Sunday, May 12, 2019

Preparing for a panel discussion on raising seed capital, successfully

I am in the process of organizing an event geared towards my favorite crowd: startup founders.  They are the most demanding group of clients I have.  There are many adjectives I would use to describe them: enthusiastic, big believers, convincing, lost, demanding, unreasonable, whining, driven, and again, enthusiastic.

For the upcoming panel discussion, I've invited as speakers two partners at venture capital firms that invest into NYC-based and international startups, an experienced angel investor who is on the board of one of the largest angel groups, and a founder of a startup that successfully raised capital before.  As a moderator, my job will be to ask them questions, the answers to which should help the audience.  What are the questions that I should ask?  What are the questions that, if you knew the answer to, would help your company get funded?

Audience participation here is welcome!

And BTW here is the link to the event:
https://www.eventbrite.com/e/successful-capital-raising-for-startups-tickets-61307312823

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Saturday, May 11, 2019

Getting Started with Your Security Token Offering

On April 18, 2019, we conducted a joint webinar on raising capital by conducting security token offerings.  My colleague and I covered the legal side of how to conduct an STO in compliance with applicable laws.  The team at tZERO handled the technical and logistical aspects of hosting an STO and actually generating tokens.  They also addressed such questions as secondary trading of the security tokens.  You can view the entire webinar here: https://www.youtube.com/watch?v=r2oSwVmIE9s

After the webinar, I created the following guide summarizing certain points that a potential STO issuer should consider.  Here is my step-by-step guide:

Step 1: Understand the regulations

Conducting a securities token offering involves issuing securities. Every offer and sale of securities must be registered with the Securities and Exchange Commission (the “SEC”) pursuant to the registration requirements of Section 5 of the Securities Act of 1933 (the “Securities Act”) unless such offering qualifies for one of existing exemptions. I previously posted a brief summary of several commonly used exemptions and regulations here.

Step 2: Understand the technology

Choosing the correct blockchain for your token is the next big decision you have to make. It needs to be secure and integrate well with different platforms and exchanges (just imagine what a costly mistake would be selecting a blockchain that does not work with your chosen security token exchange!). Most of the token industry issues tokens based on the Ethereum blockchain and the ERC-20 protocol because of its interoperability and simplicity to design. However, the ERC-20 token does not have any transfer restrictions.

The following are the four standards that build on top of ERC-20 protocol and that are specifically designed for security tokens:

ST-20 developed by Polymath
R-Token developed by Harbor
ERC-1400
ERC-1404 developed by Tokensoft

Each has a unique set of conditions tailored specifically to security tokens. Often, the choice of a platform for token issuance will help determine which standard will be used since several platforms have their own standards, such as Polymath and Harbor.

Step 3: Choose the token issuance platform

Choosing the right platform has a direct effect on the success of the offering. Several platforms have emerged that offer tokenization services to issuers. Some provide only technical assistance in generating the tokens, whereas others offer a more comprehensive set of services that include, in addition to tokenization, assistance with determining the terms of the offering, smart contracts creations, KYC/AML built-in checks, marketing assistance, and integrations with other blockchain participants.

Examples of token issuance platforms include Securitize, Polymath, tZERO, Securrency, Harbor, and Swarm, among others. Given that the platforms offer different services at different pricing points, issuers should obtain quotes from several platforms and choose the one best suited for their needs and budget.

Step 4: Set up the issuer entity and resolve corporate governance questions

The legal structure of the issuer varies greatly, and occasionally we see the issuer setting up a separate subsidiary to conduct a securities token offering. Although it is possible to form a foreign entity to conduct the STO, such a structure requires compliance with the laws governing the issuance of tokens in the home jurisdiction as well as compliance with the laws of each country where the investors are located. Also, setting up a foreign entity will preclude reliance on certain exemptions described in my separate post, such as Regulation CF or Regulation A+ (both Tier 1 and Tier 2).

Step 5: Structure the terms of your security tokens

There are no standard terms for security tokens. Some are structured to be more like shares in a corporation and offer voting and dividend rights. Others evidence a loan and the right to be repaid with interest, which may sometimes be convertible into an equity-like instrument. Yet other tokens can represent a profits interest or a revenue share, or simply a fractional ownership of an asset. One of the initial steps of an STO process is creating a summary of the token terms together with a competent legal adviser.

