ICOS and STOs: Crowdfunding on Steroids

Jim Verdonik



(This article is based on a presentation Jim Verdonik and Benji Jones did at Cryptolina18 – a Crypto Currency conference on June 15, 2018.)

We jumped into the Coin and Token offering world in 2017, because we were doing a lot of Crowdfunding work and we realized that Coin and Token offerings were just the next logical evolution of Crowdfunding.  Having invested a lot of time mastering Crowdfunding (including writing books about it and writing a state Crowdfunding law), we knew that we could use this expertise in the Coin and Token worlds.



Types of Offerings and Securities

Initial Coin Offerings (ICOs) and Security Token Offerings (STOs) are taking over the capital raising world where traditional crowdfunding left off. New platforms are being launched to capitalize on both the initial offer and sale and on post-transaction resales.

The rise of Security Token Offerings (STOs) gives us 20-20 hindsight to see that ICOs and STOs are really both offshoots of Crowdfunding. Most STOs involve selling assets that no one would ever argue are not securities. They generally involve having a common type of security (such as stock or a promissory note or a SAFE) be evidenced by a Token instead of by a stock certificate or other piece of paper

Some people are calling STOs JOBSICOs (after the JOBS Act that created Crowdfunding).

We are also getting hybrid types of offerings.

SAFTs and other hybrids start out as securities offerings and then hope to morph into something called a “utility token,” which is sometimes a security and sometimes not a security depending on who you talk to.

Other offerings give investors a choice between receiving a utility token or a Coin or an equity or a debt security.

Just when some people thought you could never do a Coin offering in the United States, the SEC has opened the door to considering both whether Coins and Tokens are securities on a facts and circumstances basis, which is a retreat from earlier statements that Coins and Tokens are always securities. As we discuss in another blog post, the most important development is that SEC has endorsed the concept that a digital asset can start out as a security and later not be a security.

Analyzing Early Mistakes

By now, we know that the people who thought Initial Coin Offerings (ICOs) were something totally new were totally wrong – and they are suffering for it. The Securities and Exchange Commission is bringing dozens of enforcement actions against ICO sponsors.

All this was avoidable, if only people had been paying attention.

To illustrate why the way ICOs were conducted were always doomed to violate securities laws, let’s look at the big picture. ICOs were just an evolution from Crowdfunding – and Crowdfunding is all about securities laws.  The pyramid below illustrates how ICO’s evolved from Crowdfunding and Crowdfunding evolved from traditional securities laws.

ICO Crowdfunding Evolutionary Pyramid

The link between ICOs and crowdfunding of course, was the Howey test, which the SEC loudly reminded everyone was not simply related to selling orange groves.

The Howey test provides the missing link, because investment contracts were not just something the SEC used in 1946 and then forgot about. The SEC has consistently used investment contracts to regulate things we would not normally consider to be a security. Investment contracts have long played a major role in real estate finance for many decades.

  • Condos that are run like hotels are often deemed to be securities based on that they are investment contracts
  • Companies that invest in real estate are often deemed to be “investment companies” that are subject to the Investment Company Act because of contracts associated with the real estate ownership
  • Tenants in Common (TICS). Real estate developers have long argued that breaking real estate into a large number of ownership pieces is not a security. The SEC has long rejected the arguments of the TICS.
  • Limited liability companies are another case in point. Some LLCs are run like a general partnership, which is not a security. Others are run in accordance with Howey Test principles.

Given this long history of using Howey test principles in many finance situations, it’s not surprising at the SEC applied the Howey test to ICOs.

Of course, a single link like the Howey test could easily be ignored if there were no other similarities between ICOs and Crowdfunding. But people who couldn’t find many other similarities just weren’t looking, because the similarities are obvious. , which we list below:

Similarities Between ICOs and Crowdfunding

Following the Evolutionary Evidence

Simply following the same rules that paleontologists use to trace human evolution back to the apes will bring you to the inevitable conclusion that ICOs evolved from Crowdfunding.

As we can see from the table above ICOs and Crowdfunding share many common traits including:

  • Selling to a Crowd of smaller less sophisticated investors rather than to institutional investors
  • The absence of long agreements
  • Relatively little due diligence
  • The need to provide detailed and easily understood disclosures to investors
  • Using software to effect the transactions
  • Using platforms and social media to find investors instead of investment bankers
  • Investors who are looking for shorter term investments, which requires developing exits through secondary trading markets
  • Producing businesses that are quasi-public, because they have large numbers of unrelated owners, but are still private because they do not file reports with the Securities and Exchange Commission.
  • Many offerings are international
  • Preselling a big part of the deal to create excitement is an important tactic
  • Giving discounts to early investors

Lessons for Avoiding Future Mistakes

The lessons we learn from this evolutionary tale is that business practices, technology and legal analysis is evolving very quickly.

This change means that ICOs are just the first of a series of new capital raising tools.

Dealing with these new tools will require many types of advisers (from financial consultants to lawyers to software engineers to PR and social media people) to work more closely together to help clients raise capital.

Lawyers will need to know what functions the software performs, how it generates value for developers and users and why old laws might apply to new products. Also, with the rise of morphing assets that are securities at the beginning but later change to something else, we will be called on to pinpoint he time when an asset changes from a security to something that is not a security.

Because regulators can’t keep up with changes, lawyers can’t just look up precedent. We have to be able to predict the future.

Knowing what happened in the past is only valuable to clients if we can use that knowledge to connect the dots and predict how regulators will interpret the new pictures our clients are creating.

Advisers who learn these lessons can add real value beyond just documenting a deal.


Law Firm Accepts Bitcoin in Payment for Legal Fees: Putting Your Money Where Your Mouth is in the Coin and Blockchain World

Jim Verdonik


(919)  277-9188

(This article is slightly a longer version of an article that was originally published in Triangle Business Journal June 15, 2018)

Back in January this newspaper asked me to predict what would happen to Cryptocurrency in 2018.

It’s almost mid-year. How are my predictions faring?

I’m giving myself an A. Here are the predictions I made and the current reality:

  • Be careful about high Coin prices. A Bitcoin was around $16 thousand at the time I wrote my January article. It’s about half that now. Giving myself a B+
  • Token offerings that comply with SEC regulations will replace unregulated ICOs. Many Crowdfunding platform websites have opened SEC compliant Token and Coin offerings. I get an A.
  • Coins and related blockchain will be entering daily life on Main Street. Several hundred thousand Coin accounts have been opened by North Carolina residents on a single leading Coin exchange. These accounts hold over $300 Million of Coins.
  • More business will be accepting Coins as payments for products and services. My law firm recently announced that it will be the first large North Carolina law firm to accept Bitcoins in payment for earned legal fees.

The last item might the most startling. 100+ person law firms traditionally have not been early adapters of much of anything.  Lawyers tend to lag the accounting profession by about ten years in adapting to business trends.

So, why is Ward and Smith taking a leadership role on Coins and Tokens?

It’s simple. We have lots of Coin related clients.  Good lawyers learn from our clients.  Our clients are teaching us about their industry.  Here are some of the many ways we have been experiencing the Coin world through our clients.

  • Raising money to finance a very large Coin Mining operation.
  • Securitized Token Offering (STO) for a blockchain energy company
  • Creating Smart Contracts for Post-Offering Automated Stock Transfers
  • Representing a coin exchange on Regulatory Issues
  • Securitized Token Offering (STO) for real estate investment fund
  • Advising a software developer about planning an SEC compliant ICO
  • Advising financial institutions about Coins and blockchain strategies

What we have learned from our clients is that Coins and blockchain are permeating virtually all business sectors. We want to play an even bigger role in Coin related industries as they grow.

To do that, we’re willing to put our money where our mouths are and start accepting Coins as payment for legal fees.

I think this is like websites. In 1990 no law firm had a website.  Now every firm does.

So, we decided we owe it to our Coin and blockchain clients to be the first instead of the last to accept payment in Bitcoin.

We also decided to lead the legal profession down this road by analyzing how legal ethics rules apply to law firms accepting Coins in different circumstances. Sharing this insight with others will allow other law firms that know less about the Coin space to follow in our footsteps.

Just accepting payment for fees that have already been earned is pretty simple. But lawyers’ trust accounts are a more complicated matter.  Then, we’re holding the client’s money.  There are lots of ethics rules about lawyers’ trust accounts.  Lawyers who want to comment about how the ethics rules should apply to Coins can see the ethics opinion request I filed with the NC Bar at http://ncbarblog.com/2018/06/add-your-two-cents-the-ethics-of-serving-clients-who-use-coins-and-digital-assets/

So, why are we helping our competitors navigate this space?

Because it’s good for our community when the legal profession leads rather than lags behind.

