risky for the taker beyond high interest rates. The most real risk is borne by the founder on repayment. As a founder you may need to pledge your private property or ﬁnd a guarantor to act in your favour and on your behalf, to satisfy credit collateral requirements. Debt instruments like corporate bonds are regulated securities and also incur costs of issuance.
IPOs – are they relevant at all?
IPOs are also called the exit. This usually is the exit strategy for early equity investors and venture capitalists, as well as founders. But, the IPO route is open to largely mature companies with certain revenue streams and proven track record. A typical IPO-ready company would have to show uniqueness not only in differentiating business idea, or solid management, but also have a proven track record of proﬁtability, revenue growth and guarantee a substantial market capitalisation for a liquid market trading.
Preparing for an IPO is expensive. It traditionally involves heavy legal efforts on drafting the prospectus and ﬁnding the right underwriter investment bank to initially back the business. But this process is also no longer being upheld in its entirety. An exemplifying case is a recent going public of a company called Slack. The social network platform followed the lead by Spotify to get the company listed without actually going through the IPO process. 2https://www.businessinsider.com/slack-spotify-tech-ipo-direct-listings-venture-funding-softbank-visionfund-2019-1
The major downside of an IPO process amounts to expense and time the company needs assume to fulﬁl all the legal requirements prescribed by each jurisdiction. Both Spotify and Slack in the USA demonstrate that costs are being cut away where logically possible. If your company has gained a recognisability and social following by the virtue of its services, you may not even need to go down the expensive IPO route. It could cost the issuing company anywhere starting with USD 2m to USD 10m to prepare and pay all related fees for an IPO. 3https://www.pwc.com/us/en/deals/publications/assets/cost-of-an-ipo.pdf Although the law is clear on security issuance, with the advent of primary listing, IPO industry is seeing a certain revamping of the process.
The bottom line being: either of the alternatives discussed above are distracting, time- consuming, irrelevant or outright expensive.
This is part two of a five part series.
HODL Your Hoopla Over SEC Changes For Exempt Offerings – Thought Leaders
Last week the The U.S. Securities and Exchange Commission released a proposal – that has yet to become regulation – to simplify how exempt offerings are done. Shortly thereafter, a flurry of articles and newsletters made their way through the digital asset industry – many of which suggested their platforms were already being modified to fit the new rules. While the SEC has proposed changes, time will tell whether the proposal is adopted – and if so, whether there will be changes to the final draft that will be published to the Federal Register.
The US exempt offering framework includes tools such as Reg D, Reg A, crowdfunding (a.k.a. Reg CF) – essentially everything that is not a public or retail offering. This framework has seen little in the way of changes or modernization since the Securities Exchange Act of 1934. There has been significant public criticism of the current rules for exempt offerings, largely because they reserve access for only the wealthiest Americans to invest in private funds, companies, and other offerings.
If passed, the proposed changes could allow for the average person to invest in earlier stage deals – such as Uber or WeWork – before they reach their lofty valuations and dumped into the public markets. Enabling SPV (special purpose vehicles) and harmonized reporting (ie combing Reg D and Reg CF into one, not two reports), and increasing the total amount that can be raised would help streamline compliance for issuing firms. Additionally, the changes could also enable crowdfunding to become a viable capital formation tool for investing in such asset classes as real estate.
Currently, US offering exemptions such as Regulation CF (crowdfunding) are quite restrictive, limiting the total amount you can raise to $1.07M USD per 12 month period and includes significant restrictions per investor. The US SEC appears to be following the lead of other jurisdictions such as Canada where regulators proposed similar changes, or Europe where regulations were updated last year, increasing the limits for the EGP (European Growth Prospectus) to €8M EUR, a little over $9M USD. According to the new proposal, companies would be able to raise up to $5M USD. While $5M is still a relatively small amount of capital, it does allow early stage companies to build their tribe with a broader investor base.
The SEC proposed similar changes to Reg A, increasing the upper limit to $75M USD. This could make Reg A viable for many later stage companies where larger Series B, C, or even D rounds demand more capital than what is currently available in Reg A.. This also opens up these investment opportunities to the retail investor, previously these deals were only available to the wealthiest corporate venture firms, private equity shops, and high net worth individuals.
Further changes include allowing accredited investors to participate in crowdfunding. Previously, if you used a crowdfunding exemption, you could not accept funds from accredited investors and would actually have to use another exemption, such as Reg D, simultaneously. This typically forces companies into more paperwork, legal fees, and an increased risk of getting something wrong – which could result in regulatory or civil actions. The proposed changes would enable companies to combine accredited and retail investors into one offering.
Aside from accredited investors, the changes also open the doors to institutional and corporate investors, including the SPV (Special Purpose Vehicle).
