Overview of the Regulation A+ Offering Circular for Crypto Tokens
By Bart Mallon
Co-Managing Partner, Cole-Frieman & Mallon LLP
It is generally accepted that the initial coin offering (ICO) from mid-2017 is dead and that firms raising money for their blockchain or token projects will need to do so in a way that is compliant with SEC laws and regulations. For many groups, this means raising money through general private placements or various SAFTs (simple agreement for future tokens) and SAFEs (simple agreement for future equity). However, raising money in this manner does not put the seller’s tokens in the hands of a mass audience which is an important element for groups who are trying to obtain network effects for their project. One alternative to traditional private offerings for token projects is the Regulation A+ public offering of tokens for up to $50M in proceeds. Although Regulation A+ has been a potential avenue for a number of blockchain groups, it has been an untested and it was unclear what the time or costs would be to complete such an offering. This all changed with the Blockstack public offering of tokens pursuant to Reg A+.
Through considerable time and cost, Blockstack submitted its Regulation A+ “Tier 2” offering to the SEC for “qualification” to publicly sell its tokens (Stacks Tokens) on April 11 2019. We have reviewed all 203 dense pages of Blockstack’s Offering Circular (which is estimated to cost $1.8M in legal and accounting fees to produce) and take this opportunity to discuss the unique characteristics of the the offering which any token project will need to address in the future. While we can see that this will be the first step in standardizing token offerings under Regulation A+, we also see that there are a number of legal, business and operational issues that any token sponsor will need to address in what will inevitably be a “not as easy as advertised” process with the SEC.
What is Blockstack & the Stacks Token?
Blockstack is a blockchain platform with a goal of “sponsoring and commercializing an open-source peer-to-peer network using blockchain technologies to ultimately build a new network for decentralized applications.” The platform has been designed to do a number of things that current blockchains and centralized working solutions (i.e. Google Docs) do, but with a focus on decentralization and a high level of privacy. Blockstack is introducing use cases which include a browser, universal user accounts and personal data lockers which are all designed to give users control over their personal data. Eventually the blockchain will allow for more decentralized apps and a smart contract platform with a new smart contract language and more clarity on costs for use of the language.
The Stacks Tokens on the Blockstack network, which are being sold in the offering, will ultimately be used as fuel for running the smart contracts on the blockchain (the tokens will be burned). The Stacks Tokens will also be used by consumers as payments for the decentralized applications that will live on the network. Tokens will also be used for polling purposes and other incentives. In general, the platform looks very similar to other smart contract platforms with some technical differences. The project sponsored is Blockstack PBC, a Delaware public benefit corporation, a company with a number of well-healed and well known investors. For more information on the Stacks Token and project as a whole, you can see their sales deck for the token offering.
$50M Regulation A+ Raise
The proceeds from the raise will be generated through two different programs – the cash program and the app-mining program. Together the programs will raise $50M in consideration over the 12 months following the “qualification” of the offering.
In the cash program, there are two different sales prices for the tokens based on whether the tokens are sold in exchange for vouchers (to persons who indicated interest to Blockstack in November and December of 2017) or if they are sold in the general offering. The price is $0.12 per token (up to 215M tokens) for investors who participated in the voucher program and $0.30 (up to 40M tokens, but can be modified to be up to 62M tokens) for investors who participate through the general offering. The total consideration amount from the cash program (vocher and general offerings) will not exceed $38M, but the total amounts are subject to the tokens ultimately distributed through the app mining program, which is variable.
App Mining Program
Blockstack is offering tokens as rewards to certain developers of applications on its blockchain. [Include more here.] These token rewards are being included as part of the Reg A+ offering because they may be deemed to be investment contracts and/or as part of the offering. Pursuant to this program, all gifted tokens will be deemed to be work $0.30 per token for the first three months after the qualification of the offering, and then based on current market prices for the tokens. The idea is that Blockstack is getting consideration in-kind with work provided on its blockchain and is paying for that work with tokens.
Other Aspects of the Offering and Business
There are a number of other interesting legal and business items which were discussed throughout the offering circular. Many of these items are unique to Blockstack’s business, but many will have general applicability to future Reg A+ digital asset offerings.
- Finalizing tokens offered in program – as previously discussed, the total amount of tokens sold through the offering is not set in stone. Directly after the SEC deems the offering “qualified”, Blockstack will finalize the allocation of tokens between the cash and app mining programs. A sale of the tokens will open 28 days after the SEC deems the offering to be “qualified”.