Whitney Christensen Saves the Day: Educating Legislators about Cryptocurrency

This is part of a series of interviews with Rick Smith of WRALTechwire (https://www.wraltechwire.com/) in June 2018 about recent major changes to laws governing cryptocurrency.



Jim Verdonik leads Ward and Smith’s Fintech and Securities Practice. JFV@WardandSmith.com Jim blogs at https://gatewaycapitalx.com/

Whitney Christensen is a government relations lawyer who works with state legislators and administrative agencies. WCChristensen@wardandsmith.com

RICK: I asked Jim and Whitney to share their views about many recent exciting changes in the cryptocurrency world.

RICK: Whitney, I understand you had a victory at the state legislature last week.

WHITNEY: Yes, on behalf of a client we were able to pass legislation to amend the North Carolina Money Transmitters Act to resolve a section of the Act related to permissible investments of virtual currency exchanges.

RICK: Why did the law need to be changed?

WHITNEY: The original sponsors of the Act and stakeholders who worked on it in 2015 did not anticipate the exponential increase in the value of Coins. Because of this growth, the original permissible investment requirement is essentially impossible to comply with today. We feel very fortunate that the legislation made it through this year, because there was a time sensitive need to fix this for the virtual currency industry in the state.

JIM: Let me say that Whitney is being modest here. If the law had not been changed this year, all of the Coin Exchanges would have had to close down the Coin accounts of all their North Carolina clients and there would be no way to buy or sell virtual currency in the state.

RICK: Would that have affected a lot of people?

WHITNEY: Well Rick, in doing research to educate our legislators I learned that well more than 100,000 North Carolina residents have Coin accounts and that these accounts hold hundreds of millions of dollars of Coins.  So, yes, this would have impacted the investments and coin usage of a big segment of the state’s population.

RICK: Those are surprisingly big numbers for North Carolina.

JIM: That’s why we’re sitting with you today Rick. Some people still think Coins are something just for people in Asia or California or South America. In reality, Coins are entering Main Street America. Everyone from Millennials to Baby Boomers are adding them to their investment portfolios and people are now using them for everyday purchases at places like Subway, KFC, Reeds Jewelers, Whole Foods and Microsoft. Some Coin exchanges have more account holders than major securities brokerage firms like Charles Schwab.

RICK: So, Whitney, how did you explain all this to our state legislators?

WHITNEY: We knew going into this year’s legislative session that it would be one of the shortest in modern history. So, we made our messaging succinct and perfectly teed up our proposed legislation before the session even began. We didn’t leave anything to chance, because it had to pass this year.

RICK: Government acting quickly? That’s unusual. How did that happen?

WHITNEY: Fortunately, Rep. Stephen Ross agreed to help us with the bill, which was huge because he sponsored the original Money Transmitters Act and is very well respected on these issues. With Rep. Ross’s help and the help of a handful of other key House and Senate members we explained to the rest of the Legislature that without this fix, the state’s virtual currency presence would dry up and NC would be branded as a state evolving in the opposite direction of technology.

RICK: How are other states dealing with this?

WHITNEY: We also told legislators that we would be one of only two states in the nation (Hawaii is the other) without access to virtual currency exchanges if we ended up inadvertently regulating them out of North Carolina.

RICK: Did that concern the legislators?

WHITNEY: State lawmakers genuinely want to do the best for the people they represent and I don’t think you need to fully understand the intricacies of our virtual currency regulations to realize that we needed to fix this for the people of the state.

JIM: Let me add that Whitney is the master of the two P’s – patience and persistence. Sometimes it takes a lot of effort getting the legislators to know what’s right. I understand Whitney was essentially camped out at the Legislature for a week straight before the bill ultimately passed.

Tokenized Securities Offerings Save ICOs from Themselves

Jim Verdonik



(This article first appeared in WRAL Techwire on March 5, 2018)

After Initial Coin Offerings (ICOs) helped young software companies raise more than $4 Billion last year, the SEC began doing a full court press to shut down the ICO world. Over a dozen SEC enforcement actions have been announced and many other investigations are already under way.

ICO Battlefield

In a jurisdiction battle between the SEC and the Commodities Future Trading Commission (CFTC), the head of the SEC has declared all blockchain Utility Tokens to be securities. In a very unusual step, the SEC has even threatened to disbar attorneys who disagree with the SEC’s opinion that all Tokens are securities. This take no prisoners approach is a warning to businesses to abandon ICOs.

To the extent the SEC wants to ensure that investors receive full disclosure, we agree with the SEC. However, as we explain in the linked articles below, normal securities laws transfer restrictions will kill the usefulness of Tokens – what good is a currency if investors can’t spend it without complying with expensive SEC rules?

This is a battle that will take years for the courts to decide. Does any business want to battle the SEC in court for several years?

In the meantime, how do we use the power of blockchain technology to finance innovation?

Tokenized Securities Solution

Our FINTECH team has worked with a client to develop new types of securities offerings – tokenized securities are the logical extension of recent software, financial and legal changes.

Our new capital raising product combines a new type of equity security with an automated stock transfer system that is powered by a Smart Contract recorded on the Ethereum Blockchain Network.  Our new type of financing has two basic objectives:

  • make ICOs fully SEC compliant.
  • harness the power of Smart Contracts and the Ethereum Blockchain Network to provide investors with a cost efficient way to resell all or part of their investments in private companies

Here’s a link to an article in INVESTOPEDIA about our client taking this groundbreaking new approach.  https://www.investopedia.com/news/equity-ethereum-firm-offers-real-stock-through-ico/

Our new capital raising product combines a new type of equity security with an automated stock transfer system that is powered by a Smart Contract recorded on the Ethereum Blockchain Network.  Our new type of financing has two basic objectives:

  • make ICOs fully SEC compliant.
  • harness the power of Smart Contracts and the Ethereum Blockchain Network to provide investors with a cost efficient way to resell all or part of their investments in private companies

What real world problems are we solving?

The SEC is cracking down on traditional ICOs.  Literally dozens of companies are being investigated.  Enforcement actions have started.  We desperately need an SEC compliant alternative to ICOs.  We think tokenized securities offerings are a solution.

An older problem is how do angel investors who don’t want to wait for an IPO or company sale resell stock on a cost efficient basis?

Blockchain Smart Contracts facilitate peer to peer transactions without intermediaries that charge resale commissions and without draining the time of the company’s management arranging transactions.

This approach won’t provide the same liquidity as public markets do, but private companies that are growing their businesses will generate some investor interest.  We think this makes sense for:

  • Investors in successful companies who want to exit early,
  • Investors who missed the boat when the company first raised money and now want to jump aboard and
  • Company management who can offer impatient investors who want liquidity an alternative to selling the company

How do we do all that?

Here are links to several articles we have written that explain.

Our first article describes the changes to Delaware’s corporate law that permit companies to use automated stock transfer systems. https://gatewaycapitalx.com/2018/02/16/delaware-law-on-blockchain-and-other-automated-stock-transfer-and-records-systems/

Our second article describes why it is difficult for companies that do traditional ICOs to comply with the SEC’s post-offering transfer restrictions.https://gatewaycapitalx.com/2018/03/01/securities-re-sale-restrictions-the-achilles-heel-of-icos/

Our third article describes the specifications for a Smart Contract that will comply with SEC transfer restrictions.https://gatewaycapitalx.com/2018/03/02/designing-blockchain-smart-contract-securities-transfer-systems-that-comply-with-securities-law-re-sale-restrictions/

After the Supreme Court decides the question of when Tokens and COINS are securities and when they aren’t, it may be safe to jump back into the ICO waters. Until then, however, Tokenized securities offerings make a lot of sense.

Even then, ICOs are limited to companies than can create Tokens and use Tokens in their business model.  That’s primarily software companies.  Tokenized securities are a long term solution for businesses in any industry.

March Madness: SEC Trash Talks ICO Lawyers

Jim Verdonik


(919) 277-9188

(This article first appeared in Triangle Business Journal on March 1, 2018)

March is basketball month.

Some basketball players are gentlemen – handshakes for opposing teams. Other players trash talk opponents.

But, what if referees started trash talking players?

Currently, the SEC is full court pressing Blockchain/Coins entrepreneurs off the court by shutting down their ability to raise money through Initial Coin Offerings (ICOs).

Is the SEC acting like a player or a referee?

The issue is: are Coins/Tokens securities?

The analysis involves legal principles the Supreme Court announced in SEC v Howey that selling land with service contracts was a type of security called an “investment contract.”  The Howey test is “whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”

Condo hotels often involve investment contract issues. Sometimes condos that are real estate are also securities and sometimes they aren’t.  Specific facts matter, including the sales pitch and provisions of rental pool contracts under which hotels share revenue with condo owners.

Condo hotels are the gentlemanly side of the SEC. The SEC gives guidance about specific facts and does not try to kill the entire Condo hotel industry.

