Tech

Crypto start-ups are trying to get their house in order ahead of a possible SEC crackdown

Key Points
  • A growing number of cryptocurrency start-ups are filing with the SEC when they raise money through token sales.
  • At least nine companies have raised more than $350 million through registered offerings since early August.
  • They're showing a willingness to work within the boundaries of securities law.
Crypto start-ups prepare for SEC crackdown on ICOs
VIDEO0:5100:51
Crypto start-ups prepare for SEC crackdown on ICOs

Despite all the hype around initial coin offerings this year, U.S. regulators have yet to offer specific rules on what's legal and what isn't. So a growing number of crypto start-ups are taking compliance into their own hands.

Since early August, at least nine companies have filed token sales with the SEC to raise a total of more than $350 million, according to data compiled by CNBC. The latest was Unikrn, an e-sports betting company backed by celebrity investors including Mark Cuban and Ashton Kutcher. On Tuesday, Unirkn filed to raise $20 million through sales of its digital currency called Unikoingold.

ICOs, which hardly existed before this year, offer a new way for blockchain companies to raise cash without tapping traditional venture investors or the capital markets. Many projects have solicited funds directly from their website even though it may be years before they bring a product to market.

In late July, the SEC issued its first public warning on ICOs, indicating that securities laws may apply to the sale of new digital coins. The SEC later issued another warning about ICO scams and last month charged two companies for ICO fraud.

Even without a clear set of laws, companies are getting the hint.

Mark Cuban, who just called bitcoin a bubble, says he plans to invest in Unikrn
VIDEO0:5300:53
Mark Cuban, who just called bitcoin a bubble, says he plans to invest in Unikrn

"The idea is to be proactive and engage regulators to foster goodwill," said Meltem Demirors, director at the Digital Currency Group in New York.

When registering token sales with the SEC, companies are using short Form D filings, the same type of document that start-ups use to disclose private venture rounds. They only provide basic information, like the name and contact information for principals and the industry group. In a section that asks what type of security is being offered, where a typical start-up would select "equity," these companies are checking the "other" box and writing in something that includes the word token.

ICO filings with the SEC account for a small fraction of the more than $2.7 billion that's been raised through token sales this year. There's so much chaos in the global crypto market that the Chinese government banned all ICOs in September, classifying them as illegal ways to raise money. On Wednesday, Reuters reported that Russian authorities plan to regulate the market and will determine how by the end of the year.

Most of the projects going the SEC route are using a framework called the Simple Agreement for Future Tokens (SAFT), which was created by crypto start-up Protocol Labs and used for the first time in August. The agreement lays out how the tokens can eventually be used and provides for certain investor protections in case the project dissolves.

Unlike many ICOs, SAFTs are limited to accredited investors for people in the U.S., meaning ordinary retail investors can't participate.

"The view people are starting to settle on is that a pre-sale of a tokenized service needs to be done as a sale of a security," said Lowell Ness, a partner at law firm Perkins Coie and an expert in securities law. "They use the proceeds from that sale to go build the network. Once the network has been built and the token is fully functional and could be immediately used, then it's OK to deliver the token to the world."

For example, Kik Interactive's new blockchain-based network was not yet up and running when the online chat company raised $50 million in August, so it sold SAFT securities to accredited investors and filed with the SEC.

'Solicit input'

The following month, once the service launched, Kik raised another $49 million without registering with the SEC. At that point, the digital tokens could be used as a utility on its service and no longer represented an investment, a company spokesman said. Kik users will be able to use Kin tokens for digital commerce on the network

Protocol Labs, the creator of SAFT, accounts for more than half of the money that's been raised, pulling in over $200 million in August. The cash from the ICO is being used to build technology for a blockchain-based storage network called Filecoin.

There's no guarantee that SAFT filings will be enough to satisfy the SEC in the future. But Digital Currency Group's Demirors said they're at least an indication that companies want better regulatory guidelines.

"These projects are attempting to demonstrate a desire to solicit input from regulators," she said.

Engaging with the SEC won't solve every concern around ICOs. The technology is still nascent and the business models are untested.

AngelList CEO Naval Ravikant, who's been investing heavily in cryptocurrencies and helped come up with the idea for SAFT securities, expects to see plenty of highs and lows before the market settles. Here's one of his tweets from last month:

Schwark Satyavolu, a partner at Trinity Ventures, agrees and said that some regulation is a good thing as it will knock out the shadiest digital currency start-ups.

"This will winnow the chaff from the grain and provide higher-quality deals with more information visibility," he said.