- Tier 2 investor qualification – the offering is a “Tier 2” offering which means both accredited and unaccredited investors will be allowed to invest. Because it is a Tier 2 offering, the unaccredited investors are limited to invest 10% of the greater of annual income or net worth.
- Concurrent Reg S offering – Blockstack is raising additional capital from non-US persons in a concurrent offering. The tokens sold in the Regulation S offering will be subject to a 1 year lockup (investors cannot use during the lockup period) and are being sold at $0.25 per token.
- Tokens subject to a time-lock – for many reasons Blockstack has chosen that the purchased tokens will be introduced to the platform over time, with full distribution of all sold tokens 2 years after the qualification of the offering. Blockstack will release 1/24th of the sold tokens at inception, then will release 1/24th of the sold tokens once a month thereafter (every 4,320 blocks on the bitcoin blockchain).
- No restriction on transfers of tokens – this offering is not of restricted securities (see our earlier post about token distribution issues / restricted securities) and are free usable and tradable (on a registered exchange or ATS) upon release from the time-lock; however, Blockstack believes the Stacks Tokens will not initially trade on any crypto exchanges and this will make it hard to sell the tokens.
- “Cap Table” – there was much information presented about the current token float (the genesis block created 1.32B tokens) and the amount of tokens sold in previous offerings (various private placements and SAFTs). After all the offerings and various distributions, there will be 116M tokens unallocated that Blockstack will control and can utilize however they wish. Many of the issued tokens have been or are being provided to related entities to compensate employees, similar to stock option grants.
- Use of proceeds – as is the case with most all offerings, there is a discussion of how the sponsors will use the cash proceeds from the sale. Blockstack also discusses the use of the cash proceeds under different levels of total subscription (25%, 50%, 75% and 100%).
- Milestones – through a previous funding round, Blockstack was provided with capital if they met certain milestones with respect to the development and adoption of the Blockstack network. While they easily met the first milestone (technical implementation of certain features of the blockchain), it is unclear if they will meet the second milestone (dealing with adoption of the network). They will be required to “return a significant amount of capital that Blockstack currently intends to use in the development of the Blockstack network.” The milestone is 1M verified users by the end of January 2020. Blockstack specifically says that at current growth rates it will not achieve the second milestone.
- Hard Fork from Bitcoin – Blockstack currently runs as a virtual blockchain on the bitcoin network. It will ultimately transition over to its own blockchain when it has a large enough network to maintain security. This will involve a “hard fork” to the Blockstack network and its associated risks.
- Risk Factors – as with any public or private placement, there are attendant risks which are disclosed to potential investors. These include normal investment risks (operations, catastrophic events, etc) and general risks related to digital/crypto (loss of token, irreversible, loss of keys, various hacks, forks, volatility, uncertain tax treatment, etc), however, there were a number of interesting Blockstack specific risks including: risk of not attracting both users and developers to the platform, the time-lock risk, regulatory risk (does not have New York BitLicense, is not a money transmitter or money services business, potential violation of Regulation M with respect to its activities in its own tokens, etc).
Legal Issues Presented
In addition to the description of many of the business issues related to the creation of the blockchain, there are a number of novel legal issues presented and addressed in the offering circular. Below we have identified the most interesting of these issues and have included how Blockstack has addressed them.
- Are the tokens securities? Blockstack believes that the current tokens (non-sufficiently decentralized) are a type of security called an investment contract and are not equity or debt securities:
We do not believe that the Stacks Tokens should be characterized as either debt or equity under the securities laws. We believe that these tokens should currently be characterized as investment contracts. Holders will not receive a right to any repayment of principal or interest, as might be expected under a traditional debt instrument; nor will they receive an interest in the profits or losses of any Blockstack affiliate, any rights to distributions from any Blockstack affiliate, or any legal or contractual right to exercise control over the operations or continued development of any Blockstack affiliate, as might be expected for a traditional equity instrument.
- When will the tokens be “sufficiently decentralized” so they are no longer securities? This is one of the most important questions of the offering and essentially addresses the question of when the SEC will lose jurisdiction over the tokens in the offering and when/how Blockstack can issue, sell or otherwise use the tokens as rewards for certain activity on its blockchain.
