Here’s How Entrepreneurs Can Make Their ICO Securities Compliant With Reg A+

Is it possible to make an initial coin offering that complies with U.S. SEC security rules? The good news is yes, and you can use Regulation A+ to do so. But you may need a bit more patience than you expected.

With approximately $2 billion of capital raised worldwide this year alone, it’s fair to say that initial coin offerings (known as ICOs and very different than IPOs) are causing a great deal of change in how startups raise capital. The rate of change in ICOs, digital currency markets (think Bitcoin and Ether) and in the blockchain field has been so fast that regulators are scrambling to catch up.

In the U.S., there has been a period of wishful thinking among some ICO entrepreneurs, who have charged forward with ICO plans that assumed the SEC would allow a relaxed playing field — and some U.S. ICOs have taken place that were made based on these optimistic assumptions.

In July, however, the SEC made it clear that in some cases initial coin offerings are considered securities transactions, which must, therefore, comply with existing SEC securities regulations — the exception being those that pass the “Howey Test“, which is difficult to pass with confidence. Few ICOs do.

This step by the SEC was helpful because it removed the uncertainty many were feeling. But of course, this new context places U.S. ICO entrepreneurs in a challenging situation. The ambient expectation about ICOs is that they are simple, low cost, and can be completed in weeks while raising large amounts of capital easily.

Those expectations are difficult to reconcile with the need to slow down and wrestle with existing securities rules and regulations, and the confusion and expense that come from learning about them and complying with them.

So when a U.S. entrepreneur reaches the conclusion that their ICO must comply with one or other U.S. securities regulation and accepts that there will be a significant cost, plus time and effort involved, what approach will work best? This is where I see some good potential.

It turns out that Regulation A+ is a rather good partner for ICO’s:

• Reg A+ allows investors worldwide, of any wealth level, to participate – providing very democratic access to capital — which is one of the mainstays of ICOs.
• ICOs use a White Paper to describe their offering in an informal manner. The Reg A+ equivalent is the Offering Circular, which is far more specific and detailed, and complements and expands on the usual white paper.
• Reg A+ allows capital raises of up to $50 million per year, enough to cover the needs of many ICOs.
• Broad marketing to investors is allowed in Reg A+, which suits ICOs.
• Reg A+ requires Anti Money Laundering checks for all investors as part of the validation of investors, and background checks on the principals of offering companies, which is a good practice for ICOs to enhance their credibility and reduce the risk of loss.
• Reg A+ allows offering companies to test-market their offering in an informal manner called “testing the waters.” ICOs can use this process to gauge interest, and while it is not a replacement for the “pre-invest with discount” phase that ICOs use, there is enough potential here to make it worth considering.
• Reg A+ provides for liquidity for resale of investments purchased by the Reg A+ investors, just as ICOs do. Note that there are restrictions here for Reg A+ that I will explain later.
• The ways in which a Reg A+ offering is put together matter greatly in generating a successful outcome, and many of the success factors are similar to those for ICOs.

In essence, Regulation A+ provides the U.S. ICO entrepreneur with a viable path to compliance with SEC securities regulations , while allowing the ICO to provide many of the engaging aspects that make it such a popular capital raising system.

An important step in using Reg A+ for an ICO is the proper use of Smart Contracts and the Token Software. Smart Contracts are intelligent software programs that enforce the rights and limits of a company’s specific token, while each ICO token is programmed using blockchain logic to be inherently intelligent and aware of its situation, context, and history.

These two components must be programmed so that the tokens will automatically restrict themselves to transactions that adhere to the specifics defined and stated in their particular Regulation A+ offering.

A good example of this is that SEC-allowed exchanges must be used. I know of one that has been pre-announced as of now; Overstock.com’s Medici.

Reg A+ has settable options, and of course, each offering has terms that are specific to it. These must be built into the Smart Contract and the Token up front. This will take thought, discussion, and legal advice.

Most Reg A+ offerings are made using Tier 2, which has the requirement of an audit up front and ongoing reporting obligations post offering of profit/loss and revenue reporting every six months with an annual audit and significant changes to the business must also be reported when they take place. These reporting obligations are a downside of Reg A+ Tier 2.

However, for ICOs that choose to accept investors from a small number of U.S. States that are easy and fast to make Blue Sky filings with, and therefore to depend heavily on non-US investors for a large part of their capital raise, then the Tier 1 Reg A+ can be appealing.

Tier 1 is limited to $20 mill per year, and the post offering reporting obligations are far simpler. Material changes to the business must be reported, no annual audit is required, and an audit is not required when starting this form of Reg A+.

I have calls with ICO entrepreneurs about making compliant ICOs often these days, and I see a tendency for some to make the following three mistakes that I want you to avoid:

• Denial about their ICO being a securities offering, despite the SEC ruling. Some entrepreneurs seem to have received advice or are otherwise attached to the belief that because they are launching an ICO with a freely tradable token, they are somehow immune from securities rules. This is so rarely the case. It turns out that passing the Howey Test is remarkably difficult to do with confidence. My advice: Get a second opinion before you take the risk of forging forward – before it’s too late.
• Hoping to retrofit a Reg A+ offering to an ICO that’s going live to investors in a few week’s time. That is just not possible to do. The process of filing to have a Reg A+ offering qualified by the SEC takes at least 60 days, plus preparation time and the software work — and more. At such a late stage the only thing to do is to pause the ICO, make the Reg A+ filing or make a Reg D 506c offering, which is much faster to implement and costs less to set up, but is restricted to accredited (wealthy) investors. Then continue the ICO once the needed steps have been taken.
• Strap-on tokens. A company that is not a natural ICO will not become a viable ICO just because a token is added. The token must be relevant to the fundamentals of the business, it must add real value and it must be attractive for its potential network growth effects. A conventional company with a marginally relevant or linear token without strong network effects will likely fail to gain sufficient investor interest when the offering goes live.

I hope that the US ICO entrepreneurs who read this article will find it helpful in clarifying a practical way forward for securities compliant ICOs. Stay tuned for more on this subject!

Please know that I am not an attorney, so do not interpret my writing here as if I am one! There are excellent securities attorneys that can quickly advise ICO entrepreneurs in a cost-effective and efficient manner.

Rod is a Forbes Contributor. Read the read the full version of this column on Forbes.com.

Rod Turner is a seasoned serial entrepreneur. CEO of Manhattan Street Capital, he helps CEOs raise capital via IPOs, Regulation A+ and Compliant ICOs for Mid-Stage companies.