Contrast this with the SEC trash talking Initial Coin Offerings.

Rightly, the SEC reminds people the Howey test governs and is taking action against some ICO sponsors for fraud. That’s normal.  Commit fraud and you should face consequences.

But the SEC’s Chairman is trying to shut down the every form of ICO. According to the SEC’s Chairman, all Coins/Tokens are securities under the Howey test.

Beyond that, the SEC’s Chairman is threatening to sanction law firms that disagree with the SEC’s ICO dictates. According to the SEC’s Chairman, all lawyers who think there is room for debate are abetting fraud.  By doing so, the SEC is giving up its role as referee and is getting down and dirty like a player in a street pickup game.

Who’s the target of SEC wrath?

Lawyers advising clients to fully disclose risks to investors when they sell securities called SAFTs, but who also advise that Tokens later issued to SAFT holders are not securities because Tokens are used to buy products and services – like discount coupons.

If you invest in a business that operates gold mines, you are buying securities and should make disclosures to investors. But SAFT lawyers think if the business gives owners gold nugget dividends, the gold is not a security.  Maybe that’s a winning argument, maybe not.  There is room for disagreement.

Who suffers if gold/Tokens are not securities? Investment bankers will make less money reselling securities if Tokens are not securities.  Is the SEC protecting investment bankers at the expense of investors?  Why?  What good are currencies if you have to pay investment bankers to let you buy things with them?

Why does this matter?

Coins/Tokens are vital elements of blockchain technology. Declaring war on blockchain financing means America will fall farther behind the world in implementing this important technology.  Unlike other countries, America’s small tech companies lead the way in innovation.  We can’t rely on giant companies to lead.

We need impartial referees who call fouls when players break disclosure rules, not referees who try to stop the game by trash-talking the lawyers for one team.

The SEC should prosecute fraud. The courts (not the SEC) will decide what are and aren’t securities.

Designing Blockchain Smart Contract Securities Transfer Systems that Comply with Securities Law Re-Sale Restrictions

Jim Verdonik


(919)  277-9188

In my last article, we discussed why securities law resale limitations for “restricted securities” pose serious problems for both issuers of COINS and Utility Tokens that the SEC deems to be securities and for issuers that want to use blockchain technology to create automated efficient stock transfer systems.

Most of the public discussion about ICOs has focused on how issuers can make offerings that comply with securities laws. There has been relatively little discussion about how investors can resell COINS and Tokens that are securities.

As we point out in our prior article, what good is a COIN or Token if you can’t spend it or resell it?


Let’s begin developing our detailed plan for COIN and Token re-sales by discussing the opportunities and challenges offered by blockchain securities transfer systems.

Blockchain Smart Contracts the Perfect Automated Stock Transfer Systems

In mid – 2017, the State of Delaware amended its General Corporation Law to allow Delaware corporations to use blockchain and other digital stock transfer and corporate records. See my article of February 16, 2018 for discussion of these amendments to the Delaware General Corporation Law.  Coincidentally, this change occurred at approximately the same time the SEC declared that most Coins/Tokens are securities. https://gatewaycapitalx.com/2018/02/16/delaware-law-on-blockchain-and-other-automated-stock-transfer-and-records-systems/

What’s so startling about that you might say? Businesses have been maintaining massive amounts of digital records for many years.

But blockchain software is capable of doing a lot more than simply storing records. Blockchain and smart contracts also enable peer to peer transactions to occur without an intermediary.  Blockchain software actually transfers the ownership from one account to another account.  That means that sellers who own anything in digital form can transfer what they own to buyers in return for payment of a COIN or Token.

This new technology will make stock transfers more efficient by removing middlemen and their annoying fees. Who will be replaced?

  • Broker-dealers
  • Stock transfer agents

That’s great!

But most issuers typically want to spend as little time thinking about stock transfer issues as possible. When was the last time you heard a CEO say:  “At our annual strategy planning retreat, we decided to make stock transfer our highest priority.”

Of course, that never happens. Stock transfer issues are the sleepy backwater of the securities world.

The danger is businesses will make a quick decision to automate an annoying process without fully thinking through how their new stock transfer system will comply with securities laws. That would be a big mistake.  If you normally drive a four cylinder car that requires you to push the pedal to the floor and keep it there to accelerate from 0 to 60, you might not be able to handle a high powered V- 8 engine without some practice.  Blockchain’s power can easily cause you to accelerate yourself right off the road.

So, in this article, we’ll talk about:

  • SEC rules you should consider when you design you automated securities transfer system.
  • Some smart contract features you can use to manage your securities transfer system.

Let’s start by reviewing some securities transfer basics, because some people who purchase and sell COINS and Tokens are not familiar with the SEC rules that govern re-sales after securities are sold in an offering that is exempt from registration.

What are “Restricted Securities”?

When issuers sell securities under an exemption from registration instead of registering the offer and sale are issuing “restricted securities.” SEC Rule 144 (a) (3) provides:

The term restricted securities means:

(i) Securities acquired directly or indirectly from the issuer, or from an affiliate of the issuer, in a transaction or chain of transactions not involving any public offering;

(ii) Securities acquired from the issuer that are subject to the resale limitations of §230.502(d) under Regulation D or §230.701(c);

Now, let’s talk about the rules that govern “restricted securities.”

Ignoring these rules can create big SEC problems.

Statutory Underwriters and Coming to Rest

The reason the SEC limits an investor’s ability to resell “restricted securities” is to ensure that that the issuer’s sale to the investor is not just the first step of a plan to evade the requirements of offering exemptions from registration. For example, if the exemption from registration requires the issuer to only sell securities to “accredited investors,” it would be easy to avoid that requirement by selling to an accredited investor who then re-sells to unaccredited investors.

To prevent such circumvention of exemption rules, the “restricted securities” sold in exempt offerings have to “come to rest.” Until the securities “come to rest,” any resale of the securities will be deemed to be a continuation of the offering that must satisfy the same exemption requirements that applied to the original offering.

If the restricted securities have not come to rest, the investor who resells the restricted securities is deemed to be a statutory “underwriter, who is continuing the issuer’s original offering. Because “coming to rest” is an ambiguous concept.  So, the SEC issued Rule 144 to create a “safe harbor” to allow both issuers and investors to know when re-sales do not continue the original offering.  SEC Rule 144 is one safe harbor.  In 2016, Congress created another safe harbor by adding Section 4 (a) (7) to the Securities Act of 1933.

The Preliminary Note to SEC Rule 144 explains the problem:

“The term “underwriter” is broadly defined in Section 2(a)(11) of the Securities Act to mean any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates, or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking. The interpretation of this definition traditionally has focused on the words “with a view to” in the phrase “purchased from an issuer with a view to *  *  * distribution.”  An investment banking firm which arranges with an issuer for the public sale of its securities is clearly an “underwriter” under that section. However, individual investors who are not professionals in the securities business also may be “underwriters” if they act as links in a chain of transactions through which securities move from an issuer to the public.”

If an investor complies with Rule 144, they are not deemed to be a statutory underwriter and the resale of the restricted securities will not deemed to be part of the original offering. Generally, the securities will also cease to be “restricted securities” after the Rule 144 resale and unless purchased by an affiliate if the issuer the securities will thereafter be freely tradable without again requiring an exemption from registration.

To ensure that restricted securities are not resold without complying with Rule 144 or another exemption, the SEC requires issuers to impose transfer restrictions.

The transfer restrictions rules for traditional certificated restricted securities are well known. We repeat them here, because many issuers and investors in the COIN world are not familiar with them.

Resale Restrictions of SEC Rule 506 and COINS and Tokens

The transfer restrictions applicable to COINS or Tokens vary depending on what exemption from registration an issuer uses for the original offering. Some other exemptions from registration (such as Regulation A or Regulation CF) have different resale restrictions than those issued under Rule 506.  We discuss Rule 506 below because more than 90% of private offerings use Rule 506.

All securities issued under SEC Rule 506 are “restricted securities.” Rule 506, which is used for most private securities offerings will probably be used for most offerings of COINS and Tokens that are considered securities.  So, let’s consider how “restricted” COINS and Tokens can be transferred following a Rule 506 offering.

Rule 502 (d) requires issuers (among other things) to provide written disclosure to each purchaser prior to sale that the securities have not been registered under the Securities Act and, therefore, cannot be resold unless they are registered under the Securities Act or unless an exemption from registration is available.

Issuers are also required to place a “restrictive legend” on the securities highlighting these same facts. Where securities are issued in uncertificated form, issuers and transfer agents typically impose stop transfer orders, which trigger the same transfer procedures, including an opinion from legal counsel that the transfer complies with securities laws.

Removal of such restrictive legends or stop transfer orders typically involves a transfer agent (acting as the “transfer police”) obtaining a legal opinion from securities lawyers that the transfer can proceed under an exemption.

