Digital Assets and Crowdfunding: How This Relates to Investor Status
Virtual reality, downloadable fashion, digital footprint… it seems like more and more of our daily lives are being uploaded to the internet, with each day bringing in a new concept for our heads to wrap around. Honestly, it’s tough to keep up with everything! Cryptocurrency was one of those things. It seemed to pop out of nowhere, and the next thing we all knew, everyone everywhere was talking about the best ways to get into the action. There are so many ways to do so, but why should anyone use them? It can be daunting to figure out where to start. More importantly, one should know what cryptocurrency is, and how it affects day-to-day life for the average person.
What is cryptocurrency, and how does it work?
Cryptocurrency may seem like a new phenomenon, but it has been around much longer than most people realize (Evan Jones, A Brief History of Cryptocurrency, CryptoVantage (June 17, 2022). The initial idea for cryptocurrencies was actually conceived in the late 20th century, and the first crypto was produced in 1995: Digicash by David Chaum. The idea was to create a new digital currency not tied to physical institutions, such as banks (Jones, supra.). This opened the gateway to the current market of cryptocurrencies that we have today, with household names such as Bitcoin and Ethereum.
Digital assets, like Cryptocurrencies, are made possible by a technology called Blockchain. Blockchain has three properties: traceability, immutability, and transparency (Mrugakshee Palwe, What is Blockchain? Everything you need to know, CryptoVantage (January 7, 2022). ‘Traceability’ refers to the ability to track where the money comes from and where it is going (creating a record), ‘immutability’ means that the data within the Blockchain is non-tamperable, and ‘transparency’ refers to the open-access of information to the public (Palwe, supra.). Blockchain is formed by the individual- you guessed it- Blocks! Each block contains transactions taking place on that specific Block, and all of those Blocks are linked together to create a Blockchain that records the transactions. (Palwe, supra). For a more in depth look at Blockchain and the integration into current economics, click here.
What is Crowdfunding?
Crowdfunding is a strategy businesses use to buy and sell securities to a large population. Although considered a private offering, crowdfunding is similar to a public offering (or publicly-traded offering) due to the ability of the Issuer being able to advertise to multiple people. Crowdfunding, also called investment crowdfunding or equity crowdfunding, has become more accessible and more streamlined following the passage of the JOBS Act during the Obama administration. The Jobs Act expanded investment crowdfunding from its limited scope within the States to throughout the 50 states and the U.S. territories. Since then, investment crowdfunding has been a great option for businesses that may not have the access to certain accredited or sophisticated investors or other traditional funding sources such as bank financing. In addition, investment crowdfunding is an excellent tool for entrepreneurs even if they do have access to traditional investors and bank financing. It is one of the only ways that a business owner may raise capital on their own terms (Kassan, 2017).
How do digital assets relate to crowdfunding?
Although there are legislative proposals circulating throughout Congress, and some may pass soon, there are no clear-cut or uniform regulations regarding digital assets, such as cryptocurrencies and NFTs. The Securities Exchange Commission (SEC) has been able to regulate these digital assets through the broad definition of an “investment contract” as further defined under the U.S. Supreme Court’s Howey Test. Still, the SEC has a fair amount of work to do, but with the usual securities enforcement, there may be a few consistent requirements, especially regarding investment crowdfunding.
Crowdfunding is a great resource for entrepreneurs to receive financial support to start their endeavors, but a fair amount of restrictions come with using this strategy. There are two types of investors: accredited and unaccredited. The difference between the two types is based on wealth and assets. If a business is using crowdfunding to raise capital, then each received investment is a security. There are many exemptions under the 1933 Securities act that specifically relate to crowdfunding. These exemptions were created to both increase the investor pool and lessen conflict between state and federal laws (Ross, 2021). These exemptions will determine how many investors are permitted and how much capital a business may raise (Ross, 2021). Digital assets relate to crowdfunding because now they offer a new method of financial support through a digital marketplace. That means crowdfunding is increasing its reach to a wider audience.
