How to legally finance blockchain projects?

Speculate in bull market, do things in bear market

Before the next Bitcoin halving or the bull market that will accompany it, smart friends have already started to make relevant arrangements. The most obvious thing is that there are more friends who come to consult the Mankiw team for project financing.

In the process of communicating with entrepreneurs, it is inevitable to talk about the SAFT (Simple Agreements for Future Tokens Future Token Investment Agreement) that people in the circle often say. What is the legal effect of SAFT? Can it really meet the legal compliance needs of Chinese entrepreneurial teams? In this article, let’s talk about it.

Legal Attributes of SAFT

SAFT is an investment agreement specifically for Web3 projects built on the blockchain network. It was released on October 2, 2017 by a law firm called Cooly in the United States.

SAFT aims to provide a compliant Token issuance path based on the US securities law system for Web3 projects. SAFT agrees that the project party will use the subscription rights of the tokens after the future network goes online as the consideration in exchange for the current funds of the investors, which will be used for the current development and construction of the project network. Since Security Token is the key regulatory object in various jurisdictions, SAFT establishes a set of agreement mechanisms to finally realize the effect of the Utility Token network on-line, so as to avoid the SEC and related laws. Supervision of Web3 project token investment and financing behavior.

SAFT financing is mainly divided into two steps:

(1) Project development stage

For Web3 projects that are still in the development stage, after investors have invested money, their profit expectations depend on the management and development of the network by the project team’s development team. Since tokens have no practical utility, the nature of tokens at this stage is more similar to a value representation of equity, and the captured value is the future cash flow capability of the Web3 project.

This kind of investment behavior may meet the standards of the Howey Test, which belongs to the “Investment Contract” (Investment Contract), and thus must be included in the strict securities regulation of the US Securities Regulatory Commission. However, it is possible to apply for an exemption under Regulation D Rule 506 of the U.S. Securities Act without securities registration, limiting investors to Accredited Investors.

(2) Project development completes the online stage

• For the project network that has been developed and launched, the tokens issued (Already-functional Utility Token) have many functions (use, consumption, governance, etc.) that allow users to access the ecological network of the Web3 project. The nature of the token at this stage is a value representation of the right to use, which is defined as a utility token.
• Since the token already has practical properties, generally speaking, the main purpose of investors buying the token is to obtain the practical value of the project network, not for pure profit. Moreover, for a decentralized token economic system or governance system, the price of the token in the secondary market is completely affected by the supply and demand relationship in the market, not dominated by the contribution of the project development team.
• This is greatly different from (1) the role of tokens in the project development phase. Therefore, the SAFT white paper believes that such Utility Token does not have the attribute of “securities”, and generally will not be subject to the strict supervision of the US Securities Regulatory Commission.

SAFT agreements are not secure

• It is important to note that (emphasis added), the purpose of SAFT is to comply with the regulations of the US SEC. Strictly speaking, it is only applicable to professional investors (Accredited Investment), and it is not suitable for most small and medium investors.
• The SEC has issued many challenges to SAFT in the recent Kik case and Telegram case, which shows that there are flaws in the design and issuance rhythm of utility tokens.
• As one of the drafters of the SAFT white paper and one of the lawyers who know Crypto and US securities laws best, Marco Santori, who is currently Karken’s general counsel, was overturned by the SEC in February 2023 because of Karken’s Staking as a Service business. Needless to say, each project has a different network, a different Token function design, a different token economic design, and a project SAFT protocol with different investors.
• In addition to SAFT, there are many legal methods for Web3 investment and financing, such as SPA (Share Purchase Agreement) and SAFE (Simple Agreement for Future Equity) involving equity, as well as TPA (Token Purchase Agreement) and SAFT (Simple Agreement for Future Equity) involving tokens. Future Tokens), or a combination of SAFE + Token Warrant/Side Letter.
• Which form to take depends on the nature of Web3 investment and financing.

The Nature of Web3 Funding

• When valuing traditional equity projects, more attention is paid to the company’s future cash flow capabilities, because shareholders enjoy the legal rights of the company’s profit distribution.
• When valuing token projects, the traditional cash flow valuation model is not applicable, and more attention is paid to the scale effect of the project network, the demand between the network and tokens, and the functions of tokens. Therefore, compared to token financing projects, token economy is very important.
• We can give two examples for an intuitive comparison.

(1) Twitter’s Web3 assumption

• The current Web2 Internet giant Twitter of the creator ecology operates through the organizational form of the company. Its goal is to maximize the interests of shareholders, which embodies shareholder capitalism. The value of investment lies in the company’s ability to obtain future cash flow, and the stock price reflects The value of future cash flows.
• And imagine a Twitter based on the new economic model of Web3, which uses its tokens to motivate all participants in the network ecology (content creators, developers, verifiers, other market participants, etc.) to jointly maintain the Twitter ecological network and promote governance. The effectiveness of tokens is not only a medium of exchange, but also provides utility for users to access the Twitter ecological network, consume products/services on the Twitter ecological network, and govern decisions on the Twitter ecological network.
• This new Web3 economic model releases economic interests and governance power from centralized entities to the entire decentralized ecological network, and all stakeholders involved can share the value they create, which reflects stakeholder capital doctrine.
• In this model, Twitter’s equity may not necessarily be meaningful. Twitter’s tokens will replace equity to capture greater value on the Twitter ecological network. The token price reflects the ecological network’s supply and demand relationship for tokens.

(2) Opensea and Blur

• Opensea, once the world’s largest NFT trading platform, received US$300 million in financing from Paradigm and Coatue in January 2022, with a valuation of US$13.3 billion. Opensea’s cash flow is mainly supported by its transaction fees. Opensea’s projects can be understood as typical equity investment and financing projects in Web3. They can be applied to traditional business models in many ways. Investors capture the company’s future cash flow value, equity investment is preferable.
• During the same period, in March 2022, Blur received $11 million in financing from Paradigm. In front of the mountain of Opensea, Blur directly activated the community (in the form of airdropping tokens to community participants) a year later, opened a feast of liquidity in the NFT market, and realized a corner overtaking of the Opensea network effect. Such projects of Blur can be understood as typical token investment and financing projects in Web3. What investors capture is the ecological scale effect of Blur network. The larger the volume of ecological applications and users, the greater the market demand for this functional token. High, the price of the token depends on the value discovery in the market.
• However, considering the sluggishness of Blur tokens after listing and the limitations of Token functions, it can be seen that how to design the functions of tokens and the token economic model is the top priority of the long-term operation of the project.
• It can be seen that the substantial increase in the value liquidity of the Web3 project has put forward higher requirements for the project party. It needs to be able to describe the future model of the project and the arrangement of the token economy relatively clearly at the white paper financing stage, otherwise it will be difficult to connect later SAFT and development plan.

summary

The purpose of SAFT is to comply with the regulations of the US SEC. It is only suitable for professional investors, and it is not suitable for most small and medium investors, let alone investors who are all relatives of Chinese citizens.

As a Chinese entrepreneur, SAFT is neither the only nor the best choice for financing in the early stage of entrepreneurship. Equity financing + token terms (SAFE + Token Warrant/Side Letter) can also be used. On the one hand, it can also solve the problem of SAFT circumventing the United States. The purpose of securities regulation, on the one hand, can also provide a way for projects to raise equity while retaining the possibility of token financing.

The most important thing is that the purpose of starting a business is not just to raise money, but to go back to the fundamentals of business, use the money raised to solve social problems, create more business value, and not spend too much money. I can’t resist our nonsense.