Following Circle’s acquisition of SeedInvest earlier this year, we’ve received numerous questions around crypto and how it figures into the startup fundraising ecosystem. In the not too distant future, we believe startups will be able to tokenize their securities, as well as facilitate the secondary trading of the same, providing liquidity and enabling capital to flow across geographic borders. If that means absolutely nothing to you – don’t worry! Investing in securities or crypto, both involve an “alphabet soup” of acronyms, and we’re here to help explain what you need to know.
Initial Public Offering (IPO)
You’ve probably heard of an Initial Public Offering, or IPO, as this is the most traditional way to purchase stock in a company. The key thing to note about an IPO is that this is the first (initial) time a private company is offering some share of the business to the public, and is typically simultaneously listed on a national stock exchange platform such as the New York Stock Exchange. This doesn’t necessarily mean the company has to be new – established, larger private companies are also able to carry out an IPO in order to raise capital further down the line.
Is an IPO regulated? Yes! In the United States the manner in which IPOs are conducted is heavily regulated by the SEC, as well as other regulatory agencies. However, just because something is regulated doesn’t mean it always goes to plan! A number of unicorn startups haven’t fared well this year, with companies like WeWork being forced to rethink its strategy and valuation. It is important to note that the SEC does not opine on the merits of an offering, but rather whether all of the company’s disclosure obligations have been met.
Initial Coin Offering (ICO)
The IPO’s less traditional cousin is the Initial Coin Offering, or ICO, a relatively new entrant to the fintech lexicon. As with an IPO, it is a means of generating funds via entering the public market for the first time, only this time with a new token or cryptocurrency. In this instance, upon making an investment you are issued tokens to represent that investment, as opposed to shares in a company. It is sometimes unclear whether these tokens are classified as securities; if they meet the conditions as defined by the SEC in The Howey Test, they must comply with certain regulations. As such, difficulties arise when ICOs are not treated as securities. ICOs also bring an increased likelihood of fraud and manipulation, as the markets for these assets are not regulated in the same way as traditional capital markets, and therefore come with significant additional risk. Tokens dependent on a secondary market like an exchange for liquidity run into regulatory barriers to entry if classed as securities. Issues also arise if tokens are sold with only the promise of later being made available on an exchange, as many were never listed. It’s safe to say the ICO bubble has burst – as of August 2019 the median return on investment dropped to -87%.
Is an ICO regulated? No, in the United States they are largely unregulated. In June 2019, the SEC filed a $100M lawsuit against Kik Interactive, which launched a cryptocurrency offering within its messaging app, for illegally conducting a securities offering. Similarly, in October 2019 the SEC halted Telegram’s alleged $1.7B unregistered digital token offering.
Security Token Offering (STO)
A Security Token Offering (STO) is also a means of capital raising. An STO is the issuance of a financial security in the form of a digital asset (aka security token), typically representing ownership rights in real-world assets with monetary value (such as stocks, bonds, funds, or real estate investment trusts), or crypto assets (such as network protocols), in line with existing securities exemptions. Put simply, a compliant token sale. STOs address the issues raised by the Howey Test, and are a means of tokenizing tradable financial assets in a public offering, in line with regulatory governance. An investor participating in an STO can expect similar benefits and protections afforded to investments in traditional securities. STOs offer a safer approach for investors through increased investor protections and legal recourse in the case of fraud or misrepresentations. They also have the potential to more easily bring liquidity to a typically illiquid market.
Is an STO regulated? Yes! In the United States STOs are heavily regulated by the SEC, as well as other regulatory agencies. STOs provide investors with the financial risks and disclosures beforehand, and usually involve a qualification process with the SEC. This year, Blockstack became the first SEC-qualified token offering under Regulation A+. This is a prime example of a company leveraging an STO in order to raise capital by launching a digital token to both accredited and unaccredited investors, while adhering to existing US securities laws.
Initial Exchange Offering (IEO)
An Initial Exchange Offering, or IEO, is a more recent form of token-based fundraising, which witnessed a surge in popularity this year. The initial offering takes place directly on a crypto exchange and is administered by the exchange on behalf of a startup seeking to raise capital with newly-issued tokens, which will be listed on the exchange afterward (for a fee). Often, the intent of an IEO is market manipulation; first to drive awareness around the asset, initially arbitrarily pricing it low, hiking up the price, allowing the startup to cash out when the price is high. There is typically a limit on the total number of tokens available for purchase, which should theoretically guard against price volatility. However, this limit risks large investors (‘crypto whales’, who own a large quantity of a token), influencing the token price and thus the market. If both the company and investors sell the tokens simultaneously, the price will collapse. The instant liquidity of these multimillion dollar offerings mean they frequently take place extremely quickly (Fetch.ai raised $6M in just 22 seconds). But not everyone comes out on top – of the IEOs that concluded in the first half of 2019, the median return was -81.4%.
Is an IEO regulated? No, in the United States they are unregulated. As with any offering, any platform offering the trading of securities and operating as an “exchange,” as defined by the federal securities laws, must register with the SEC as a national securities exchange or be exempt from registration. Similarly to ICOs, issuers who take this route are gambling with regulators as there is no protection against potential lawsuits.
This post was written by Alice Hankin on December 4, 2019
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