One of the unique aspects of the blockchain movement is that it has been driven almost entirely by retail investors. Blockchain, the most popular wallet provider and custodial solution for crypto assets, just hit 25 million wallets in June. To give you some perspective, that's more customers than TD Bank, Charles Schwabb, and E-Trade have combined. And although there has been speculation for some time about institutional capital moving into the market, for the time being the vast majority of those wallets are owned by small investors.
Looking back at 2017, there were several factors that led to the hyperbolic run-up of crypto assets, but there was one driver responsible for most of the growth: people figured out you could pre-sell tokens. In 2017, entrepreneurs discovered that they could bootstrap the creation of blockchain networks by selling tokens before the networks were operational. And once it became apparent that there were people willing to pay for (essentially) the promise of tokens, the result was the staggering bull run of 2017. This realization also led to the tokenization of many other kinds of assets.
Now, unbeknownst to these entrepreneurs, the definition of the tokens they were selling changed when they began to sell them before there was an operational network. There's a very specific term that's used to describe the sale and purchase of an asset with the expectation of one day returning a profit, and that is a security. Once blockchain entrepreneurs began to sell securities, the smart money in the space realized it was only a matter of time before the SEC got involved. That realization led to the creation of the SAFT.
What is a SAFT?
SAFT stands for "Simple Agreement for Future Token." The white paper framework was created by a team at Cooley headed by Marco Santori, who is now President & Chief Legal Officer at Blockchain (mentioned above). The full description of a SAFT and its implication for future token sales is beyond the scope of this article (you can get a more in depth account here) but the gist is that it allows for the pre-sale of tokens in a way that is compliant with securities law. The catch? Only accredited investors are allowed to participate. Here's the basic description of how the framework plays out.
1. The token issuer enters into a written agreement with a group of accredited investors. This written agreement is called a SAFT, and is an agreement for the network developer to sell a pre-specified amount of tokens at some point in the future for some amount of money.
2. This written document, the SAFT, essentially becomes a security that is Reg D compliant (more on this later). In this framework, this agreement (i.e piece of paper) is the security, and no pre-functional tokens are issued.
3. The network is built (hopefully). Once it's operational, functional tokens are issued in the amount specified in the SAFT to the group of accredited investors.
The basic framework was predicated on the SAFE (Simple Agreement for Future Equity), originally pioneered by Y-Combinator. Hats off to Marco, it's a nifty little get out of jail free card that will allow blockchain developers to raise capital (largely) the same way they did in 2017. The catch? Only accredited investors can get in on the fun.
How to Comply with Securities Law 101
There are three different ways to be compliant with securities law. Regulation D, Regulation A+, and Regulation S. I've included the description of each type of compliance provided by Anthony Pompliano's in his article "The Offficial Guide to Tokenized Securities", which I recommend you all read.
"Regulation D — This allows an offering to avoid being registered with the SEC, but requires an electronic filing of “Form D” after the securities have first been sold. The individuals offering the security may generally solicit investors for an offering that meets the requirements of Section 506c, which requires verification that the investors are accredited and the information provided during the solicitation must be “free from false or misleading statements.” In most cases, investors who purchase a Regulation D offering may not sell their ownership stake for at least 12 months after their initial purchase.
Regulation A+ — This exemption allows an issuer to offer a security qualified with the SEC to non-accredited investors through general solicitation for up to a total of $50,000,000 in investment. Due to the requirement to register the security, Regulation A+ issuance can take longer compared to other options. Regulation A offerings require qualification of a Form 1-A offering circular, including audited financials. Due to the requirement to qualify the security and complete an audit, Regulation A+ issuance can cost more and take longer compared to other options. Regulation A+ offerings treat all money raised as revenue and tax it as such if the money doesn’t represent equity in the underlying company.
Regulation S — This is when an offering of securities is deemed to be executed in a country other than the US and therefore not subjected to the registration requirement under section 5 of the 1933 Act. Issuers of the security are still required to abide by the security regulations in each country where they offer their security."