Step 6: Select your STO team

The very first step in conducting a successful security token offering is assembling a team of service providers with prior experience in STO issuances. You will need to select a legal adviser, a token issuance platform, and possibly a marketing agency and a broker-dealer. Depending on the type of offering you elect to conduct, you may also need to retain services of a transfer agent and engage local counsel in jurisdictions where you intend to sell the tokens.  In the future, I'll write about what types of services to expect from your legal adviser.

Step 7: Understand resale restrictions and secondary trading

It is important to carefully select the right exchange for your security tokens. Many exchanges allow trading of cryptocurrencies and utility tokens. Hosting the trading of security tokens requires exchanges to get additional regulatory approvals.  It is my understanding that there are currently only two U.S. centralized exchanges that are authorized to trade security tokens: tZERO and
OpenFinance.

There are several others that are in the process of getting the necessary regulatory approvals to trade security tokens. You should learn the listing requirements and understand the regulatory compliance of the exchanges ahead of conducting your STO.

I hope this guide, together with the webinar, will help you find answers to some of your questions regarding raising capital through the issuance of security tokens.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Overview of US federal securities law exemptions available for raising capital

Every offering of securities must be registered with the SEC unless it qualifies for an available exemption and I am often asked to describe various types of exemptions and regulations that are available to private companies raising capital.  I go over Regulation D, Regulation CF, Regulation A+ rules with clients about once a week.  I also teach the same at Fordham Law School.  Below I am posting a summary that I hope you will find helpful.  Note that the table does not include all available exemptions and regulations.  Email me if you'd like a nice pdf version.


Regulation CF (Crowdfunding):

Amount to be Raised:
Up to $1,070,000 in a 12-month period

Type of Issuers:
US entities only
Other limitations apply

Investors:
Any investor (accredited[1] and non-accredited).  However, there are limits as to how much non-accredited investors can invest depending on their net worth or income.

Marketing Limitations:
Issuers can only communicate and market through a registered crowdfunding portal.  Any type of marketing and communication is permitted through the portal (so long as not misleading).  Outside of the portal platform, only very limited factual communications are permitted.

Resale Limitations:
These are restricted securities that generally cannot be resold for one year unless (i) back to the issuer, (ii) to an accredited investor, (iii) as part of a registered offering, or (iv) to a family member or for estate planning purposes.

Filing Requirements:
Issuers must file Form C with the SEC and update it annually so long as, generally, securities issued in Regulation CF offering are outstanding.

Information Requirements:
In addition to providing disclosures about the company and the offering, the issuers must provide financial statements (which have to be audited if the offering exceeds $535,000 and the issuer has sold securities in reliance on Regulation CF before).

General comments:
Although cheaper than conducting a Regulation A+ offering, the $1.07 million cap on the gross proceeds makes it a relatively expensive undertaking.  Also, the issuer must conduct its offering through one of the registered crowdfunding portals.


Regulation D Rule 506(b):

Amount to be Raised:
Unlimited

Type of Issuers:
Any issuer, including foreign issuers
Certain limitations apply (such as that the issuer cannot be a “bad actor”)

Investors:
Unlimited number of accredited investors and up to 35 non-accredited but financially sophisticated investors. 

Marketing Limitations:
No general solicitation or advertising is permitted.  Offers and sales should be made only to those investors with whom the issuer has pre-existing relationship.

Resale Limitations:
Restricted securities (i.e., not freely tradeable generally for at least one year)

Filing Requirements:
Issuers must file Form D with the SEC within 15 days after the first sale.  The issuer also needs to make notice filings in every state where the investors reside.

Information Requirements:
If the issuer accepts money from non-accredited investors, it must provide a private placement memorandum with specific mandated disclosures specified in Rule 502 of Regulation D.

General comments:
This exemption may not be suitable for those offerings that are conducted online through unrestricted web portals because of the restriction on solicitation and advertising (because posting offering details on a website is generally considered to be advertising).


