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Stories From the Crypt: Some ICO Lessons From Dot-Com 1.0 — A Venture Lawyer’s Perspective

It has been an interesting Spring thus far in the ICO market, particularly from the perspective of a venture lawyer. On the one hand, the SAFT, introduced in October, 2017 by Protocol Labs and Cooley LLP in connection with Filecoin’s ICO, appears to have been widely adopted by US token issuers and the broader blockchain community. Given the alluring simplicity of the SAFT form as well as the premised upgrade in regulatory certainty touted in The SAFT Project Whitepaper, it should come as no great surprise that the SAFT enjoyed almost immediate adoption as the de facto standard legal vehicle for compliant US-based ICOs. It’s also fair to say that the high degree of adoption accorded the SAFE form in the early-stage financing venture ecosystem — among many of the same players as are now involved in crypto-related projects — paved the way SAFT adoption. Not for nothing, the two forms share significant DNA and at first glance even look interchangeable.


In paralell with this rapid adoption, the SAFT and, more so, the legal reasoning set forth in The SAFT Project Whitepaper, was almost immediately taken to the woodshed by a vocal and diverse group of critics. Within weeks of the SAFT’s introduction to the blockchain community, Cardozo Law School, under the auspices of The Cardozo Blockchain Project, put out what it called “Research Report #1”. The Cardozo Report convincingly challenged the central premise of the SAFT, namely that utility tokens issued to SAFT investors upon “Network Launch” would fail the Howey test (the Howey test is a reference to the seminal US Supreme Court decision with respect to what is and is not a “security” for purposes of the federal securities laws). According to the reasoning set forth in the Cardozo Report, such tokens would be subject to the federal securities laws. In fact, asserted the Cardozo Report, “the SAFT Approach ultimately fails to deliver a simplified and binary compliant token sale framework as advertised”.
In addition to the skepticism levied against the legal analysis underpinning the SAFT, critics took major umbrage with the fact that access to ICOs using the SAFT approach would be limited to accredited investors, thereby locking out anyone who didn’t meet the income and/or net worth tests set forth under the federal securities laws. This attack carried with it a conspiritorial political dimension, specifically that the SAFT was another example of entrenched wealthy interests hiving off early profits while leaving so-called “main street” investors to fight over the table scraps. To add insult to injury, those complaining of being shut out of the ICO gold rush are in many cases the people responsible for the emergence of blockchain technology itself, i.e., the academic and engineering communities as well as the hacker-cryptoenthusiast community that sprung up around this core group. Whether true or not, this narrative has firmly taken hold as one of many subplots in the current crypto revolution.


With the recent news that the SEC has issued eighty subpeonas to various participants in the ICO market, there is a sense that the initial honeymoon period, at least for US ICO issuers and investors, may be coming to a close. The SEC had previously expressed skepticism with respect to the two-step, binary approach formulated in The SAFT Project Whitepaper, and it has also made clear its deep concerns with the broader ICO market with respect to “pump and dump” schemes, highly marketed frauds and scams, and a litany of other boiler-room methods for separating investors from their hard-earned money. As disruptive a technology as blockchain is (and almost no one seriously doubts that it is), the concerns of the SEC are somewhat of a “back to the future” phenomenon to those of us of a certain age, with familiar echoes of the first dot-com boom and the concerns of “irrational exuberance”.


As someone who lived through dot-com 1.0, the current moment brings back memories. I was working as a mid-level corporate associate at Wilson Sonsini Goodrich & Rosati in Palo Alto right as the original dot-com boom was cresting in late 1999/early 2000. Two distinct impressions have stayed with me most about that time, both of which may be instructive to the current crypto moment.