Will the same procedures be used for Utility Tokens that are deemed to be securities under the Howey test?

There is no exemption from resale restrictions simply because securities are evidenced by a Token rather than by stock certificates.

This raises challenges in the context of a “restricted” COIN or Token that is a security – in effect the blockchain acts as the “transfer police” and thus the smart contract used to mint the COIN or Token needs to implement rules to ensure compliance.

Application to SAFT Utility Tokens and Offshore ICOs

Some issuers may choose to comply with resale restrictions even if they think their Utility Tokens are not securities to minimize liability risk – for example the one-year Blackout Period to satisfy Rule 144. If the issuer sold a SAFT and it takes a year to develop the Utility Token, the tacking provisions of Rule 144 should exempt Token transfers by non-affiliates.  Rule 144 (d) (3) (ii) provides:

“Conversions and exchanges.  If the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms.”

Issuers that may complete development of their Utility Tokens before one year may want to build into their SAFTs the flexibility to delay issuing Utility Tokens until one year has passed.

American companies and their affiliates that sell COINS or Tokens outside the U. S. may have an obligation to ensure the securities “come to rest” outside the U. S. before they are resold into the U. S. See SEC Regulation S for examples of the safe harbor resale restrictions for different types of securities offerings.  For Category 3 securities, issuers that are not public reporting companies must ensure that equity securities are not resold in the U. S. for one year.

As we discuss in an earlier article, however, SEC rules restricting transfers may destroy the business case for issuing COINS and Tokens. https://gatewaycapitalx.com/2018/03/01/securities-re-sale-restrictions-the-achilles-heel-of-icos/

On the other hand, some Tokens are meant to represent securities. These “tokenized” securities may be stock, debt, warrants, or contracts like SAFES, KISSES and BITES that issuers want to be tokenized to create efficient stock transfer systems where sellers can make automated transfers to buyers.

Tokenized securities fit more neatly into traditional SEC transfer rules than Utility Tokens and COINS that are created to be spent to buy technology, products and services.

SEC Rules Affecting Smart Contract Design Choices for Automated Securities Transfer Systems

Different issuers will have different goals. Smart contracts can be designed to achieve specific goals.  The issues you should consider when designing automated securities transfer systems if COINS or Tokens are or might be securities, include the following:

One-Year Blackout Period Imposing a one year blackout period after the offering will allow all non-affiliates to resell freely under Rule 144. This uniformity makes administration simpler.
Prohibit Affiliates from owing Tokens Affiliates can never resell freely under Rule 144.   Some Rule 144 conditions to re-sales always apply to affiliates.  They don’t disappear after one year, because they are “control” securities.  Insider trading and fraud rules also make it prudent to exclude affiliates from owning Tokens.  (Note:  affiliates can own certificated securities that have the same economic rights as Tokens, but that transfer outside the smart contract.)


Only allow re-sales to Accredited Investors This will position you to permit re-sales under Section 4 (a) (7) in you make financial and other information available and comply with other Section 4 (a) (7) requirements. But be careful, because Section 4 (a) (7) prohibits public solicitation by sellers.

Limiting re-sales to Accredited investors will also help you deal with Section 12 (g) issues discussed below.

Limit the number of owners of the class of equity securities Have your smart contract reject any transfers that would increase the number of Token owners above the Section 12 (g) triggers for public reporting if your token is an “equity security” and you have $10 Million in assets at the end of any year. Record owners must be less than 2,000 total owners of which less than 500 can be unaccredited investors.  (Note: the number of record owners includes all securities of the same class whether or not evidenced by a Token.) This is important only if you are concerned that trading will force you to become a public reporting company before you are ready to comply with securities laws.
Require consent of the Issuer Requiring the issuer’s consent for potential buyers to have the opportunity to purchase Tokens on resale allows the issuer to require buyers to make representations about being Accredited Investors and KYC/AML issues.  Issuer consent can also be conditioned on imposing new transfer policies to adapt to changing securities and other rules.
Issuer Repurchase Rights Giving the issuer the right to repurchase Tokens under defined conditions gives the issuer leverage to enforce the other rules.   It may also discourage hacking and other illegal activity.

We note that SEC in its directive re DOA Tokens and ICOs in July 2017 raised the question whether Token transactions violate the “securities exchange” provisions of Section 6 of the Exchange Act. See 15 U.S.C. §78e.  In that context, the SEC was addressing platforms that effect transactions in the securities of multiple issuers, but issuers should not assume that they can totally ignore Section 6 of the Exchange Act.  A review of past SEC no-action letters suggest that issuers would be wise to implement rules described in the no action letters.  The SEC has not yet set forth guidelines for automated stock transfer systems.  Therefore, retaining the flexibility to make changes is important.

Smart Contract Features

In implementing a smart contract to power your automated securities transfer system, keep in mind a few technical rules that can help keep you achieve your securities compliance goals described above:

  1. All Tokens will be subject to the same rules in your smart contract.
  2. Build flexibility into your smart contract and transfer policies to make changes as securities rules change over time.
  3. Your best friends in your smart contract are the power to:
  • Burn
  • Reject
  • Replace
  • Repurchase

“Burn” means to terminate or destroy all or less than all of the Tokens that have not been sold or that have been Rejected through the smart contract.

“Reject” means the ability to take possession (or otherwise eliminate ownership) of all or less than all outstanding Tokens with or without paying compensation.

“Replace” means the ability to (i) terminate the original smart contract governing outstanding Tokens, (ii) record a new smart contract to create a class of replacement tokens and (iii) and automatically replace all or less than all outstanding Tokens with such replacement tokens.

“Repurchase” means the right to repurchase (i.e. Reject) a Token. The power to repurchase is a useful tool for eliminating Token owners that break your rules.Remember, you offering only lasted a few weeks or months. Your smart contract driven transfer system has to withstand the test of time in a fast changing world.

These tools will enable you to enforce the issuer’s rights and fulfill the issuer’s obligations through the smart contract as circumstances change.

Remember, your ICO or other securities offering only lasted a few weeks or months. Your smart contract driven securities transfer system has to withstand the test of time in a fast changing world.

Securities Re-Sale Restrictions: The Achilles Heel of ICOs

Jim Verdonik


(919)  277-9188

COINS and Tokens are creating a new capital raising world.

For the past year, the Securities and Exchange Commission has been focused bringing law and order to that new world.

Much of the focus has been on:

  • Whether a COIN or Token is a security.
  • If a COIN or Token is a security, how to comply with disclosure rules and conditions for exemptions from registration.

Complying with securities laws at the time you first offer and sell securities is certainly important.  Criminals have taken advantage of investor greed.  In other cases, many ICOs failed to provide even basic disclosures, because the sponsors believed they were not selling securities.

Fraudsters will continue to prey upon investors who don’t know that there is no such thing as a “sure bet,” but the days of businesses routinely ignoring securities disclosure and registration rules are over.

New ICOs in the U. S. are making good faith efforts to comply with securities rules about exemptions from registration and disclosure requirements. That’s the easy part of securities law compliance for ICO sponsors.  Exemption and disclosure issues are fairly routine – the tricky part is whether the resale of the Token or COIN complies with securities laws.

The securities law compliance debate is moving to what happens after the offering is over. Issuers who focus only on holding their offering outside the U. S. or only on conducting a compliant U. S. offering should also focus on developing post-offering securities law compliance strategies.

In this article, we will focus on why the nature of COINs and Utility Tokens makes it difficult to comply with routine post-offering resale restrictions and still achieve your business purpose and why blockchain transfer systems pose securities compliance difficulties. Our focus will include:

  • SAFTS and underlying Utility Tokens in the U. S.
  • ICOs conducted by U. S. based companies outside the U. S.
  • Tokenized securities offerings in the U. S. that utilize blockchain stock transfer systems for post-offering transfers by investors
  • Revenue models where issuers intend to charge transfer fees each time a Coin or Token is spent or resold.

SAFTS and Utility Tokens Post-Offering Issues

SAFTS (Simple Agreements for Future Tokens) were introduced in mid-2017 about the time the SEC announced that many ICOs were unregistered securities offerings. Everyone agrees SAFTS are securities that need an exemption from registration and full disclosure. The only debate is whether the Token that is issued when the software development project produces a viable product is a security. This “utility token” may be issued months or even years after the SAFTS are sold depending on how complex the software development project that creates utility is.

The basic premise of the SAFT is that, because the software development risk is eliminated or reduced before the Token is issued, other market forces that are unrelated to the efforts of the Token sponsor become the predominant factor in determining the value of the Token.

The analogy is that investing in a gold mining business is a security, but after the gold comes out of the ground the gold itself is not a security, because the value of gold or other commodities is determined by the laws of supply and demand, which no single person or business controls.