An SPV is a corporate entity created for a specific purpose – usually for reasons such as limiting liability, tax efficiency, investment, or capital formation. For example: In order to tokenize a piece of real estate, you might form an SPV, and transfer the deed to the real estate into this company. The purpose of that company/vehicle is to hold the deed of this real estate and maintain a accurate record of who the owners are, SPVs are commonly used for investment funds as well.
Combined, SPVs, corporate investors, accredited investors, and major institutional investors can move large amounts of capital. However, they weren’t able to invest in crowdfunding offerings in the US. This created an interesting paradox for companies raising capital, if you could get the big fish interested, you would avoid the crowd – but, if your offering didn’t look good enough for professional investors, your last resort may be crowdfunding. The crowdfunding industry as a whole has faced a lot of criticism from professional investors for low returns and low deal quality, this is likely to change when retail investors have access to the same deals as larger institutions.
Finally, the new crowdfunding regulations propose several major changes to how much each investor can put into any one offering. Currently, investors who do not meet the accreditation thresholds were limited on how much they could invest based on the lower of their income or net worth. The new regulations would change this to the greater of those two. These changes are expected to not only fuel innovation, they are likely to bring in a lot of smart money as well.
For example, an investor with a net worth of $750,000 and an income of $150,000 couldn’t qualify as an accredited investor. This person has a Phd in bioscience and finds a startup with a revolutionary innovation in the field of bioscience – they are not qualified as an accredited investor and barred from investing. Ironically, they can be an advisor to any institutional investor on why this particular startup is so hot – but under the current rules, they are not qualified to risk their own money.
While these changes are welcomed by most market participants, they are not a sure thing. This proposal for a new exempt offering framework is not yet regulation, it still has to make it’s way through the government and be entered into the Federal Register. Looking back at the proposals for crowdfunding in the US we can see how different a proposal can be from the regulation – and there are still a lot of lobbying dollars that want to see the status quo maintained. It is important to not make important business decisions based on this proposal – rather, look at these changes as a larger trend among securities regulators globally.
We’re seeing securities regulators trying to make easier for distributed capital formation. Crowdsales and crowdfunding are actually becoming something that the regulators across around the world are working together to harmonize their frameworks. By combining the crowdfunding regulations from jurisdictions around the world, early stage companies would be able to access global capital and build a global investor base, without being forced to break the rules like most of the ICO and STO issuers are doing today.
Perhaps the most exciting thing about the SEC’s proposed changes is how they demonstrate a very coordinated effort among securities commissions globally. As this new era of capital formation emerges, businesses will be able to combine and leverage the regulatory frameworks of multiple countries. That being said, for US based offerings, we still have to wait for the new regulations before knowing what they will look like, or their impact on the digital securities industry.
Why EU blacklisting the Cayman Islands matters for the STO industry – Thought Leaders
On February 18th the European Union added the Cayman Islands to its tax haven blacklist. While this has not made the news in the security token industry, it has had major implications. Due to the strict demands of AML & KYC in many jurisdictions, regulators are focusing more resources on beneficial ownership, tax transparency, and enforcement.
For companies raising capital, the blacklisting means you should not take money from a Cayman fund if you’re a European issuer. In the EU, a lot of the investment in security tokens, real estate, and private equity comes from or through Cayman fund structures. Cayman is also where a large portion of American VC funds are domiciled.
The current tax haven blacklist also includes American Samoa, Fiji, Guam, Oman, Palau, Panama, Samoa, Trinidad and Tobago, US Virgin Islands, Vanuatu, and Seychelles.
Any company taking funds from a Cayman domiciled fund, or working with a platform/issuer/bank in that market should be aware that being associated with a blacklisted country could create significant new risk exposure for your project, and possibly yourself. These changes are effective immediately. Until recently, most firms could fly under the radar but the EU is also rolling out a public registry of corporate ownership. This will not only make non-compliance much easier to spot but also increases the ability for regulators in the EU to investigate and enforce.
The regulation could impact people working at (including directors, officers, or significant shareholders) a company that received funding from a Cayman source after the blacklist date. Enforcement severity changes by country but can include criminal charges, company seizure, and known associates may end up on a variety of sanctions and watch lists. Not to mention the reputational damage.
This is a good example of why a good AML program does not only consist of face matching a document and pinging an API to name match a sanctions list – you are opening up your venture, and most likely yourself, to massive liability. Your legal and regulatory obligation is to take a risk based approach. What that looks like can change by country, transaction value, activity history, etc., so AML program needs to be dynamic, robust, and comprehensive enough to catch things like narrative sanctions.
