Cryptocurrencies are hot. And often the sale of cryptocurrencies is referred to as Crowdfunding. Unfortunately, the use of “cryptocurrencies” and “Crowdfunding” together creates confusion about both, along with some pretty serious legal risks.
We use “Crowdfunding” to mean raising money for a business or other venture online. We say “donation-based Crowdfunding” when we’re talking about Kickstarter, where people ask for donations. We say “equity-based Crowdfunding” when we’re talking about raising money from investors, who receive a stock certificate or some other security.
A cryptocurrency is, well, hard to pin down. It’s a transaction registered in a distributed, secure database. Because it exists in limited quantities and is secure, it has value. Like anything of value, it can be used as a currency. For purposes of this post, the key feature of a true cryptocurrency is that is has value of itself, like a nugget of gold.
You use Crowdfunding to sell shares of stock. Obviously, the paper certificates representing the shares of stock have no value by themselves, they have value only to evidence ownership in the business that issued the certificates or, more exactly, in the cash flow the business is expected to generate. So it wouldn’t make sense to say “I’m selling nuggets of gold using Crowdfunding.” The nuggets of gold have an intrinsic value without reference to the cash flow of anything else, or at least you hope they do. I can go shopping with a cryptocurrency like Bitcoin or Ethereum, just as I can shop with US dollars or, historically, with gold.
This is where things get tricky and words matter. The blockchain – the technology underlying all cryptocurrencies – can be used for a lot of things other than cryptocurrencies. As it happens, one of the things the blockchain can be used for is to keep track of stock certificates. In fact, the blockchain works so well keeping track of stock certificates that it will undoubtedly be used by (or replace) all public stock transfer agents within the next five years.
What’s happening today is that companies are selling what they call “cryptocurrencies” that are really just interests in the future operations of a business, i.e., really just hi-tech stock certificates. Cool, they’re using blockchain technology to keep track of who owns the company! But that doesn’t mean what you’re buying is really a cryptocurrency and that you’re going to get rich like the early buyers of Ethereum.
Words are powerful, and the confusion around cryptocurrencies is deepened by the nomenclature. Sales of cryptocurrencies are often referred to as “initial coin offerings,” or ICOs, which implies a similarity to “initial public offerings,” or IPOs. Yet if we’re being careful, the two have nothing in common. In an IPO a company sells its own securities, which have value only based on the success of the company. In an ICO somebody sells a product that has intrinsic value of itself.
Ignoring the difference is going to land someone in hot water, probably sooner rather than later. A company that sells something it calls a cryptocurrency but is really just a share of stock is selling a security, even if that company has an address near Palo Alto. And a company that sells a security is subject to all those pesky laws from the 1930s. If you sell a cryptocurrency that is really just a hi-tech stock certificate, then not only do you risk penalties from the SEC and state securities regulators, you’ll also face lawsuits from your investors if things don’t go as planned.
How to know whether you’re selling a true cryptocurrency or a hi-tech stock certificate? Here are some tips:
- If the value of the cryptocurrency depends on the success of the business, it’s a security.
- If the value of the cryptocurrency depends on, or is backed by, real estate or other property, it’s a security.
- If the cryptocurrency is marketed as an investment, it’s probably a security.
- If the value of the cryptocurrency depends what the buyer does with it, rather than the success of the business, it’s probably not a security.
- If the cryptocurrency merely gives the holder the right to participate in a group effort (g., the development of software), it’s probably not a security.
- If you’re selling the cryptocurrency in lieu of issuing stock, it’s probably a security.