From Crowdfunding to ICOs: Tips for Creatively (and Legally) Financing Your Business

TCSW – Wednesday, October 10, 2018

Brian EdstromShareholder & Attorney,

Avisen Legal, P.A.

David DucciniFounder & CEO,

Silicon Prairie Portal and Exchange, LLC

This presentation provides general information only. Nothing in this presentation, and nothing the presenters say during this presentation or at this event, is offered as legal advice. Raising money from investors likely requires you to comply with federal and state securities regulations, which are highly complex. This presentation does not cover all aspects of these, or other potentially applicable, regulations. You should consult an attorney prior to raising money from investors.

OverviewWhat problem does an ICO or Crowdfunding solve?

• Raising money is hard, especially for early-stage companies

• You may be tired of: - bootstrapping your business- schmoozing with VCs or angel investors- trying to get a loan- asking friends and family for help

• Crowdfunding and ICOs present an alternative to the above options… but

• Doing it wrong could land you in trouble. Big trouble.

Overview

Questions we hope to answer with this presentation:

• What is (securities) crowdfunding?• How do I engage in crowdfunding legally?• What is an ICO?• How do I conduct an ICO legally?• Assuming I am fully compliant with the law, is a crowdfunding

campaign or ICO right for me/my business?

What is Crowdfunding?Utilizing the Internet to raise money from a “crowd” of investors to support your project. Typically, money is only collected if a stated minimum target is reached.

Rewards vs. Securities Crowdfunding

Rewards Crowdfunding• securities laws don’t apply• mostly unregulated• the sky is the limit on $

raised• you typically don’t “owe”

investors anything in return*

Securities Crowdfunding• securities laws apply• regulated at federal and

state level• limits apply to the $

amount raised• investors expect something

in return

*Though you could be accused of fraud if you promise, say, a copy of your product in exchange for a contribution and then don’t deliver on that promise

What is Crowdfunding?• Reward-based crowdfunding: contribution is made in return

for reward of nominal value– or nothing at all.• Kickstarter• Indigogo• GoFundMe

Rewards Crowdfunding– Success Stories

• Oculus Rift- Raised $2.5 million through Kickstarter to create virtual reality headsets- Sold to Facebook 3 years later for $2 billion

• Astropad (MN company)- Raised over $645,000 on Kickstarter to create Ipad app, Luna Display

• Potato Salad Guy- Set $10 goal to raise money to finetune potato salad recipe- Raised $55,492 on Kickstarter… to make potato salad

Rewards Crowdfunding– (Not so) Success Stories

Reality:

• Crowdfunding does not bring the crowd to you.

• Most successful (Kickstarter) projects raise less than $10k.

• Over 63% (Kickstarter) projects fail to reach minimum target.

What is Crowdfunding?• Securities crowdfunding: Think Kickstarter, but where you

promise investors equity or a financial return in exchange for investment

• Regulation CF• MNvest• SCOR• Other State Regs

Securities Crowdfunding– Success Stories

• Rustech Brewing (MN company)- Raised $62,500 through a MNvest offering to build a brewery

• Tilion Brewing Co (MN company)- Raised $230,000 through a “SCOR” offering to build a brewery

• Silicon Prairie Portal & Exchange (MN company)- Raised $254,000+ money to build its own crowdfunding platform!

Securities Crowdfunding– (Not so) Success Stories

Reality:

• Crowdfunding does not bring the crowd to you.

• Around 40% of securities crowdfunding offerings do not hit minimum target

• Crowdfunding issuers’ ability to repay investors is yet to be seen

How do I engage in crowdfunding legally?Three Initial Questions:

1. What do you give to or promise people in exchange for a financial contribution?

2. Are you engaged in a securities offering?

3. If you are engaged in a securities offering:- is the offering registered or exempt under federal law?- is the offering registered or exempt under applicable state law?

More on questions 2 & 3 later...

How do I engage in crowdfunding legally?To conduct a lawful Securities Crowdfunding offering, you MUST:

1. Conduct the offering through a registered portal (some exceptions apply)

2. Prepare a disclosure document and other required information to provide to investors

3. Comply with applicable geographical restrictions

4. Comply with applicable limits regarding the total $$ raised through the offering

5. Comply with applicable limits regarding $$ raised from individual investors

6. Comply with applicable restrictions on advertisements

Failure to meet the above, and other, requirements will expose you to civil, administrative, and (in a worst case scenario) criminal liability

What is an ICO?