For example: The most popular security token platforms today only use KYC for digital onboarding of natural persons – not corporate entities. However, when you look at the investors in their previous token issuances you can see that most of the funds are coming from corporate accounts, corporation owned wallets, but the on-chain transaction and KYC is done by an individual. These platforms are missing the technical capabilities to spot transactions coming through blacklisted jurisdictions such as Grand Cayman.
iComply recently helped a virtual asset exchange pass the audits needed to offer their users the ability to spend virtual assets, such as Bitcoin and Ethereum, with a Visa card. This process involved independent audits from Visa, their banks, and regulators – each wanted to see the client demonstrate how they would be able to identify these risks and fulfill the requirements of a whole web of regulations.
Now that they have passed the audit, they are first to market with a very compelling offer compared to their competition who still have months of development on their AML systems before their applications will go through. Using iComply to get ahead of the regulations has also put them ahead of their competition.
We can expect the same for the security token market. Token issuers need to pay close attention to their AML compliance – Telegram had to refund over $1B USD over AML, has spent millions in court with the SEC, and the OCC has not even started with them yet…after that, how many of their “not investors” will be ready to jump onto an investor class action lawsuit? We have already seen this with the recent OCC case against MYSB in New York, or with the SEC and AirFox in Boston.
Regulated Digital Assets Take Over in 2020 – Thought Leaders
2018 was the highwater mark for initial coin offerings (ICOs), when 1,253 new coins raised $7.8 billion. In 2019, this “Wild West” market went from boom to bust. Dollars raised in ICOs plummeted 95% compared to 2018, and the Securities and Exchange Commission (SEC) continues to announce new actions against various ICO players for fraud and unregistered issuances. The sheriff has come to town.
Regulation, my old friend
It’s no consolation to investors who lost millions in ICO scams, but they were part of a natural market evolution. The laws governing traditional securities were also originally inspired by bad actors like “bucket shops” that emerged as another new technology, the telegraph, was changing financial markets. The SEC’s decision to crack down on digital assets and apply those same laws to blockchain securities is good news for market participants.
Blockchain securities have the potential to increase efficiency, lower costs, provide greater transparency and mitigate risk. However, the financial industry can’t fully realize the potential of blockchain securities without a public market and regulated ecosystem to support their full lifecycle. That means fully compliant issuing, investing, trading, settlement and custody.
Governments around the globe are working to establish the necessary frameworks in their own jurisdictions. This is lowering the risk of investing in blockchain securities by introducing investor protections associated with traditional markets. Although different jurisdictions have different requirements for regulated entities, investors, traders and users, there are four common areas being addressed:
- Distribution – how are security tokens created and why, and how are they delivered to their owners?
- Custody – where is the ultimate record of ownership kept and by whom?
- Reporting and Record Keeping – what additional regulatory requirements are placed on participants such as transfer agent services?
- Specific Processes – what additional processes are required, for example, in order to move security tokens between personal and master wallets?
The SEC and the Financial Industry Regulatory Authority (FINRA) have established guidance in all four areas through a series of communications including the report on The DAO and a joint statement on broker-dealer custody of digital assets. The necessary U.S. framework is finally in place to allow regulated, public trading of blockchain securities to blossom.
If the juice don’t look like this
In parallel with these regulatory developments, companies have rushed to create the necessary market infrastructure. Critical components are in place and more are coming this year. The question for those considering whether to participate: is the juice from this 2.0 version of digital assets worth the squeeze? The answer will be yes if the blockchain securities market looks like an upgrade of traditional markets, which would require that it offers two key benefits to investors and companies looking to raise money.
The first is efficiency. Blockchain securities need to eliminate the cumbersome data systems and manual paper-based processes of traditional securities trading. The potential is there but execution is everything as the saying goes. Implemented correctly, blockchain can efficiently support the entire lifecycle of digital assets from issuance and investing through trading, settlement and custody.
The second benefit is smart oversight. To be viable over the long term, the blockchain securities market needs to be fully compliant not only to satisfy regulators, but to create liquidity. It needs to supply investors with convenient access to transparency, account safeguards, and regulated trading. This will require integration with traditional brokerage accounts as well as intuitive user interfaces.
I’ve become so numb
I was hoping to get through this article without using “disruption” because I know we are all numb to the concept. Unfortunately, I keep hearing that blockchain securities will disrupt financial markets. I’ve said it myself! But the reality is that blockchain securities are an evolution not a revolution. The same year that ICOs peaked at $7.8 billion, the traditional US securities industry raised $2.4 trillion. For blockchain securities to become a mainstream asset class, they can’t remain on the island of personal wallets. They need to be bought, held and sold by retail investors, institutions, and advisors through traditional trading systems and brokerage accounts. That could happen as early as this year.
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- Security Token Group Study Reveals Investors Hedging US Markets with Security Tokens