In the common public, digital assets are recognized as currency and tokens of some sort of wealth. In the investment world, digital assets may be considered securities depending on whether the digital assets are offered to the public for exchange of investment dollars. With the Howey Test the main components are an investment of money in an enterprise with an expected profit. For example, Company A utilizes one of the approved crowdfunding websites to promote buying a share in the business. Investor B sees this offering and has the option to either use standard money or cryptocurrency to buy a share. The cryptocurrency is purchased with tangible money (money that is backed by a financial institution), and although the crypto itself is not backed by any financial institution, it still takes on a monetary value because it was purchased at that value. When investor B uses crypto to buy a share of Company A, the crypto takes the space of the investment of money aspect of the Howey Test. The expected profit comes from the expectation that the value of the initial investment will provide a return on that investment. The presence of cryptocurrency does not replace the necessary components of the Howey Test.
How do digital assets alter the qualifications of crowdfunding investors?
The JOBS Act also sets forth rules for the type of investors who may participate in an investment crowdfunding offer. For instance, Rule 506(c), an investment crowdfunding exemption under Regulation D under the U.S. Securities Act of 1933, that allows a business to raise an unlimited amount of money from investors through public advertisement and general solicitation so long as each investor is accredited. An investor is accredited when they have more than a $200,000 annual salary or more than $1,000,000 (excluding their primary residence) in net worth (17 C.F.R. § 230.501). For a private business to be an accredited investor the requirements are a little different. It must have total assets of $5,000,000 or more (Ross, 2021).
As investors are of concern, the question is whether the SEC considers cryptocurrencies to be income or a part of the net worth of the crowdfunding investor. If digital assets are considered a part of the investor’s annual income or net worth, then it's possible that the investor may be considered an accredited investor, depending on the value of such digital assets. The accredited investor status opens up more investment opportunities for investors. For instance, regulation crowdfunding (Reg CF) has different rules and limitations for accredited and nonaccredited investors. Specifically, non-accredited investors may only invest up to 10% of their annual income or net worth, or $2,200 annually - whichever is greater, across all Reg CF campaigns. There is no such cap for accredited investors. Similarly, Regulation A+ allows non-accredited investors to invest up to 10% of their annual income or net worth, whichever is greater, in a single Reg A+ Tier 2 campaign. There are two Tiers under Reg A+. A business raising money under Tier 1 may offer securities up to $20 million per year and up to $75 million per year in a Tier 2 offer. These investment limitations are significant in relation to cryptocurrencies because as the market continues to heat up, the value of these assets will increase and when assessing net worth they may be included in the calculation, thus allowing more opportunities for accredited investing. For more information on Reg CF and Reg A+, click here!
As a recap, take a look at the inquiry below:
Are cryptocurrencies securities that can be offered to investors through an investment offering, such as an investment crowdfunding offer?
Answer: Previous SEC chair Jay Clayton stated in 2018 that cryptocurrencies are commodities, NOT securities. Clayton explained that a commodity may be considered a security when it constitutes an investment contract: an investment of money in an enterprise with the expectation of profit (Roger E. Barton, Christopher J. Mcnamara, and Michael C. Ward, Are Cryptocurrencies securities? The SEC is answering the question, Reuters (March 21, 2022). In 2021, however, the current SEC chair Gary Gensler used the same” investment contract” definition of securities and concluded that many cryptocurrencies are in fact securities.
This means that moving forward, an issuer of cryptocurrencies will need to register those digital assets as securities with the SEC or be issued an exemption from registration in addition to providing investor disclosures as required by the Securities Act under Regulation D (Barton, Mcnamara, Ward, supra); (Ross, 2021).
Can cryptocurrencies be used to buy securities?
Answer: In theory, cryptocurrencies can buy just about anything. There are still many obstacles to universal purchases, such as groceries and gas, because of the lack of capacity (Palwe, supra). Maintaining large Blockchain cryptocurrencies, such as Bitcoin, takes an excessive amount of electricity to process a small number of purchase transactions, so the expansion is outrunning the technological capabilities (Palwe, supra.). As for purchasing intangible assets, such as securities, crypto can be used for those too. It seems pretty simple! Add the crypto of choice to the associated card (a crypto card) and use it like a regular debit or credit card (Rakesha Sharma, What can you buy with Bitcoin? Investopedia, (February 21, 2022). Please note that some cryptocurrencies are more widely accepted than others, with the most widely accepted being Bitcoin, Etherium, and Cardano (Disha Sinha, 10 Best Cryptocurrencies for Everyday Usage in 2022, Analytics Insight, December 30, 2021).