Initial Coin Offering: The sale of cryptocurrency “tokens” to raise money for a business venture or (usually blockchain-related) project.

• “Tokens” can represent different things, not always equity in company

• Investors may be able to invest using US$ or other cryptocurrencies

• Different from Initial Public Offerings (IPOs), which involve sale of stock in the company

What is Blockchain?

A distributed public database that keeps a permanent record of digital transactions.

• Each “block” is a record of a specific transaction, which are linked together and secured in a “chain” using cryptography

• “Transparent” and decentralized• Resistant to modification• Not only used for cryptocurrencies

What is a Cryptocurrency?

A proposed medium of exchange that is created and stored electronically in the blockchain.

• Use cryptography to record and control transactions• No physical form • Cannot always be exchanged for other commodities• No inherent value• Not insured• Not controlled by a central bank or other authority

Cryptocurrencies - Examples

• Bitcoin• Ethereum• Litecoin• Monero• Ripple• Dogercoin• Sia• NZT• ZCASH• 2GIVE

ICOs – Success Stories• Protocol Labs, INC. (Filecoin)

- Raised $257 million via two offerings in 2017.- Filecoin represents data storage on a decentralized storage network

• Wenn Digital Inc. (KODAKCoin) - Raised $6.75 million in 2018.- KODAKCoin is used for payments for licensing photographs

• Telegram Group Inc. – Raised $1.7 billion(!) via two offerings in 2018- Telegram already has messaging service; now aims to create Telegram Open Network that will

become an alternative to credit cards

ICOs – (Not so) Success Stories• REcoin Group Foundation and DRC World– SEC Fraud Charges/

Asset freeze (9/29/2017)• PlexCorps – SEC Fraud Charges/Asset freeze (12/4/2017)• Munchee Inc. – SEC Cease and Desist Order (12/11/2017)• AriseBank – SEC Asset Freeze (1/30/2018)• Cherubim Interests, Inc. – SEC Trading Suspension (2/16/2018)• PDX Partners Inc. – SEC Trading Suspension (2/16/2018)• Victura Construction Group, Inc. – SEC Trading Suspension

(2/16/2018)• Centra Tech – SEC Fraud Charges/ Injunction/ Penalties (4/2/2018)

Source: https://www.sec.gov/news

SEC Actions Involving ICOs• NYTimes: Subpoenas Signal S.E.C. Crackdown on Initial

Coin Offerings (2/28/2018)

• CNBC: SEC Subpoenas TechCrunch Founder’s CryptofundAmid Broader Investigation into Digital Coins (3/2/2018)

• EBIT News: SEC Issues 80 Subpoenas to Cryptocurrency Funds (3/5/2018)

What do Regulators Say?

SEC Chairman Jay Clayton: I have instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.

I believe every ICO I’ve seen is a security.

Source: https://www.sec.gov/news/speech/speech-clayton-012218

Source: Comments in a 2/6/2018 US Senate hearing

What do Regulators Say?

Financial Industry Regulatory Authority (FINRA):

Where [cryptocurrencies] are securities or where an ICO involves the offer and sale of securities, FINRA may review the mechanisms—for example, supervisory, compliance and operational infrastructure— firms have put in place to ensure compliance with relevant federal securities laws and regulations and FINRA rules.

Source: https://www.finra.org/sites/default/files/2018-regulatory-and-examination-priorities-letter.pdf

What do Regulators Say?

North American Securities Administrators Association (NASAA):

The recent wild price fluctuations and speculation in cryptocurrency-related investments can easily tempt unsuspecting investors to rush into an investment they may not fully understand. Cryptocurrencies and investments tied to them are high-risk products with an unproven track record and high price volatility. Combined with a high risk of fraud, investing in cryptocurrencies is not for the faint of heart.

Source: http://www.nasaa.org/44073/nasaa-reminds-investors-approach-cryptocurrencies-initial-coin-offerings-cryptocurrency-related-investment-products-caution/

What do Regulators Say?

Minnesota Department of Commerce:

The Minnesota Department of Commerce is urging Minnesotans to proceed with caution and understand the potential risks of any investment or transaction involving a virtual currency such as Bitcoin.

Source: https://mn.gov/commerce/media/news/?id=81448

Why have so many ICOs gone wrong?