Investors in gold try to determine when the market will rise and fall and buy and sell based on their opinions. If market forces control the value of Utility Tokens, then the holders of the Utility Token controls how much profit they make by deciding whether and when to spend or resell their Utility Tokens just like the buy/sell decisions commodities traders make determines their profits.

In this scenario, Utility Tokens would not be the type of security known as an “investment contract” under the Supreme Court’s test in SEC vs. Howey because the amount of profit depends on the investor’s decisions and not on the efforts of others.

The SEC, however, has vehemently denounced this premise. Essentially, the SEC is asserting that the usefulness of a Token always depends on the efforts of persons other than the Token owner.  While some SAFT proponents may underestimate the continued influence of the efforts of the Token sponsor on the Token’s value, the SEC is taking a very broad approach in saying that the efforts of the Token sponsor almost always continues to determine the Token’s value and therefore, the profits of Token investors.

Since the Howey investment contract test is a facts and circumstances test, it is reasonable to conclude that having utility does not always mean that a Token is not a security and does not always mean that a Token is a security.

Who cares?

One might say: Who cares whether the Utility Token is a security or not if you complied with securities laws when you issued your SAFT?

You don’t need to comply with securities laws a second time when people decide to convert convertible preferred stock to common stock or convertible debt securities to equity securities. That’s because the offering exemption and the disclosure that covered the original offer and sale of the convertible security also covered the securities issuable upon conversion. The same rule applies for exercising warrants.

The convertible security or warrant is a continuous offer to sell the underlying securities. If the issuer is seeking to induce the holders to convert or exercise, the issuer should make updated disclosures. For example, if the issuer offers to change the conversion terms or exercise price to induce conversion or exercise, the SEC deems the changed terms to constitute the offer of a new security.

Why would SAFTs and Utility Tokens be different from convertible securities? 

Transfer is the Primary Purpose of COINS and Utility Tokens

One difference is that a traditional security represents ownership of some type of economic right that exists independently of whether you can transfer the securities. The value of traditional securities comes from a debt being repaid or a dividend or a liquidity event, such as an IPO or merger.  Currently, most traditional securities of private businesses are never resold or actively traded.  Transferability is a nice additional feature for traditional private securities, not the whole value.

COINS and Utility Tokens on the other hand have no purpose if you cannot transfer them easily. Imagine the chaos if you imposed complex transfer restrictions on U. S. Dollars or Euros.

Unlike traditional securities, the primary purpose of COINS and Utility Tokens is to serve as a type of transferable currency that is used to purchase technology, products and services. Therefore, traditional securities resale restrictions will probably substantially impede the usefulness of Utility Tokens, if they are securities.

This means that even issuers who fully comply with SEC rules when they offer and sell Coins or Tokens will have problems dealing with resale questions, if Utility Tokens are considered securities. What good is Token that supposedly enables you to purchase something, if securities laws impose expensive time consuming barriers to spending the Tokens?

One of the primary benefits issuers of SAFTS (Simple Agreements for Future Tokens) would gain, if the Utility Tokens issued to owners of SAFTS are not deemed to be securities, is that the Token owners could freely spend their Tokens without securities law restrictions.

The SEC’s pronouncements that all Utility Tokens that are issuable to SAFT owners will be securities, therefore, go far beyond simply wanting to ensure that purchasers of SAFTs receive adequate disclosure.

This raises the question: Is the SEC intentionally undermining the usefulness of COINS and Tokens?

Governments around the world fear COINS and Tokens that break government monopolies over currency. Is the SEC joining China in seeking to ban COINs and Tokens?

What effect will this have on how blockchain develops in America?

COINS and Tokens are not absolutely necessary for all blockchains, but the reality is that many blockchain creators and users find COINS and Tokens useful instruments. Therefore, the SEC’s campaign against COINS and Tokens could substantially change the direction of blockchain development.

This raises the question: Do we want securities laws steering technology development?

Affiliates of Sponsors Foreign ICOs

It is common practice in many ICOs to reserve Tokens for later sale by the sponsor and its affiliates of issuers. Restrictions on re-sale by affiliates are even more onerous than for re-sales by non-affiliate investors.  Therefore, Utility Tokens owned by affiliates would be even less useful as a currency than Utility Tokens owned by non-affiliates.

Foreign ICOs

So far, we have focused on issuers who conducted U. S. SAFT offerings.  There are many complex issues associated with U. S. based companies trying to do an offering that is completely outside the U. S.,  but issuers who successfully conduct ICOs outside the U. S. without selling to U. S. investors should also consider what will happen after their ICOs.

If their Utility Tokens are securities under U. S. securities laws, then resales by investors of Tokens into the U. S. would constitute the resale of a security in the SEC’s view. Spending the Utility Tokens in the U. S. would probably be considered reselling them in the U. S. for securities law purposes, because the SEC has long taken the position that exchanging anything of value for a security constitutes a sale of that security.

That will not matter if the sponsor creates a resale market that is totally outside the U. S., but many U. S. issuers have conducted offerings outside the U. S. on the assumption that the Tokens will later be used to purchase technology, products and services in the U. S. Keeping Tokens offshore may substantially decrease demand for such Tokens and decrease their value.

Broker-Dealer Issue: Revenue Model of Utility Token Sponsors

We have focused on the usefulness of Tokens when they are issued.   Let’s turn our attention to how Token sponsors intend to generate revenue.

Some Token sponsors intend to create marketplaces where Tokens are the medium of exchange.  If the sponsor’s revenue model is to collect transaction fees each time someone uses a Token to purchases something, this raises the question whether the sponsor is acting as an unregistered broker-dealer.

If the Token is a security, is the transaction fee a commission for selling the security? Maybe not. Maybe the commission is on the sale of the technology, products or services that the Token buys. However, the SEC has questioned whether Token sponsors need to register as broker-dealers.

The SEC has a long history of protecting broker-dealers from competition. Is this another in a long series of actions by the SEC to protect Wall Street?

Tokenized Securities

On the other hand, some Tokens are meant to represent securities. These “tokenized” securities may be stock, debt, warrants, or contracts like SAFES and KISSES that issuers want to be tokenized to create efficient stock transfer systems where sellers can make automated transfers to buyers.

I describe 2017 changes to Delaware’s General Corporation Law to permit such automated stock transfer systems in my article of February 16, 2018.  https://gatewaycapitalx.com/2018/02/16/delaware-law-on-blockchain-and-other-automated-stock-transfer-and-records-systems/

Whether the instrument is a traditional stock certificate, a tokenized security or a COIN or Token that the SEC deems to be a security, restricted stock transfer restrictions following an unregistered offering are essentially the same. They must satisfy their obligations to avoid conducting a distribution through statutory “underwriters.”

The new wrinkle for issuers of tokenized securities is that blockchain powered stock transfer systems require careful planning to comply with restricted stock transfer rules. My next article will discuss how to design blockchain stock transfer systems to comply with restricted stock rules.


The cost efficiency and convenience of automated blockchain stock transfer systems will be impeded, however, unless the SEC clarifies how broker-dealer and securities exchange regulations under the Securities Exchange Act of 1934 impact the blockchain and smart contract stock transfer systems issuers would like to implement.

Regulatory Clarification Needed

No one disputes that investors need adequate disclosures when businesses sell securities to raise capital. Some ICO issuers turned a blind eye to securities laws.  Action should be taken to restore the principle that investors deserve full disclosure.  But the SEC’s rush to classify all COINS and Tokens as securities raises a host of other questions for which the answers are much less clear:

  • Should spending Tokens to buy technology, products and services really be subject to the same re-sale restrictions as reselling securities?
  • Should marketplaces where Tokens buy technology, products and services be added to Wall Street’s monopoly over securities sales?
  • Should issuers of tokenized securities be prohibited from creating automated efficient stock transfer systems as the Delaware General Corporation law now permits?
  • Should securities laws be used to maintain government monopolies over currency?

There is no need to make this a winner-takes-all game.

Why not create a system where disclosures are required when issuers raise capital, but exempt COINS and tokens from all the other restrictions that automatically follow the determination that something is a security?

If the SEC does not show restraint, it would be useful for Congress and the Courts to act to place reasonable boundaries over the extent to which the banner of investor protection should be used to regulate commerce and technology.


Delaware Law on Blockchain and Other Automated Stock Transfer and Records Systems

Jim Verdonik


(919)  277-9188

One of the best applications for Blockchain technology is automating the tedious process of maintaining stock ownership records.

Delaware requires corporations to be able to produce a list of stockholders entitled to vote and in some circumstances to share that list with the stockholders of the corporation.

For many businesses, this is a fairly simple task, because their stockholders rarely change. If your stockholder base is more active, however, automating the stock transfer record keeping process through blockchain software may be useful to you.