The first is the inconsistent quality control with respect to start-ups getting funded. There were simply so many startups, so much money pouring in and such a gold rush mentality, that when combined with the short track record with respect to “Internet investing” (as it was then called), diligent vetting of founders, product, and candidly even legal documents was often an afterthought. Relatedly, there was often minimal oversight of how funded (often grossly overfunded) companies actually deployed capital. Recall that these were the days of Series A funded companies throwing lavish company parties, hosting elaborate offsites, and installing pool tables and ping pong tables in spacious staff lounges.


The second impression that has stuck with me from the days of late-nineties venture lawyering is that there existed a kind of “exit industrial complex” comprised of savvy, opportunistic founders, venture firms, law firms and investments bankers hellbent on getting companies to an exit, which at that time typically meant an IPO. The last throes of this phenomenon was well chronicled in “e-dreams”, Wonsuk Chin’s excellent 2002 feature documentary about the rise and fall (mainly the fall) of As a result of these two broad market forces, many of the companies that got into registration and then went public were, with the benefit of hindsight, destined for disaster.


I would posit that the story of the first dot-com boom is instructive to the current blockchain season in two ways. First, to the critics of the SAFT framework, be careful what you wish for because you just might get it. The SEC’s determination to strictly enforce the federal securities laws when it comes to ICO investing may well result in a bucket of knowledgeable investors with access to high-quality ICO dealflow who are non-compliant for Reg D purposes and are therefore ineligible for a SAFT investment. However, surely there are many more non-accredited investors (who by definition have less ability to withstand losses in relative terms) who are vulnerable to the lower echelon of the crypto market and as such would be sitting ducks. This logic extends from ICOs to the token re-sale market, regulation of exchanges, etc.


Further, the sheer velocity of money going into blockchain-dedicated funds, blockchain companies, and ICOs dwarfs even the bloated funding rounds of the late 90s (an SF-based fund formation attorney we work with has formed over thirty dedicated blockchain funds in the past twelve months). Clearly there are many highly complex, labor-intensive protocols being developed which will require significant cash to get to functionality. Saying that, it is worth bearing in mind that the Ethereum protocal was developed without hundreds of millions of dollars of outside capital.


Second, much as the token economy has the allure of liquidity (evidenced by the fact that blockchain funds are typically structured more like hedge funds than venture funds), nevertheless the emergence of the SAFT approach, hold periods (sometimes imposed retroactively), and regulatory uncertainty would seem to point to the potential for significant pent-up illiquidity with respect to token investing. How and when this ultimately manifests is anyone’s guess at this point. However, not unlike the late 90s, investors are going to want their returns and one could readily imagine a massive sell-off, perhaps sparked by adverse events in the broader economy.


Taking all this into account, what then is the best to think about due diligence when it comes to investing in blockchain as an asset class? Speaking to numerous advisors and investors on this topic, it’s fair to say that, first, the old rules apply. Fund managers and issuers need to ensure, through fulsome disclosure, the nature and risks of token investing (e.g., regulatory uncertainty, protocol risk, implementation risk, etc.). Study the issuer’s Whitepaper, diligence the founding team, invest in tokens with a high bar with respect to compliance, spend time on Telegram chat rooms and other sites where these issues are socialized. Second, it’s also true to say that, with respect to diligence, crypto as an investable asset class is so young that there is very little long-term data to guide investors.


One thing it seems everyone can agree on is that incredible things are taking place with respect to blockchain technology. There is every reason to embrace this period of mindblowing disruption. And, not unlike the emergence of the world wide web in the 90s, you don’t really have to fully understand the underlying technology to appreciate the degree and speed of change taking place. However, it is also worth bearing in mind lessons of the recent past in thinking about this moment. As many have said before and many will say again, those who forget the past are doomed to repeat it.


I spoke with over a dozen players in the blockchain space in thinking about and putting together this post, from founders to advisors to investors to engineers (with respect to the latter, shout out to Crypto Mondays in New York City for pulling together a dedicated community of crypto enthusiasts on a weekly basis). Without “naming names” (the vast majority of people I connected with requested that they be on background only), I want to thank everyone I spoke with for their time and sharing their perspective.