Most blockchain companies have either vied for Reg D or Reg S compliance. Companies that want to be perceived as legitimate will generally opt for Reg D compliance, as incorporating outside of the US will inevitably raise suspicion from investors. Don't get me wrong, I think that companies striving to be compliant is a massive step in the right direction. The only issue with being Reg D compliant is that tricky article about accredited investors, because the end result is that it's shutting out anyone with a net worth of less than $1 million from early investments in token networks. So why does the SEC mandate that only accredited investors can invest in Reg D compliant securities?
There's Actually a Pretty Good Reason
Let's take one step back and ask what it means to be an accredited investor. It's a pretty loose term, and it means different things in different countries. There are several criteria you can meet to become one in the US, but generally you need to meet the requirement of having a net worth of over $1 million. In other countries, like the UK, investors with any net worth can assume enterprise risk if they successfully complete an additional qualification exam. Governments have created this class as a way of identifying investors with the level of financial intelligence needed to engage in extra risky investments.
In a lot of ways, the SEC restrictions are an appropriate measure designed to protect retail investors from putting more money than they can afford to lose into risky investments. The rationale behind the rule is that it is extremely difficult to thoroughly vet a company if the organization hasn't registered its shares as securities yet. Once a company is compliant, there are all sorts of measures (standard reporting style, internal financial transparency, etc...) that make it easier to due diligence. There's also the argument that an individual with a higher net worth would be able to weather the loss of their investment more easily.
Why the Current System Isn't Really Fair
The long running counterargument to the SEC's refusal to allow non-accredited investors to invest in certain riskier asset classes is that it perpetuates the 'rich will get richer' cycle. Risky investments present the greatest opportunity for outsize returns. Many have argued that by only allowing the richest 1% of Americans to participate in financially transformative investments, the government is putting a ceiling on upward mobility.
My view is that the criteria for determining an accredited investor don't make a whole lot of sense. Having a certain net worth does not (in my opinion) act as an accurate test of financial sophistication or intelligence. Just think about how many people have made their money in ways that don't promote financial intelligence. Better yet, think about people that didn't make their money at all and inherited it.
The other side of the coin is just as bad, if not worse. How can the SEC possibly determine that you aren't financially savvy for not having achieved a certain level of wealth? Think about all of the financial analysts, correspondents, authors, etc... who don't have $1 million to their name.
It seems to me like net worth (or the minimum income requirement of $200k for two consecutive years) is at best a poor proxy for financial intelligence. At the very least, if the rationale behind restricting access to Reg D compliant securities to accredited investors is truly protectionary, investors should be allowed to take some sort of test to prove their financial competence. The fact that no such qualification exists isn't even with so many people calling for it kind of says it all.
How to Change the Rules
As was previously mentioned, most of the growth in the crypto thus far has been driven by retail investors. Blockchain (the company, not the technology) alone oversees more than 25 million wallets. For the first time, many 'un-accredited' average joe's are beginning to take a stronger hand in their own finances. And for many people, that has meant questioning the SEC's accreditation requirements now that their investment vehicle of choice (ICO's) may no longer be available to them.
Ironically, as volatile as crypto assets are, they're probably one of the most level playing fields for investors in the last couple of decades. Naval Ravikant has famously said that there are only a couple hundred people in the world who have the level of knowledge to actually invest in this space (as oppose to speculate). In fact, you could make the argument that if you've made over $1 million in the traditional financial system, it's more likely that you know nothing about crypto or blockchain than if you haven't made $1 million.
The booming market for crypto assets (current downturn aside) is coming at an opportune time. The Dodd-Frank Act requires that the SEC requires a review of the definition for accredited investors every four years. The last review was in December of 2015, which means we'll have another mandatory review taking place in just over a year. One of the most exciting things about the blockchain space is the opportunity to rewrite the rules. There will never be a time that makes more sense to re-evaluate what it means to be a 'sophisticated investor' than in the nascent stages of an industry.
Changing the rules will require coordination among the community and someone to take the lead. But I, at least, am hopeful that we can make a difference.