Regulation D Rule 506(c):

Amount to be Raised:
Unlimited

Type of Issuers:
Any issuer, including foreign issuers
Certain limitations apply (such as that the issuer cannot be a “bad actor”)

Investors:
Accredited investors only

Marketing Limitations:
General solicitation and advertising are permitted. 

Resale Limitations:
Restricted securities

Filing Requirements:
Issuers must file Form D with the SEC within 15 days after the first sale.  The issuer also needs to make notice filings in every state where the investors reside.

Information Requirements:
None

General comments:
Many issuers rely on this exemption.  The issuer has to take reasonable steps to verify that purchasers of securities sold in any offering under Rule 506(c) are accredited investors.


Regulation A+ (Tier 1):

Amount to be Raised:
Up to $20 million per year

Type of Issuers:
US and Canadian entities only
Certain types of entities (such as shell companies, issuers of penny stock or other types of investment vehicles) are ineligible

Investors:
Accredited and non-accredited investors 

Marketing Limitations:
Generally marketing and advertising are permitted, but certain limitations exist.  When using “test-the-waters” marketing or before the registration statement has been qualified with the SEC, the issuer has to specifically state whether a registration statement has been filed and if yes, then provide a link to the filing.  Also, there needs to be a disclaimer saying that no money is being solicited and that none will be accepted until after the registration statement is qualified with the SEC.  All solicitation material must be submitted to the SEC as an exhibit. 

Resale Limitations:
Unrestricted securities, but limitations on trading exist

Filing Requirements:
Issuers must file Form 1-A with the SEC and get qualified.  Companies need to count their shareholders for the purposes of Section 12(g) registration.

Information Requirements:
Form 1-A requires detailed disclosures about the issuer, including financial statements which need not be audited unless audited financial statements already exist.  Generally, the level of disclosure is similar to that required in an initial public offering. 

General comments:
Issuers raising money in a Regulation A+ Tier 1 offering must comply with the individual "blue sky" laws of each state where they plan to sell their securities.


Regulation A+ (Tier 2):

Amount to be Raised:
Up to $50 million per year

Type of Issuers:
US and Canadian entities only
Certain types of entities (such as shell companies, issuers of penny stock or other types of investment vehicles) are ineligible

Investors:
Any accredited and non-accredited investor.  However, there are limits on how much non-accredited investors may invest depending on their net worth or income.

Marketing Limitations:
Generally marketing and advertising is allowed, but certain limitations exist.  When using “test-the-waters” marketing or before the registration statement has been qualified with the SEC, the issuer has to specifically state whether a registration statement has been filed and if yes, then provide a link to the filing.  Also, there needs to be a disclaimer saying that no money is being solicited and that none will be accepted until after the registration statement is qualified with the SEC.  All solicitation material must be submitted to the SEC as an exhibit. 

Resale Limitations:
Unrestricted securities (at the federal level)

Filing Requirements:
Issuers must file Form 1-A with the SEC and get qualified.  After the offering, the issuer has ongoing reporting obligations.

Tier 2 offerings are exempt from complying with state “blue sky” laws (although states can (and generally will) still require that information provided to the SEC also be filed with the state, and that the issuer pay filing fees.

Information Requirements:
Form 1-A requires detailed disclosures about the issuer, including audited financial statements.  The level of disclosure is similar to that required in an initial public offering.

Tier 2 issuers are required to include audited financial statements in their offering documents and to file annual, semiannual, and current reports with the SEC on an ongoing basis. 

General comments:
Companies are required to engage the services of a transfer agent.


Regulation S:

Regulation S is an exclusion from the registration requirements of the Securities Act for offerings made outside of the United States by both U.S. and foreign issuers.  A compliant Regulation S offering must follow two general conditions: (i) the offer or sale must occur in an “offshore transaction” and (ii) there be no “directed selling efforts” into the United States. 