• Is the “coin” really necessary?• Over-hyped• Fraud• Ignoring securities laws

How do I engage in an ICO legally?Four Initial Questions:

1. What does the coin/token really represent? I.e., what do investors hope to get by purchasing the coin?

1. Is the coin a security?

2. If the coin is not a security, why not? (This better be good…)

3. If you are engaged in a securities offering:- is the offering registered or exempt under federal law?- is the offering registered or exempt under applicable state law?

Now to the boring part…

Overview of Securities LawsFederal Laws at Play:• Securities Act of 1933• Securities Exchange Act of 1934• Investment Company Act of 1940

State Laws at Play:• Minnesota Securities Act• Other States’ Laws

Enforced by:• SEC• FINRA

Enforced by:• MN Dept. of Commerce• State securities regulators• Attorneys General (?)

What do securities regulations do?• Require registration of securities offerings, unless exempt• Limit who can sell securities• Limit how securities are sold• Impose reporting requirements• Impose anti-fraud provisions

*Tip: Its all about disclosure; say what you do, do what you say

Is it a Security?“Security” is defined broadly in federal (and state) statutes:

Securities Act: The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

*Tip: When in doubt, assume it’s a security.

Is it a Security?

SEC v. Howey, 328 U.S. 293 (1946)

Establishes 4-part test for defining “investment contract”1. A person invests money2. In a common enterprise3. Is led to expect profits4. Solely from the efforts of others

Is it a Security?

The Howey Test isn’t the only game in town

• State v. Gopher Tire• SEC v. C.M. Joiner• State v. Investors Security Corp• Others

Tip: Don’t be an arm chair lawyer!

Its Not a Security, it’s a “Utility Token!”Ask yourself:• How is the token marketed?• What do investors hope to get out of the token?• Are investors only motivated by “utility” use, or also by hope

the value of the coin, itself, will increase?• Has SEC taken action against similar “utility” tokens?

“Whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.” – 7/25/2017 SEC Press Release

Planning to say its not a Security?

Minnesota Securities Act, Section 80A.70; EVIDENTIARY BURDEN.

(a) Civil. In a civil action or administrative proceeding under this chapter, a person claiming an exemption, exception, preemption, or exclusion has the burden to prove the applicability of the claim.

(b) Criminal. In a criminal proceeding under this chapter, a person claiming an exemption, exception, preemption, or exclusion has the burden of going forward with evidence of the claim.

*Tip: Do your homework first, not after you receive a subpoena

Must it be registered with the SEC?Securities Act Sec. 2: Unless a registration statement is in effect, it is unlawful to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell a security.

But… several exemptions apply.

*Tip: Before applying for registration, always consider whether an exemption applies

Must it be registered with states?Minnesota Securities Act: It is unlawful for a person to offer or sell a security in Minnesota unless:- The security is a federal covered security;- The security, transaction or offer is exempted from registration- The security is registered with the Minnesota Department of

Commerce

Other states have similar requirements

*Tip: Review registration/exemption requirements in every statewhere offers occur

Finding an Exemption1. How much money do you need?2. Do you want non-accredited investors?3. Do you want to advertise?4. Where (in which states) do you want to raise money?5. How much money can you afford to spend?

Common Exemptions

Federal Exemptions State (MN) Exemptions

Rule 506(b) of Regulation D+ [federal preemption applies] +

Rule 506(c) of Regulation D+ [federal preemption applies] +

Rule 504 of Regulation D+ SCOR (Minn. Stat. 80A.50(b))*

Regulation A Tier 2* [federal preemption applies]

Regulation A Tier 1* Must register with state(s)*

Regulation Crowdfunding (Reg CF) + [federal preemption applies]

Section 3(a)(11) and Rule 147A MNvest (Minn. Stat. 80A.461) +

+ Requires a notice filing* This “exemption” is actually a simplified registration requirement.

This chart identifies common exemptions from federal securities law requirements, and state (Minnesota) exemptions/requirements commonly paired with those federal exemptions.

How much money do you need?

• As much as possible • Up to $50 million• Up to $20 million• Up to $5 million• Up to $2 million• Up to $1 million

Unlimited (Rule 506(b) or (c))

$50 million (Reg A Tier 2)

$20 million (Reg A Tier 1)

$5 million (Rule 504/SCOR)

$2 million (MNVest)

$1 million (Reg CF)

Do you want non-accredited investors?

Accredited investors include individuals who:• for the past two years, have made at least $200,000 per year (or

$300,000 if joint with a spouse’s income) • have a net worth of at least $1 million, not including the value

of the individual’s home.