Obviously, publicly-traded corporations have a changing stock ownership base. But some types of private corporations do as well.  The reasons private companies have large numbers of changing owners (and that many more are likely to in the future) include:

  • COINS and Tokens offerings (some of which may be equity securities) are being marketed to retail investors in the U. S. and foreign jurisdictions. In many cases, these investors are reselling without restrictions.
  • Several years ago, the number of record owners that triggers public company reporting requirements under Section 12 (g) of the Securities Exchange Act of 1934 was increased 2,000 as long as no more that 500 are not Accredited Investors. So, some private companies have a lot of shareholders.
  • Crowdfunding is increasing the number of private businesses that have hundreds of stockholders.
  • Certain Crowdfunding exemptions (Regulation CF and Tier 2 of Regulation A) provide that owners who purchase shares in these offerings are not counted toward the number of stockholders that trigger Section 12 (g) registration.
  • Regulation A permits stockholders to resell their shares in the same offering the issuer uses to raises capital. This facilitates a few large stockholders reselling to many other investors while the company is still private.
  • Early angel investors are becoming more proactive in seeking to be able to exit their investments before the corporation is sold or becomes public.
  • Brokers-dealers are operating secondary trading markets for mature private companies.
  • Corporations are choosing to stay private much longer than several decades ago. Private Unicorns have market caps that exceed $1 Billion.
  • Public reporting requirements under Sarbanes-Oxley and other “reforms” make it more expensive to be a public company, which has caused many businesses to choose to stay private. There has been a substantial decrease in the number of public companies.
  • Large private tech and science based businesses have granted stock options and restricted stock to many employees.
  • Private equity funds provide the capital for private businesses to grow much larger than without becoming public. Many of these businesses reward employees with equity grants.
  • Families use trusts and LLCs for estate tax planning purposes. So, shares are distributed to many family members.Several states have already changed their corporate statutes to permit the use of blockchain and other technology to record corporate records, including stock ownership ledgers.

All these factors are increasing the demand for cheaper more efficient securities transfer systems.

In other article, I discuss how to design your blockchain transfer system to comply with SEC rules or transferring “restricted securities” and why SEC transfer restrictions are the Achilles of the ICO world.



In this article, however, we will  focus on how state law applies to automated securities transfer systems.

 Several states have already changed their corporate statutes to permit the use of blockchain and other technology to record corporate records, including stock ownership ledgers.

Let’s look at how Delaware is treating blockchain and other record keeping technologies.

The Delaware General Corporation Law (“Delaware GCL“) was amended in 2017 to authorize using “electronic networks and databases” for records that state law requires corporations to maintain.

Section 224 of the Delaware GCL says that corporate records may be kept on “one or more electronic networks or databases (including one or more distributed electronic networks or databases).” This authorization is broader than either stock transfer records or blockchain.  It applies to any type of corporate records and to any type of “electronic records of databases.”

Section 219 of the Delaware GCL specifically covers stockholder lists. Section 219 (c) defines what a stock ledger is, but Section 219 does not \use the term “stock ledger.”

(c) For purposes of this chapter, “stock ledger” means 1 or more records administered by or on behalf of the corporation in which the names of all of the corporation’s stockholders of record, the address and number of shares registered in the name of each such stockholder, and all issuances and transfers of stock of the corporation are recorded in accordance with § 224 of this title.  The stock ledger shall be the only evidence as to who are the stockholders entitled by this section to examine the list required by this section or to vote in person or by proxy at any meeting of stockholders.

The Delaware GCL requires four types of information to be in a stock ledger:

  • Stockholder name
  • Stockholder address
  • Number of shares registered under each name
  • All issuances and transfers

In assessing whether blockchain is suitable for use as a “stock ledger,” it should be noted that the Delaware DCL does not specifically require a physical mailing address and does not require the corporation to record only legal names in birth certificates. Corporations rarely inquire as to the legal status of names and often use email and other types of addresses that stockholders give them.

Corporations should, however, consider the impact of anti-money laundering, anti-terrorist and anti-privacy laws on the information they collect about stockholders in original issuances and stock transfers.

So, what does a corporation do if a record owner only provides a blockchain address?

No law requires any person to have a physical mailing address. Therefore, people can choose their addresses, which can be electronic or not.  Likewise, people change addresses and are not required it inform corporations in which they own stock of address changes.  Many stockholders are unreachable.

Tax and other laws may require businesses to report information to the IRS and other agencies. Names are associated with social security and other tax ID numbers for reporting tax information, but the Delaware GCL does not require such tax ID information to be in the “stock ledger.”

Securities laws (such as those relating to bad actors, accredited investors and beneficial ownership) may affect decisions about what information corporations should require stockholders to provide, but such information is not required to be included in the stock transfer ledger.

Note that the requirements for a stockholder ledger are different from a stockholder list (the stockholder list is not required to include all issuances and transfers. Section 219 (a) of the Delaware GCL provides that:

The corporation shall prepare, at least 10 days before every meeting of stockholders, a complete list of the stockholders entitled to vote at the meeting; provided, however, if the record date for determining the stockholders entitled to vote is less than 10 days before the meeting date, the list shall reflect the stockholders entitled to vote as of the tenth day before the meeting date, arranged in alphabetical order, and showing the address of each stockholder and the number of shares registered in the name of each stockholder. Nothing contained in this section shall require the corporation to include electronic mail addresses or other electronic contact information on such list.

“Stock ledgers” are part of the “books and records” of a corporation. Section 220 of the Delaware GCL gives stockholders limited rights to inspect corporate books and records and specifically includes “the corporation’s stock ledger, a list of stockholders and other books and records.”

Section 224 of the Delaware GCL that governs the form of corporate records does not require corporations to maintain paper records, but it does require that records kept in electronic form be kept so that they “can be converted into clearly legible paper form within a reasonable time.”[1]

What other information is required by the Delaware GCL to be in the corporate records?

Section 224 of the Delaware GCL provides that records kept in electronic form must be kept so that they:

“(i) can be used to prepare the list of stockholders specified in §§ 219 and 220 of this title, (ii) record the information specified in §§ 156,[2] 159,[3] 217(a)[4] and 218 of this title, and (iii) record transfers of stock as governed by Article 8 of subtitle I of Title 6.[5]

Other provisions of the Delaware GCL that permit notices to be delivered in electronic form will enable corporations to communicate with their stockholders through blockchain addresses. These include: notices of preferences and special rights for stock certificates,[6] stock transfer restriction notices,[7] electronic notices,[8] and notices regarding “public benefit” status.[9]

The bottom line is that blockchain stock transfer records can, if thoughtfully implemented, satisfy the requirements of the Delaware General Corporation Law.

Blockchain is a relatively new technology. Corporations may find that they need to customize blockchain software to make it suitable for stock transfer ledger purposes. For example, corporations may want to make it easier to locate and convert into paper form the information required to satisfy the paper and inspection requirements of Delaware General Corporation Law.

This raises the question of what type of blockchain should corporations use for stock transfer ledger purposes. Other blockchain solutions may emerge over time, but the Ethereum Network is a good candidate, because the Ethereum Network accommodates “Smart Contracts” that permit corporations to decide what data to collect and who has access to the information.

Of course, there are several important differences between traditional stock transfer records and using the blockchain:

  • Blockchain enables sellers to make it known that they want to sell, how many shares they want to sell and the price they are willing to sell at and buyers to make it known that they want to buy, the number of shares they want to buy and the price they want to pay.
  • Blockchain facilitates direct communications between potential sellers and buyers.
  • Blockchain actually powers the transaction between buyers and sellers instead of passively recording it after the fact.

All of these blockchain capabilities raise securities law issues for corporations intending to use blockchain for their stock transfer ledgers, including compliance with:

  • Offering rules for original issuances by issuers
  • Stock transfer restrictions following issuances of unregistered securities
  • Section 12 (g) of the Securities Exchange Act of 1934
  • Broker-dealer issues and
  • Rules related to securities trading exchanges.

Unless corporations understand rules for stock transfers and include in their software functions that assure compliance, they risk violating numerous securities laws. Smart Contracts are a vehicle for establishing these rules.

We deal with these issues in other articles.

[1] Section 224 of the Delaware DCL:  “Any records administered by or on behalf of the corporation in the regular course of its business, including its stock ledger, books of account, and minute books, may be kept on, or by means of, or be in the form of, any information storage device, method, or 1 or more electronic networks or databases (including 1 or more distributed electronic networks or databases), provided that the records so kept can be converted into clearly legible paper form within a reasonable time, and, with respect to the stock ledger, that the records so kept (i) can be used to prepare the list of stockholders specified in §§ 219 and 220 of this title, (ii) record the information specified in §§ 156, 159, 217(a) and 218 of this title, and (iii) record transfers of stock as governed by Article 8 of subtitle I of Title 6. Any corporation shall convert any records so kept into clearly legible paper form upon the request of any person entitled to inspect such records pursuant to any provision of this chapter.  When records are kept in such manner, a clearly legible paper form prepared from or by means of the information storage device, method, or 1 or more electronic networks or databases (including 1 or more distributed electronic networks or databases) shall be valid and admissible in evidence, and accepted for all other purposes, to the same extent as an original paper record of the same information would have been, provided the paper form accurately portrays the record.”

