What you need to know about how the JOBS Act affects Smart Securities

The single most fundamental problem that every startup faces is the dilemma of how to secure funding. Seeing as 25% of startups go under within their first year of business, it’s clear that the funding problem is not always an easy nut to crack. But all that may be going away now as smart securities are stepping in to fill the breach.

Also called Security Token Offerings (STOs), Digital Asset Securities (DAS), digital security (DSO), asset-backed token (ABT) smart securities are gaining a lot of hype as a swift, secure and less expensive way for startups to access funding. In fact, smart securities are considered to be such a great source of alternative funding, that they are expected to grow into a $10 trillion opportunity by 2020.

With smart securities, businesses can make legally compliant offerings that attract both traditional and non-traditional investors. By virtue of the regulations under the JOBS Act, small businesses can access a number of funding options to source much-needed capital.

There are pros and cons though. This article lays bare all the basics you need to know about smart securities and how the provisions of the JOBS Act will regulate issuance and investment in them. But first, it’s important to look at where smart securities come from.

In the beginning, there were ICOs and crowdfunding

What you need to know about how the JOBS Act affects Smart Securities 1

Source: (Bloomberg) How Much Have ICOs Raised in 2018? Depends on Who You Ask

Pretty much the predecessors of smart securities, Initial Coin Offerings (ICOs) and crowdfunding provided alternative sources of crucial funding for startups. ICOs are actually a form of crowdfunding.

Brought to popularity by platforms such as Indiegogo, Lending Club, GoFundMe and Kickstarter crowdfunding allows businesses to directly raise money from the public. So instead of chasing after Angel Investors or Venture Capitalists, the business put up a project and then invite individuals to contribute whatever they have towards its success. Usually, their contributions would be rewarded with benefits like early access to the project or other such perks.

While ICOs are a form of crowdfunding, the difference is that they use cryptocurrency. In an ICO, the reward for putting up funds for the stated project or business venture is a new cryptocurrency coin or token. This is usually exchanged for money or other popular cryptocurrencies.

After the first big ICO by Ripple in 2013, ICOs pretty much caught fire. The apex of the explosion was the $18 million in funding raised by Ethereum in 2014. The ICO rush wouldn’t last though, especially since large amounts of capital were being raised on nothing more than an idea and white paper, without any of the safeguards of the securities laws.

N.B. Now we even have guidance from the SEC to avoid “increased risk of fraud and manipulation because the markets for these assets are less regulated than traditional capital markets.”

The understanding was that ICOs were not securities but utility tokens that only provide access to investors. So ICOs became all the rage but no one knew quite how to fit them into the securities laws.

The large amounts of money being made from ICOs have now begun to attract the attention of the SEC. With the increased attention has come a revival of the debate over whether ICOs are securities and this debate is going nowhere soon. The debate has also in turn brought about uncertainty in the prospect of ICOs.

The recent struggles of Canadian social media startup, Kik, with the SEC are a case in point here. In 2016, Kik had a Token Distribution Event (TDE) where it raised $97 million during the launch of its KIN token. Apparently, the SEC now believes that TDE was done in violation of the Securities Laws and has served notice of an enforcement action against Kik.

In the event that the KIN token is found to be a security, there will be serious consequences for Kik. This may include fines and the application of restrictions that will wreck the current ecosystem that uses the coin.

No one wants that uncertainty anymore. Investors want to feel secure in their investments and with the increasing drop in funds being raised from ICOs, it’s becoming clear that investor attention is shifting elsewhere.

The evolution of Smart Securities

Source: The State of Smart Securities 2019 by NovaBlock Capital & Security Token Summit

Smart securities are similar to ICOs but without all the risk and lack of regulatory uncertainty. Smart security is basically just like any other security traded on the stock exchange. It is an intangible asset that is tied to the physical assets or property of a real-life company, as opposed to ICOs. Through what is called tokenization (or digitalization), it can be used to represent any number of assets.

Essentially, smart security allows an individual to contribute funds towards business and obtain in return any one of a number of benefits. This may be dividends, a share of revenue, equity or the principal plus interest.

But compared to ordinary securities, smart securities are a whole lot better. This is because:

Being digital, they are much less likely to get destroyed like the paper securities that were historically exchanged.
They simplify participation in the securities and exchange market. There’s no need for all the complicated processes and middlemen that ordinarily obtain in the issuance or purchase of securities.
There’s no need for any paperwork to track or record information regarding security. Each security can have special properties that have all the history and crucial information that concerns it. It is also possible to regulate what gets shown to who, on private blockchains.
It is also a lot cheaper to issue and buy due to the elimination of middlemen such as lawyers, issuing houses and brokers.
It provides swift access to global capital as well while mitigating most of the associated difficulties. This provides deeper funding pools and broader brand awareness.

Smart securities can be issued or purchased on a variety of issuance and compliance platforms including Securitize.io, Swarm, TokenSoft Inc., Polymath, Harbor, Dan Doney, CEO & Founder at Securrency etc.

P.S. I’ll write a separate article with a deeper dive to explore benefits of smart securities.

How does the JOBS Act affect Smart Securities?

