An Overview of STOs and Private Offerings in the US

How is a security token offered?

Technology

The benefits of tokenization should be evident, but the path to tokenizing an asset may not be so clear. Without a background in blockchain programming, it will be difficult to turn an asset into a usable token. Fortunately, there are several platforms that have been created specifically to aid in the creation and issuance of security tokens. From a technical standpoint, the vast majority of security tokens are ERC-20 tokens — tokens that are built on top of the Ethereum blockchain in adherence with the ERC-20 technical standard. Essentially, the ERC-20 standard introduces a set of rules that tokens should follow to ensure that they will interact properly with each other and the Ethereum network. This has the added benefit of creating a simple and widely available code template that can be used to create ERC-20 tokens. The act of creating an ERC-20 token on Ethereum is fairly simple from a technical standpoint, and with the help of a security token issuance platform, it can be as simple as selecting a name, ticker symbol, and token supply.

In addition to the ERC-20 standard, there have been new proposals for security token standards on Ethereum, such as ERC-1400 and ERC-1450.

Compliance

In the early days of cryptocurrency, initial coin offerings (ICOs) were offered without regard for US security regulations. This is largely because the tokens issued through these ICOs were so called “utility tokens” that did not represent traditional securities. This does not mean that they were not securities themselves, as evidenced by results like this cease and desist order directed at CA-based food app Munchee. Recent SEC statements have brought a bit more clarity to the regulation of token offerings. Statements like this from SEC chairman Jay Clayton indicate that the determination of whether a token is a security is done on a case-by-case basis. This determination is made primarily through the application of the Howey Test.

There is no uncertainty surrounding the classification of security tokens. Security tokens are, by definition, securities. Therefore they must follow the same regulations as any other offering. Navigating the regulatory framework surrounding security issuances in the US is a confusing and difficult process. Many of the security token issuance platforms will also help you with this. Choosing which exemption(s) to pursue is largely dependent on the security being offered, how much money is being raised, who can invest, and a variety of other factors, so I have prepared a quick summary of the most commonly used fundraising exemptions to help clarify the differences between each.

Reg CF

Pros:

  • Reg CF offerings are open to all US investors.
  • Easy Filing Process — A Reg CF offering requires the issuer to file SEC Form C

Cons:

  • $1.07MM/year maximum
  • Securities are restricted for a year
  • Financial statements are required
  • Reporting — Companies that perform a Reg CF offering become reporting companies, and must file annual and semiannual reports.

Reg CF is great fit for companies seeking to raise a small amount from an active and engaged client base. Reg CF allows companies to approach fundraising in the same way other entrepreneurs have used Kickstarters in the past, though for instead of iPhone accessories or board games, they are selling equity or some other security. Using Reg CF benefits the issuer, as it creates an engaged and active group of investors that act as free advertising for the project. The downside is that it is a complicated process relative to the amount of funding that can be raised. The issuer then becomes a reporting company upon completion.

Reg A+

There are 2 tiers of Reg A+ offerings. Tier 1 allows for raises of up to $20MM. Tier 2 allows for raises of up to $50MM.

Pros:

  • $50MM maximum
  • Open to accredited and unaccredited investors.
  • Securities are unrestricted
  • Test The Waters — Companies utilizing Reg A+ can take indications of interest from potential investors to determine if it is worth it to proceed with the formal Reg A+ approval process.

Cons:

  • Difficult Qualification Process — The qualification process for Reg A+ is both expensive and time consuming. The SEC review process typically takes around 3 months, and companies performing a Tier I offering must also undergo state review.
  • Reporting — Companies that perform a Tier 2 offering under Reg A+ must file annual and semiannual reports with the SEC (Tier I offerings do not require reporting).

The major benefit of a Reg A+ offering is the fact that the securities sold will be unrestricted. The securities are immediately tradable, allowing investors to capitalize upon the liquidity benefit tokenization provides immediately. Additionally a Reg A+ offering is open to everyone, not just accredited investors, which is great if you are trying to reach a broad investor base. The downside of using Reg A+ is that it is difficult and expensive. The registration process is by far the most difficult of any of the exemptions, and it can take a very long time — often over 90 days.

Reg D Rule 504

Pros:

  • Anyone can invest
  • Easy Filing Process — Issuer must file Form D with the SEC

Cons:

  • Maximum of $5MM
  • General Solicitation only allowed under specific circumstances
  • Securities are usually restricted

Reg D Rule 504 is great for issuers who are would like to raise $5MM or less. It’s relatively easy, and it’s open to the general public. The downsides are that the securities sold through Reg D are generally restricted, and general solicitation is usually not allowed. This is great if there is a lot of investor interest already, but not so great if you were looking to publicize your offering and build excitement around your business.

Reg D Rule 506(c)

Pros:

  • Unlimited Raise Amount
  • General Solicitation Allowed
  • Easy Filing Process — Issuer must file Form D with the SEC

Cons:

  • All investors must be accredited — Essentially you can only raise money through institutions and rich people.
  • Securities are restricted

Reg D 506(c) is the most commonly used private fundraising exemption in the US. It is popular because the filing process is simple, you can advertise, and you can raise an unlimited amount of money. The only downsides are that the securities will be restricted, and you have to ensure that all investors are accredited.

Reg S

Pros:

  • Unlimited Raise Amount
  • General Solicitation is allowed as long as it is not targeted at any US investors

Cons:

  • Cannot sell to US investors
  • Securities are restricted — generally, securities sold under Reg S cannot be resold to US investors for a year

Reg S is the regulation placed upon US issuers and foreign companies looking to sell securities to investors outside the United States. This is not really an exemption. It is more of a way for the US to extend their jurisdiction to securities offered outside their borders in an attempt to keep the securities from flowing back to US investors. Reg S is often used in combination with one of the other exemptions when issuers are selling to both US and international investors.

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