[2] Section 156 of the Delaware DCL governs partly paid shares.

[3] Section 159 of the Delaware DCL governs transfer rules for when shares are transferred as collateral security.

[4] Section 217(a) of the Delaware GCL governs stock held by fiduciaries

[5] Article 8 of subtitle I of Title 6 of the Delaware Code governs security interests in stock and other financial assets.

[6] Section 151 (f): “Within a reasonable time after the issuance or transfer of uncertificated stock, the registered owner thereof shall be given a notice, in writing or by electronic transmission, containing the information required to be set forth or stated on certificates pursuant to this section or § 156, § 202(a), § 218(a) or § 364 of this title or with respect to this section a statement that the corporation will furnish without charge to each stockholder who so requests the powers, designations, preferences and relative participating, optional or other special rights of each class of stock or series thereof and the qualifications, limitations or restrictions of such preferences and/or rights.”

[7] Section 202 (a) of the Delaware GCL states : “A written restriction or restrictions on the transfer or registration of transfer of a security of a corporation, or on the amount of the corporation’s securities that may be owned by any person or group of persons, if permitted by this section and noted conspicuously on the certificate or certificates representing the security or securities so restricted or, in the case of uncertificated shares, contained in the notice or notices given pursuant to § 151(f) of this title, may be enforced against the holder of the restricted security or securities or any successor or transferee of the holder including an executor, administrator, trustee, guardian or other fiduciary entrusted with like responsibility for the person or estate of the holder. Unless noted conspicuously on the certificate or certificates representing the security or securities so restricted or, in the case of uncertificated shares, contained in the notice or notices given pursuant to § 151(f) of this title, a restriction, even though permitted by this section, is ineffective except against a person with actual knowledge of the restriction.”

[8] Section232 (c) of the Delaware GCL states: “For purposes of this chapter, “electronic transmission” means any form of communication, not directly involving the physical transmission of paper, including the use of, or participation in, 1 or more electronic networks or databases (including 1 or more distributed electronic networks or databases), that creates a record that may be retained, retrieved and reviewed by a recipient thereof, and that may be directly reproduced in paper form by such a recipient through an automated process.”

[9] Section 364 of the Delaware GLC provides: “Any stock certificate issued by a public benefit corporation shall note conspicuously that the corporation is a public benefit corporation formed pursuant to this subchapter.  Any notice given by a public benefit corporation pursuant to § 151(f) of this title shall state conspicuously that the corporation is a public benefit corporation formed pursuant to this subchapter.”

Crunching Revenue Share Loan Numbers

Jim Verdonik


(919)  277-9188

Capital Talks are  a series of conversations Jim Verdonik is having with interesting people about anything he wants to talk about.

Viewer discretion is advised.

In this session Jim Verdonik talks with Benji Jones about: CRUNCHING REVENUE SHARE LOAN NUMBERS

BENJI: Jim, We’ve already discussed the general positives and negatives of Revenue Share Loans, but we’ve forgotten one important thing.

JIM: What’s that?

BENJI: The numbers.  How do people know the Revenue Share loan numbers work for them and their business?

BENJI: Before you start talking numbers, let’s do a short recap on how a Revenue Share Loans work.

BENJI: A revenue share is a loan that is paid back over time by the borrower “sharing” a percentage of its “revenue” at regular intervals until it has returned to the lender a fixed multiple of the amount loaned. The percentage of revenue the business pays can vary widely based on projected revenue and operating profit.

JIM: How long are the loans?

BENJI: The business’ repayment obligation might be open ended (meaning the loan remains outstanding until the stated return is met without a final due date), but more often the payback amount must be repaid in full within a specific time window (say 3 to 5 years). Having a definite end date may require the business to make a “balloon payment” at the end of that period if the monthly or quarterly revenue percentage repayments are less that the total payback amount. BENJI: Are there any economic tests you use to determine whether a business can repay its revenue share loan?  How do you know you won’t default on the loan.

BENJI: Now that I’ve explained the basic loan terms, let’s discuss three basic economic points:

  • What are the returns on investment for Revenue Share Loans?
  • How do businesses know what terms they can afford to pay so that they don’t default?
  • How do you decide whether selling equity or Revenue Share Loans is in the owners’ interests?

JIM:   I’ll jump into investment returns first.  There is a correlation between the payout multiple investors demand and the maturity date the business wants.  For example, a Rev Share loan with a three-year maturity might be marketable to investors at a 1.5x multiple.  For a five year maturity, investors might want a 1.75x multiple.

BENJI: Is there an upside for the investor?  Or is it always the same rate of return?

JIM: The total amount the investor receives is fixed, but the shorter the length of time the company takes to fulfill its obligation — the quicker the payout and the higher the rate of return (ROI).  If a company can convince investors that it can repay the loan quickly, it can attract investors with a lower payback multiple.  If a loan has a five year maturity date and the company repays the loan in three years, investors can achieve double digit annual compounded interest rates.  So, investors can “hit the jackpot,” if revenue increases faster than the company projects.

BENJI: Since the total amount investors receive is always the same, explain this jackpot concept.

JIM: The investor wins because the investor can reinvest any money the investor receives earlier than expected. Any profit from that reinvestment is a windfall for the investor.

BENJI: So, what are the best types of businesses to sell Rev Share loans?

JIM: The big three industries are: food, booze and software.

BENJI: I see the connection with food and booze, but what does software have in common with food and booze?

JIM: Restaurants, breweries and software all fit the model of starting to generate revenue after a relatively small investment.  They also tend to have repeat customers.  Software has the added advantage of having both relatively high margins and high annual revenue growth rates.

BENJI: That tells us about industries generally, but are there specific economic characteristics that tell us a particular business is a good Rev Share loan candidate?

JIM: The business attributes we look for when we recommend Rev Share deals are:

  • Either a track record of having revenue or certain near term prospects for generating revenue so that investors will start getting money back within a few months.
  • Companies that are or soon will become profitable. You can’t repay debt from revenue that you have to spend to pay your operating expenses. Revenue growth without profit growth can cause borrowers to default, because their monthly repayments increase at the same time their other expenses are increasing.
  • High margins hold the potential for profitability, but that’s only true if management controls expenses. So, the best Rev Share candidates are business where expenses don’t grow as fast as revenue.
  • Projections for high annual revenue growth rates enable companies to repay their loans from the faster growth they generate from the loan proceeds.
  • The business can make a good case that every dollar invested in marketing or expanding production has historically resulted in multiple dollars of additional revenue.

JIM: We use the traditional the Debt Service Coverage Ratio that banks use to help businesses decide whether they can repay a Rev Share loan. Banks usually want a 1.25 or 1.3 to 1 ratio of adjusted net operating profit to total debt service obligations.  A 1:1 ratio is theoretically sufficient to repay, but banks want a cushion to avoid defaults. Rev Share borrowers must decide how much of a safety net they want to build into their offering terms.

BENJI: Are there any other differences from how banks make loan decisions?

JIM: Banks also tend to be conservative about projected revenue and profit growth rates, which affect the Debt Service Coverage Ratio calculation after the first year of the loan. Business owners have to decide whether they really believe their own growth rate projections. If they believe their own projections, they can move forward based on projections a bank would heavily discount.

BENJI: How can businesses easily run the numbers to see whether they make the cut?

JIM: We have financial modeling tools that use the clients’ own data about current revenue and profits and projected growth rates to help clients quickly analyze multiple offering terms and repayment scenarios.

BENJI: What financial information do our tools give businesses?

JIM: Our tools calculate projected interest rates, projected repayment instalments and Debt Service Coverage Ratios based on the amounts they want to borrow, proposed maturity dates and the payback multiples they are considering offering investors.

BENJI: How long does that process take?

JIM: We collect relevant information from businesses using short questionnaires. A business can usually provide the information we need in less than ten minutes, if it already has historical financial information and projections

BENJI: So, then do we guaranty a successful payback? I don’t like the sound of that.

JIM: Of course not. Our financial modeling tools just show how the loan terms will work using the loan terms the business wants to test and the data and projections that businesses provide. Many factors affect whether the loan will actually be repaid. Projections are often wrong. If they are, the business may not be able to repay the loan.

BENJI: So, it all depends on the business’ own projections.