Source: The State of Smart Securities 2019 by NovaBlock Capital & Security Token Summit

Before the enactment of the Jumpstart Our Business Startups (JOBS) Act in 2012, businesses in need of funding via the sale of securities had to comply with the Securities Act of 1933.

Under the Securities Act, any business that wanted to secure funding by soliciting investment from either the public or private individuals must register with the Securities and Exchange Commission (SEC). They were also required to fulfill a host of other strict requirements.

It was very difficult for small businesses to fulfill these requirements. The Act also limited businesses to soliciting investment from accredited individuals, basically individuals that are relatively well off. This meant that the option was pretty much closed to startups and most Americans.

In order to help ensure that there can be better access to funds for startups and easier investment options for individuals, the JOBS Act was created. Under the Act, startups can enjoy relaxed securities rules under the exemptions provided in Titles I — VI of the Act.

There are three major exemptions that can be applied for. These are Regulations D, A+, and CF.

Source: http://crowdfundcapitaladvisors.com/2017-state-regulation-crowdfunding-report

Regulation D

There are three rules that are important here: Rules 506(b), 506(c) and 504. Although they are all under the same regulation, they have slightly different terms.

Annual offer limit: For offerings under Rules 506(b) and (c), there’s no annual offer limit. But for Rule 504, the limit is $5 million per 12-month period.
General solicitation: For Rule 506(c), issuers are allowed to advertise their offerings anywhere, even on the internet. This is also permitted in certain situations for offerings under Rule 504 but it is not permitted for offerings under Rule 506(b).
Investor requirements: Under Rules 506(b) and (c), issuers can attract unlimited accredited investors. Offerings compliant with Rule 506(b) can also attract up to 35 sophisticated but non-accredited investors. An accredited investor is one that has a net worth of at least $1 million or annual income of at least $200,000 each year for the last two years. The implication of this is that the issuer has to continually verify that the tokens are not sold to non-accredited individuals. There is no requirement for accredited investors under a Rule 504 offering.
SEC filing requirements: All issuers under Regulation D must fill and file Form D with the SEC.
Restriction on resale: There are restrictions on the resale of the securities under this regulation. This has the effect of severely limiting the liquidity of the token. So, it won’t make sense for issuers that want their token to double as a utility token.
Preemption of state registration: If the token will be issued in several states, there would be no need to register the Rule 506(b) or (c) offering in each of those states. This is what preemption means. For Rule 504 however, the offering must be registered in each state.

Regulation A+

Regulation A+ is an alteration of the former Regulation A under the Securities Act and was introduced in 2015. There are two tiers of offerings under this section. They provide as follows:

Annual offer limit: For Tier 1 offerings here, the annual limit is $20 million while the limit for Tier 2 offerings is $50 million.
General solicitation: For offerings under Regulation A+, general solicitation is only permitted before qualification of the offering, and that is only for the purpose of checking the eligibility of investors.
Investor requirements: For Tier 1 offerings, the issuer can solicit and accept investments from both accredited and non-accredited investors. For Tier 2 offerings, the offering is only for non-accredited investors but subject to limits.
SEC filing requirements: The offering must first be qualified by the SEC before any token can be sold. However, considering that only 55% of offering statements are qualified, this can be a bit tricky. Also, it may take a bit of time as SEC response time is at least 2–3 months. For both Tiers, the issuer must also file Form 1-A and provide 2 years of financial statements. Only in the case of Tier 2 offerings, the financial statements must be audited.
Restriction on resale: There’s no restriction on resale of the tokens here. This makes for quite high liquidity.
Preemption of state registration: State registration is not preempted for Tier 1 offerings but will be preempted for Tier 2.

Regulation CF (Crowdfunding)

This regulation was released in 2016. It provides for equity crowdfunding as follows:

Annual offer limit: The annual offer limit here is $1.07 million in each 12-month period.
General solicitation: Permitted but with limits on advertising
Investor requirements: There is a cap on how many tokens each investor can buy. Investors that make less than $100,000 a year cannot invest more than $2000 or 5% of their annual income. For investors with more than $100,000 in annual income, there is an investment cap of 10% of annual income or an aggregate of $100,000.
SEC filing requirements: Issuers must fill Form C here. They will also be required to provide a financial statement if it raises $100,000 or less. They will have to provide a financial statement reviewed by a public accountant if it raises up to $500,000 and must provide an audit if it raises more. This would have serious cost implications for the startup. The transaction must also be conducted through an intermediary, usually a licensed crowdfunding platform, and fees will lie for this service, up to 10%.
Restriction on resale: Investors will not be allowed to resell their tokens until after 12-months from purchase.
Preemption of state registration: State registration will be preempted here.

Conclusion

There’s no doubt that smart securities have the potential to redeem equity crowdfunding and provide a stable way to trade digital asset securities. But the price of this is the new regulatory considerations that each issuer must contend with. The best bet all around is for each business to look closely at each of the exemptions under the JOBS Act and decide on which best favors their unique approach. Consulting a good legal expert goes without saying. It’s not a bad idea to familiarize yourself with the basics of Jobs Act and SEC guidance if you’re planning on launching smart security in the US.

Disclaimer: I am not an attorney or a financial advisor. Everything in this article is based on my research and experience.

P.S. Please note, that laws and regulations depend on where you reside, so make sure you are consulting a local council in addition to the US attorney.