ICOs began as a way to crowdsource funds, built on a similar protocol to that of Bitcoin, the world’s first cryptocurrency. As a nascent financial vehicle, ICOs initially functioned without regulation until the SEC began to enforce the Howey test on ICOs, seeking to determine if they qualified as securities, thereby limiting the scope of ICO fundraising. Now, because of increased regulation, private placement ICOs have become more popular since they bypass regulation.
Tech companies shaped around blockchain technology and cryptocurrency began to emerge, with their own ERC20 tokens and their own identity. From there the concept progressed, as tech companies began to integrate cryptocurrency as a funding method for more complex business ideas that had been built into a blockchain structure for fundraising purposes.
In under two years, the money raised through ICOs had increased from $56 million in March 2016 to over $2 billion in September 2017. That $2 billion was matched by April 2018. This is not an insignificant sum, and it caught the attention of regulatory agencies, specifically the SEC. The CFTC, IRS, and FinCEN also took notice of the goings on with cryptocurrency.
Although cryptocurrency was developed to be a decentralized monetary system and therefore not under the regulatory requirements of fiat money, the changes to ICO events and the tremendous values attached to them made tokens start to look a lot like securities. Not only that, the SEC noticed that ICO token sales, in general, we’re starting to strongly resemble exchanges.
The SEC declared in a June 2017 report (the DAO Report) that digital currencies such as Bitcoin and Ethereum could be considered securities, and as such, traditional security regulations could apply to them. This led to a flurry of activity and effort by legal cryptocurrency stakeholders to establish compliance that would be amicable to both the SEC and the cryptocurrency world. Most notably, Protocol Labs in collaboration with Cooley LLP wrote a White Paper which laid out a conceptual framework for how token sales might fit into securities laws.
In the meantime, there was a notable shift toward a new concept in blockchain funding. It was labeled the “Private ICO.”
What is a Private Placement ICO?
- Private Placement ICOs operate within Reg D, which allows private securities to be issued without the demanding and sometimes crippling requirements of an IPO (Wall Street’s original fiat equivalent of an ICO).
- Token sales, rather than being publicly offered through a crowdfunding event, are offered only to accredited retail investors and institutions. To be an accredited investor, one must have over $1 million in net worth, or an annual income of over $200,000 ($300,000 for couples).
- Trading is restricted for a year under Reg D, meaning that exchange of assets is unavailable for an entire year. This is good because tokens are not sold immediately to third party buyers, but bad because initial investors don’t personally hold tokens for the first year, making protocol functionality a challenge.
Why are Private Placement ICOs a good thing? Because they operate within the regulatory requirements set forth by the SEC in Reg D, Rule 506, some of the legal uncertainty is addressed. With measures such as the SAFT, which is modeled after the Y Combinator SAFE notes (used to finance early stage venture capital companies) loosely set in place, the hope is that certain risks are mitigated.
Regardless, it is encouraging to see the blockchain world proactively cooperating with potential regulatory issues.