JIM. Right. Businesses decide what their projections should be. We just help businesses understand how the loan terms work in light of the data and projections they provide. Later in the offering process, we ask businesses questions about their projections that help them make disclosures to investors. Sometimes businesses change their projections because of our questions. Ultimately, however, businesses are responsible for their own data and projections. We don’t make that decision for them.

BENJI: So, what happens if business owners don’t know how to do projections? Are they out of luck doing an offering?

JIM: No. If the owners need help, we can recommend other experts to help them. It’s just not what we do.

BENJI: A lot of business owners are trying to decide whether to sell stock or other equity securities. Selling equity dilutes their stock ownership, but they need capital to grow so that they can eventually sell the business for a high price.  Can you tell us whether Revenue Share Loans will provide a higher resale price for owners than selling equity?

JIM: Selling equity usually promotes faster revenue growth than borrowing does, because if you sell equity you are not repaying debt installments each month like you have to do with a Revenue Share Loan.  That means the business can reinvest more money in growth every month.

BENJI: Is the slower monthly revenue growth significant?

JIM: Not in any single month, but it adds up over the 36 to 60 months of a loan.

BENJI: So, that means Revenue Share Loans will probably reduce the total resale price of a business compared to the resale price a buyer would pay if the business had sold equity securities.

JIM: But that’s not the whole story, is it?

BENJI: Of course not.  When you sell equity, you’re selling the investors part of the resale proceeds.  The original owners won’t receive all the resale proceeds.  How do owners know what the best deal is after you take dilution into account?

JIM: Whether equity or Rev Share is a better dilution deal for the founders and earlier investors depends on a combination of the rate of return on investment the new equity investors would want and the multiple of revenue a buyer would pay at exit when the company is sold.

BENJI: Let’s deal with the multiple of revenue when the business is sold.  There are pretty common industry standards to predict that.  But things like growth rates, margins, net profits and balance sheet items like assets and liabilities can affect the actual multiple.

JIM: Right.  The price a business will sell for is partially industry related, but company specific factors also play a role.

BENJI: Now, let’s deal with the investor expectation factor. Explain how that varies.

JIM:   Investor return expectations affect the percentage of equity investors receive.  Typically, venture investors want a 10x return on investment.  Sophisticated angel investors are often willing to accept a 5x return on their investment.  In either case, that means you give up a big percentage of ownership that usually results in the investors getting more of the sale proceeds when the company is sold.

BENJI: 10x sounds pricy.  I could buy my own island if all my investments paid 10x.

JIM: Of course, most investments don’t return 10x and Crowdfunding equity investors often expect less.  So, a business might find equity investors in the Crowd who only require a 3x return in investment.  If that happens, you might be better off taking the dilution by selling equity to boost revenue growth, but only if you can sell the company for a very high multiple of revenue.

BENJI: So Jim, what’s the bottom line?

JIM: Whether equity or Rev Share is a better deal for the founders and earlier investors depends on a combination of the rate of return on investment the new equity investors would want and the the multiple of revenue a buyer would pay at exit when the company is sold.

BENJI: So, you’re saying “It depends.”  That sounds like the type of evasive answer people don’t like about lawyers.  Give the folks a break.  Be more specific.

JIM: OK.  Here it goes.  In most scenarios, our numbers crunching indicates that selling Revenue Share loans produces a higher net sale price at exit to existing owners than selling equity does.  In short:  Rev Share loans protect not only against percentage dilution but protect against value dilution.  I hope I don’t get disbarred for giving a clear answer.

BENJI: That wasn’t really so hard.  Was it?

JIM: I just hope I don’t get disbarred for giving a clear answer without any hedges.

BENJI: You’re right.  That’s totally not very lawyerly behavior, but we’re not your average lawyers.

This is Jim Verdonik signing off until our next Capital Talk.

This article is one of a series of three articles that discuss Revenue Share Loans in detail.  You can find our other two articles at:

Loving Revenue Share Loans


Why Investors and Businesses May Not Love Revenue Share Loans



The content contained on this article does not provide, and should not be relied upon as, legal advice. It does not convey an offer to represent you or an attorney-client relationship.  All uses of the content contained in this article, other than for personal use, are prohibited.

Why Investors and Businesses May Not Love Revenue Share Loans

Jim Verdonik


(919)  277-9188

Capital Talks are  a series of conversations Jim Verdonik is having with interesting people about anything he wants to talk about.

Viewer discretion is advised

In this session Jim Verdonik talks with Benji Jones talk about:


BENJI: Jim, in our last discussion about Revenue Share loans, we gave a pretty flattering description of Revenue Share loans.  Two lawyers can’t talk about this without talking about the downside.  Go ahead.  Spoil the party.  What are the problems with Revenue Share loans?

JIM: Like anything that sounds too good to be true, sometimes it is.  Here are the issues you need to watch out for – reasons you might not to LOVE Rev Share:

  1. Repayments can slow a business’ ability to reinvest in long-term growth compared to equity.
  2. Slower revenue growth may mean a lower sale price at exit (if that’s what the business owners are looking for).
  3. Paying investors is an ongoing expense and can be headache, unless you hire someone do it like a payroll service.
  4. Paying investors also requires sharing periodic revenue numbers with many people.  This info may leak to competitors and customers.
  5. In an LLC or other pass through entity, owners will be taxed on phantom profits used to repay the loans.  That’s not a problem with equity.
  6. Future lenders may be unwilling to make new loans to the company while the Rev Share debt is outstanding.

JIM: Benji, don’t make me do all the hard stuff.  It’s your turn.

BENJI: OK, I still LOVE Rev Share, but raising capital through investment crowdfunding is complicated.  Businesses need to be prepared for added regulatory and compliance costs, as well as the distractions that accompany taking investments from a “crowd” of people.  Management still has a responsibility to provide information and respond to these investors, even if they are not “owners” of the business.  In addition, businesses raising capital through Rev Share loans will need to manage the payout process carefully.

JIM: What about investors?

BENJI: Investors should recognize that there are always risks associated with any kind of investment – particularly investments in small businesses and startups.  There is no guarantee that the business you love will actually continue to operate successfully or derive sufficient revenue to repay your loan.

JIM: Can you talk some more about what investors should consider before investing?

BENJI: Many of the things that might be appealing for companies about Rev Share loans cut the other way for investors.  For instance, unlike equity, Rev Share investors don’t have any voting, economic or management interest in the business.  Although they are creditors, they typically don’t benefit from personal guarantees, security interests, financial covenants, or other restrictions that protect banks or institutional investors.  Rev Share loans are often junior to other loans the business has now or may obtain in the future.  That means that other lenders may get paid while Rev Share loans remain unpaid.  This risk of junior debt is why Revenue Share loans offer higher interest rates than banks typically charge.

JIM: Are there any other reasons investors should be cautious?

BENJI: Although Rev Share loans offer the opportunity to support the businesses you care most about – investors should consider all of the terms being offered by the company and all the facts the company discloses, including whether the company is generating revenue, to minimize your risk of not getting paid back and maximize your expected return.  It is critical to understand the terms that govern an investment before you commit.

JIM: What’s the best way for investors to deal with these risks?

BENJI: Diversification.  Don’t invest too much of your capital in any single business or in any single type of deal.

JIM: So, are you advising investors to LOVE Rev Share loans in moderation?

BENJI: Yes.  Too much of anything can be bad for you.  Revenue Share loans are no different.

JIM: What about taxes?

BENJI: Rev Share has a more complex tax impact than say, straight debt or equity, due to the variable nature of the installment payments.  Businesses and investors alike will need to understand how tax payments and paperwork will be handled post-closing.  (Many platforms, like Streetwise and LocalStake, offer post-closing payment services to help companies manage these hurdles.)  You should consult your personal tax, accounting and legal advisors before making an investment.

JIM: Do you have any parting advice for potential Rev Share issuers and investors?

BENJI: I’ll tell them the same thing my Mother told me growing up.  It always started like this:

Before you get “hitched” . . . and ended with a tragic story.

JIM:  Sounds like you have the makings of a country-western song there.

BENJI:  There’s a lot of drama in raising capital.  So, why not?  Of course, LOVING Rev Share when you plan your deal is a lot like getting married.  Most people are in LOVE when it starts, but how long the LOVE lasts is what counts.  Having a long lasting LOVE of Rev Share depends on whether your projections were realistic and how you manage your business.  So, be careful your LOVE affair with Rev Share doesn’t end in a messy divorce.

This is Jim Verdonik signing off until our next Capital Talk.

This article is one of a series of three articles that discuss Revenue Share Loans in detail.  You can find our other two articles at:

Loving Revenue Share Loans


Crunching Revenue Share Loan Numbers


The content contained on this article does not provide, and should not be relied upon as, legal advice. It does not convey an offer to represent you or an attorney-client relationship.  All uses of the content contained in this article, other than for personal use, are prohibited.