Initial Coin Offerings (ICOs) have raised nearly $4 billion in 2017, but with some blockchain-based startups generating millions in a matter of seconds, they have also raised concerns of regulatory bodies.
Regulators around the world have banned the ICOs crowdsales to protect investors against fraud. However, the recent flurry of digital fundraising, as well as the aura of chicanery surrounding ICOs, have motivated the industry participants to search for ways to legitimize the process and ensure compliant offerings.
In October 2017, a law firm in New York announced one of the most interesting attempts to establish a legal framework that addresses the existing issues with the funding through ICOs. Protocol Labs and Cooley LLP, with the participation of those with vested interests in ICOs, have developed the “simple agreement for future tokens”, aka SAFT.
For those not familiar with the term, SAFTs are legal contracts used to raise capital from accredited investors for the development of a virtual token. Typically, under the SAFT, an investor obtains the right to a certain number of digital tokens issued by the startup in exchange for an up-front investment. The conversion rate, which is used to convey investor’s rights in the token upon a triggering event, is usually based either on discount or valuation cap.
For instance, if a startup wants to bring a token to market, instead of offering an immediately available token, the founders can issue these SAFTs to reduce the complexity of early-stage raises, and in the meantime avoid complex areas of state and federal laws.
On the operational front, the SAFT is relevant to a specific class of “utility tokens” designed to be used to purchase goods or services on a distributed network platform. For example, a digital token can be used on a blockchain-based decentralized cloud platform to purchase computing or storage capacity.
If you have an investment background you can think SAFTs contracts as modelled as something called a Simple Agreement for Future Equity (SAFE), which is a contractual legal instrument that entitles its holders the right to acquire private equity.
Both the SAFE and the SAFT are similar in many respects, except that the SAFT entitles the instrument holders with the right to tokens rather than equity.
Now, let’s take a brief overview of the SAFT and outline some features to be considered when planning to invest through the instrument in pre-ICOs activities.
As we discussed in a recent article, one key takeaway from watchdogs’ warnings was that some tokens fall within the definition of securities. As such, when a startup considers sale of digital coins, then that fundraiser must comply with relevant securities laws. This means the token must either be registered as a security or that the token qualifies for an exemption from registration requirements.
For start-up entrepreneurs, the SAFT should help overcome the shortcomings relating to the application of securities laws to digital tokens, and could be useful to deal with some of the uncertainties around regulation of these assets.
Aside from the regulatory issues, the SAFT was developed in essence to finance young start-ups, and is also designed to mature the fundraising process, particularly with some tokens are nothing more than a website and promises of new products. Further, the SAFT typically imposes a restriction on the investor’s ability to transfer or make use of the tokens until the virtual assets are vested.
The SAFT is also identical to VC funding, since it does not have a maturity nor contain interest provision, which arguably distinguishes it from debt. Nevertheless, discount between the token issuance value and the conversion rate could also be viewed as interest.
Moving from conceptualization and legitimization to implementation, the SAFT helps crypto entrepreneurs get investments without spending too much time on negotiating complex legal terms with traditional venture groups. For investors, compared to angel investing, it allows them to share in whatever success the startup experiences while potentially retaining the upside of converting the SAFT instrument into utility tokens.
Finer points really matter
To be clear, SAFTs are not investments, nor they come without cons. For instance, an investor might never realize his investment by converting the SAFT into tokens. At least, it could be a long shot before the investor be able to cash in upon effective launch.
In addition, the contractual legal innovation does not provide any governance rights, and in case the startup ‘gone with the wind’, the SAFT is likely to turn into an unsecured claim. Furthermore, investor doesn’t obtain the right to participate in the token development or management, so a start-up could face difficult dilemmas and, sometimes, wrong choices, and a SAFE holder is unable to control such decisions.
Despite advertising the SAFE as a brilliant solution to comply with laws, or at least obtain an exemption from the registration, the regulatory treatment is not entirely clear and the answer to this is likely to depend on particular circumstances.
In short, SAFT is an interesting innovation, however, it is not a “one size fits all” instrument and no one can assure it would entirely replace the pre-token sales. The instrument could be more interesting though should the startup founders develop guidelines to provide the SAFT holders with a type of engagement that is more strategic and more easily evaluated.