The board of directors of Blockstack PBC will be responsible for regularly considering and ultimately determining whether the Stacks Tokens no longer constitute securities issued by us under the federal and state securities laws of the United States. In making this determination, the board will refer to the relevant legal and regulatory standards for such determination in effect at the time of such determination, will consult with legal counsel and will, if possible and appropriate, seek consultation with relevant regulatory authorities including, we expect, the Commission. At the present time, based on the guidance cited above, we expect this determination to turn the SEC’s recent guidance on the application of the test under SEC v. W. J. Howey Co. (the “Howey test”) to digital assets set forth in its release “Framework for ‘Investment Contract’ Analysis of Digital Assets,” and specifically on whether the Blockstack network is sufficiently decentralized, which will, in turn, depend on whether purchasers of Stacks Tokens reasonably expect Blockstack to carry out essential managerial or entrepreneurial efforts, and whether Blockstack retains a degree of power over the governance of the network such that its material non-public information may be of special relevance to the future of the Blockstack network, as compared to other network participants. Under current guidance, Blockstack would expect to take the position that if the answers to these questions are that purchasers do not and Blockstack does not, the Stacks Tokens will no longer constitute a security under the federal and state securities laws of the United States. The board of directors of Blockstack PBC may also assess other criteria for making this determination, including any criteria based on additional guidance we receive from U.S. regulators. …
In the event that the board of directors of Blockstack PBC determines that the Stacks Tokens are no longer a security issued by Blockstack Token LLC, Blockstack will make a public announcement of its determination at least six months prior to taking any actions based on this determination, such as filing an exit report on Form 1-Z terminating its reporting obligations with respect to the Stacks Tokens under Regulation A.
- Are any actors related to Blockstack or its blockchain required to be registered in any way? Here, Blockstack addresses the issue of whether certain actors are required to be transfer or clearing agents because of their relationship to the blockchain and creation or distribution of the tokens:
We have taken the position that Blockstack, the miners on the network, and the network’s blockchain are not required to register as transfer agents, both because the Stacks Tokens are not currently securities registered under Section 12 of the Exchange Act, and because none of the activities Blockstack, the miners, or the blockchain is involved in are described in the definition of a transfer agent. In addition, to the extent that certain activities that meet the definition of a transfer agent are performed automatically on the blockchain, the blockchain is not a “person” that would be required to register. …
We have taken the position that Blockstack, the miners and the blockchain are not clearing agencies under the Exchange Act because the types of activities they engage in are not those described in the definition of a clearing agency. To the extent that these activities occur on the blockchain, the blockchain is not a “person” that would be required to register.
Blockstack has included similar discussions related to questions on whether it or any related actor is an investment company, broker-dealer, money transmitter, money services business, or subject to New York BitLicense requirements. All of these discussions conclude that the way the current blockchain works, and pursuant to the current interpretation of the securities laws, Blockstack and related actors would not be required to register as any of the above. It is possible that the SEC or the various state securities regulators could disagree with conclusions presented in the offering circular.
- Is the Blockstack Network or the browser an ATS? The issue of what actors may be deemed to be an ATS is an open one and will eventually be an important issue when the SEC provides FINRA and the digital asset industry with future guidance. (HFLB note: SEC and FINRA just recently released a joint statement on digital asset custody which we will be reviewing shortly.)
We have taken the position that neither the network nor the Browser should be viewed as an exchange or an ATS because neither will “bring together” anyone by sorting or organizing orders in the Stacks Tokens in a consolidated way or by receiving orders for processing and execution of transactions in the Stacks Tokens. Instead, each proposed transaction involving Stacks Tokens on the network will by individually negotiated and implemented. For example, transactions by users (such as developers or users of Decentralized Applications) will be posted on an individual basis. In addition, we will be the only “seller” of Stacks Tokens when we distribute them as rewards on the network. …
We also take the position that payments on the network and the Browser for services do not involve “orders” of securities, because they are not primarily purchases of securities. Instead, these payments are commercial sales of access to Decentralized Applications or of items bought through in-app purchases.
It is clear that Blockstack has carefully thought through the business and legal issues involved in launching a Regulation A+ capital raise in order to expand a blockchain and token network. While the offering circular provides thoughtful analysis, it also highlights the many unresolved issues that plague the digital asset space. The digital asset industry in the US is starved for clarity on many of these issues and, if this offering is ultimately qualified, it will be a large step forward in solidifying how token sponsors should proceed with capital raises. Blockstack spent a lot of money to produce the offering circular and we must hope that this filing, or a filing similar to this, can become the template for blockchain token projects of the future.
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.