Regulation S transactions are divided into three categories.  Category One, which includes offers and sales by “foreign issuers” for which there is no “substantial U.S. market interest” or offerings of securities in “overseas directed offerings” is the least restrictive, with no resale limitations.  Category Two securities, which include securities issued in equity offerings by reporting foreign issuers and offerings of debt securities, non-participating preferred stock by reporting issuers or non-reporting foreign issuers, may not be resold to U.S. persons during a 40-day distribution compliance period.  Category Three is typically the most relevant for the smaller private issuers.  Category Three includes offerings of all other securities, including equity offerings by domestic non-reporting issuers (i.e., private companies with no reporting requirements with the SEC).  Resales to U.S. persons of securities issued in Category Three offerings are restricted for one year unless they are done in compliance with an available resale exemption. 




[1] Rule 501(a) of the Securities Act defines accredited investors (in the case of natural persons) as those whose individual net worth (alone or with a spouse) exceeds $1 million (excluding the value of their primary residence) or those whose annual income exceeded $200,000 (or $300,000 together with their spouse) in each of the two most recent years and they reasonably expect reaching the same income level in the current year.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Thursday, March 21, 2019

Fundraising Startups and their Associated Persons - Can They Be Broker-Dealers?

Continuing with the theme of broker-dealer registration, I now switch to the issuer safe harbor.  As you know, a broker is "any person engaged in the business of effecting transactions in securities for the account of others."  The key phrase here is "for the account of others".  Since many startup companies cannot attract the attention of broker-dealers to help them secure funding, the companies do it themselves.  Raising funds on the company's own behalf is not considered to be a broker-dealer activity.  However, even if the issuer itself is not a broker, anyone working for it may be because they would be selling securities of the issuer for the account of the issuer, not their own.  This brings into question the fundraising activities of issuer associated persons: its partners, officers, directors or employees. Note that Rule 3a4-1(c)(1) definition of "associated persons of the issuer" does not include independent contractors.

Whether such persons have to register as broker-dealers depends on facts and circumstances of each case.  In 1985, the SEC adopted Rule 3a4-1 that acts as a narrow nonexclusive safe harbor for associated persons.  Complying with the requirements of this Rule means that such associated person will not be required to register as a broker-dealer while engaging in fundraising activities.  First, the person needs to meet all three general requirements:
  1. Not be subject to a statutory disqualification at the time of his participation; AND
  2. Not be "compensated in connection with his participation by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities"; AND
  3. not at the time of his participation be an associated person of a broker or dealer (ie, its partner, officer, director or employee).
With respect to the second requirement, the SEC noted in the Proposing Release that "This prohibition is intended to preclude compensation arrangements which vary with or depend upon the success of the sale efforts by associated persons."  This does not seem to prohibit compensating the associated person for the participation in the capital raise but precludes varying the amount of compensation based on the amount raised.  One needs to be very careful with structuring the compensation of persons engaged in fundraising for the company.

If the three general conditions are satisfied, the associated person then needs to meet one of the following three criteria:
  1. Participate only in transactions involving offers and sales of securities to institutional investors, including broker-dealers, banks, investment companies or in connection with mergers, asset sales or certain other transactions (not really applicable to startups) - Rule 3a4-1(a)(4)(i)(A, B, C, D); OR
  2. Limit activities to (i) preparing written offering materials subject to approval by a partner, officer or director of the issuer, while not engaging in oral solicitation, (ii) responding to investor inquiries, provided that responses are limited to information in the offering document, or (iii) ministerial and clerical work in effecting the transaction; - Rule 3a4-1(a)(4)(iii); OR
  3. Perform (throughout the offering or starting at the end of the offering) substantial duties on behalf of the issuer other than marketing the securities, provided that this person is not a broker-dealer or its associated person within the prior 12 months and does not participate in the sale of securities of the issuer more than once every 12 months - Rule 3a4-1(a)(4)(ii). 
The issuer's founders, directors, officers, and employees would most likely rely on the third criterion when raising capital for their company.  However, it is important to remember that such fundraising efforts cannot happen more than once every 12 month period and that their compensation cannot depend on the success of their fundraising activities.

As I previously mentioned, this Rule is a nonexclusive safe harbor.  However, it is difficult to judge what activities would be permissible if you step outside of the strict confines of the Rule.  The SEC has repeatedly brought actions against associated persons of the issuers for failure to register (although often in connection with other charges such as fraud).

In conclusion, all startup founders should carefully structure their fundraising efforts so that their team is not deemed to be unregistered broker-dealers.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.