What is an asset?
Answer: An asset is something that has value, usually meaning monetary value. It can be used as collateral later down the road if needed. Traditionally, assets are tangible items: houses, cars, money, jewelry, businesses, etc., but as discussed in this article, the idea of assets is rapidly changing and expanding to a broader digital space.
Are digital assets considered income or are they included in net worth calculations?
Answer: Assets are not typically considered income, but they are included in the overall net worth calculation. They seem to be treated closer to stocks in this regard.
Can a business accept cryptocurrencies while crowdfunding?
It appears that, yes, crypto can be used for crowdfunding.
Do digital assets need to be registered in the same way as traditional offerings?
Yes! The “Framework for “Investment Contract Analysis of Digital Assets” memorandum set out by the SEC published in 2019 says digital assets must be registered. The digital assets will follow the Howey test to determine whether there has been an investment contract. This test has three parts: (1) the investment of money (2) in a common enterprise (3) with a reasonable expectation of profits to be derived from the efforts of others. (SEC memorandum).
Cryptocurrencies are something that is constantly changing, especially within the securities regulatory environment. Our mission at the firm is to help small businesses, investment companies, nonprofits, and cooperatives navigate this new field of law as easily as possible so that they may raise alternative capital for their impactful enterprises. We will do this by increasing accessibility and comprehension of the securities legal implications of their business ventures. Contact us today for a consultation to get started with your own business venture.
Evan Jones, A Brief History of Cryptocurrency, CryptoVantage (June 17, 2022), https://www.cryptovantage.com/guides/a-brief-history-of-cryptocurrency/#:~:text=The%20idea%20for%20cryptocurrency%20first,cryptographic%20electronic%20money%20called%20Digicash
Mrugakshee Palwe, What is Blockchain? Everything you need to know, CryptoVantage (January 7, 2022), https://www.cryptovantage.com/guides/what-is-blockchain/
Roger E. Barton, Christopher J. Mcnamara, and Michael C. Ward, Are Cryptocurrencies securities? The SEC is answering the question, Reuters (March 21, 2022), https://www.reuters.com/legal/transactional/are-cryptocurrencies-securities-sec-is-answering-question-2022-03-21/#:~:text=In%202018%2C%20Clayton%20clarified%20in,%22%20June%206%2C%202018).
Rakesha Sharma, What can you buy with Bitcoin? Investopedia, (February 21, 2022) https://www.investopedia.com/what-can-you-buy-with-bitcoin-5179592
Jenny Kassan, Raise capital on your own terms: How to fund your business without selling your soul (Berrett-Koehler Publishers, Inc.) (2017)
Bill Hinman and Valerie Szczepanik, Framework for “Investment Contract” Analysis of Digital Assets, Securities and Exchange Commission (April 3, 2019), https://www.sec.gov/files/dlt-framework.pdf (SEC)
Disha Sinha, 10 Best Cryptocurrencies for Everyday Usage in 2022, Analytics Insight, (December 30, 2021), https://www.analyticsinsight.net/10-best-cryptocurrencies-for-everyday-usage-in-2022/
Chynnique Ross, Securities Law 101, Elizabeth L. Carter, LLC, (February 11, 2021) https://www.elcesq.com/post/securitieslaw101
Chynnique Ross, Defining the Accredited Investor, Elizabeth L. Carter, LLC, (March 16, 2021) https://www.elcesq.com/post/accreditedinvestor
Chynnique Ross, Introduction to Regulation D, Elizabeth L. Carter, LLC, (April 1, 2021), https://www.elcesq.com/post/introduction-to-private-placements-regulation-d
Alana Reyes-Jones, A closer Look at Reg A+ and How It Relates to the Tulsa Race Massacre, Elizabeth Carter, LLC, (June 7, 2021)