Most people (around 95% of the U.S. population) do not meet these thresholds, making them non-accredited investors

Do you want to advertise?• Some securities regulations prohibit general advertising or

solicitation.• General advertising and solicitation occurs when you share

information about the offering with someone with whom you do not have a preexisting, substantial relationship. This could include:

• Social media posts• TV/newspaper interviews• Verbal conversations with strangers

Advertising Violation?

A metaphor:

Don't celebrate your sea salt for being "formed by the primal sea more than 250 million years ago" without also disclosing it expires next year.

Source: https://i.redd.it/3ent6tkrz4c01.jpg

What if this was a securities offering?

Advertising Violation?

“A University of Minnesota professor is hoping to raise money to research the parasite that's devastating Minnesota's moose population. […] While researchers also plan to apply for research grants, Wolf said the $6,000 funding goal at the university's crowdfunding site is a good way for members of the public to help the research along. So far about half of the goal has been raised.”

Where do you want to raise money?• All securities offerings must comply with both federal and state

securities laws.• To avoid registering the offering, you will need to comply with

an exemption in each state where securities are offered or sold.• Some federal regulations (e.g., Rule 506(b) & (c), Reg CF)

preempt state regulations, though you may still need to file notice of the offering with state(s).

How much can you afford to spend?• Each of the options discussed here involve some form of

regulatory filing.• Some require lengthy disclosure documents. • Some require audited/reviewed financial statements.• Some require ongoing reporting.• Legal, accounting, and filing fees can be expensive

Common Exemption Options

Question Regulation CF MNvest Rule 504/ SCOR + Reg A Tier 1 Reg A Tier 2 Rule 506(b) Rule 506(c)

How much money do you need?

Up to $1 million allowed

Up to $2 million allowed

Up to $5 million allowed

Up to $20 million allowed

Up to $50 million allowed

Unlimited amount allowed

Unlimited amount allowed

Do you want non-accredited investors?

Non-accredited allowed, but

investment limits apply

Non-accredited allowed, but

investment limits apply

Non-accredited allowed, subject to

state law requirements

Non-accredited allowed

Non-accredited allowed, but

investment limits apply

Up to 35 non-accredited

allowed, so long as they are

“sophisticated”

Non-accredited not allowed

Do you want to advertise? *

Only limited advertising

allowed

Only limited advertising

allowed

Advertising allowed, but only in states where

registered

Advertising allowed

Advertising allowed

Advertising notallowed

Advertising allowed

Do you want to raise money from investors in multiple states?

Sales permitted in all states

Sales permitted in MN only

Sales permitted in all states where

state law requirements are

also met

Sales permitted in only those states

where the offering is qualified

Sales permitted in all states

Sales permitted in all states

Sales permitted in all states

How important is it to you to minimize legal & accounting fees? **

Highest Costs Medium Costs Medium Costs Highest Costs Highest Costs Lowest Costs Lowest Costs

This chart contains limited information only and is not provided as legal advice. This chart does not address “bad actor” restrictions, integration issues, anti-fraud provisions, regulations applicable to finders, agents, broker-dealers or investment advisers, reporting requirements, or other regulations that may apply to a company conducting a securities offering. Companies planning to engage in equity crowdfunding should consult an attorney and an accountant before commencing the offering.

Is Crowdfunding or an ICO right for me?• Do you have a well thought-through business plan?• Do you have a marketable story?• Do you have a “crowd” of interested persons ready to support

you?• Do you have a compelling idea for using blockchain

technology?• Are you comfortable with securities law compliance?

Securities Crowdfunding– Success Stories(Revisiting)• Rustech Brewing (MN company)

- Raised $62,500 through a MNvest offering to build a brewery

• Tilion Brewing Co (MN company)- Raised $230,000 through a “SCOR” offering to build a brewery

• Silicon Prairie Portal & Exchange (MN company)- Raised $254,000+ money to build its own crowdfunding platform!

ICOs – Success Stories (Revisiting)• Protocol Labs, Inc. (FileCoin) – raised $257mm from accredited

investors via two 506(c) offerings (8/7/2017 and 8/25/2017)

• Wenn Digital Inc. (KodakCoin) - raised $6.75mm from accredited investors via 506(c) offering (1/16/2018)

• Telegram Group Inc. – raised $1.7 billion(!) from accredited investors via two 506(c) offerings (2/13/2018 and 3/29/2018)

Questions?

Brian Edstrom David Duccini612-584-3407 651-645-7550bedstrom@avisenlegal.com David.Duccini@sppx.io