Is SAFT really effective for financing blockchain projects?
Is SAFT effective for financing blockchain projects?
Bull Market for Cryptocurrencies, Bear Market for Actions.
Smart friends have begun to lay out related plans before the next Bitcoin halving market or the accompanying bull market arrives. The most obvious is that more friends who came to consult the Manquen team about project financing matters.
During the communication with various entrepreneurs, we inevitably talk about the legal effect of SAFT (Simple Agreements for Future Tokens) frequently mentioned by insiders in the circle. What is the legal compliance requirement for SAFT for Chinese start-up teams? This article is here to discuss this.
Legal Attributes of SAFT
SAFT is an investment agreement specifically for Web3 projects built on the blockchain network, which was launched by a US law firm named Cooly on October 2, 2017.
SAFT aims to provide Web3 projects with a compliant token issuance path based on the US securities law system. The SAFT agreement stipulates that the project party will use the right to subscribe to tokens on the future network as a consideration to exchange for the current funds of investors, which are used for the development and construction of the project network at present. As equity tokens (Security Token) are the key regulatory objects in various jurisdictions, SAFT establishes a set of protocol mechanisms to ultimately achieve the effect of the functional token (Utility Token) network launch and avoid the supervision of the US Securities and Exchange Commission and related laws on Web3 project token financing and investment behavior.
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SAFT financing is mainly divided into two steps:
(1) Project development stage
For Web3 projects still in the development stage, the expected profit of investors after investing money depends on the network management and development of the project development team. Since the tokens do not have actual utility, the nature of the tokens at this stage is more similar to a value representation of equity, capturing the ability of Web3 project’s future cash flow.
This investment behavior may meet the standards of the Howey Test and belong to the “investment contract,” which needs to be included in the strict securities regulation of the US Securities and Exchange Commission. But exemptions can be applied for according to the US securities law Regulation D Rule 506, without the need for securities registration, limiting investors only to qualified investors (Accredited Investors).
(2) Project Development and Launch Stage
For projects that have already been developed and launched, the tokens issued (Already-functional Utility Token) have many functions (such as usage, consumption, and governance) that allow users to access the Web3 project ecosystem. The nature of the token at this stage is a representation of the value of usage rights and is defined as a functional token (Utility Token).
Since the token already has practical attributes, the main purpose of investors purchasing the token is generally to obtain the practical value of the project network, not for the sole purpose of making a profit. Furthermore, for a decentralized token economic system or governance system, the price of the token in the secondary market is completely influenced by the supply and demand relationship of the market, and not dominated by the contribution of the project development team.
This is in stark contrast to the role of tokens in the project development stage. Therefore, the SAFT white paper believes that such Utility Tokens do not have the attributes of “securities” and are generally not subject to strict regulation by the U.S. Securities and Exchange Commission.
The SAFT Protocol Is Not Safe
It is particularly important to note that (emphasis added), the purpose of the SAFT is to circumvent the regulations of the U.S. SEC and strictly speaking, it is only suitable for professional investors (Accredited Investment) and is not suitable for most small and medium-sized investors.
The SEC has issued many challenges to the SAFT in recent Kik and Telegram cases, indicating flaws in the design and issuance rhythm of functional tokens (Utility Token).
Marco Santori, one of the drafters of the SAFT white paper, one of the lawyers who understands Crypto and U.S. securities law the most, and currently the general counsel of Karken, was overturned by the SEC in February 2023 due to Karken’s Staking as a Service business, not to mention SAFT protocols for projects with different network, token function design, token economic design, and investor attributes.
In addition to SAFT, there are many legal ways for Web3 financing, such as SBlocking (Share Purchase Agreement) involving equity, SAFE (Simple Agreement for Future Equity), TBlocking (Token Purchase Agreement) involving tokens, SAFT (Simple Agreement for Future Tokens), or SAFE + Token Warrant/Side Letter that combines the two.
Which specific form to adopt depends on the nature of Web3 financing.
The Essence of Web3 Financing
When evaluating traditional equity projects, more attention is paid to the company’s ability to generate future cash flow, as shareholders have a legitimate right to share in the distribution of company benefits.
When evaluating token-based projects, the traditional cash flow valuation model does not apply. More attention is paid to the network effect of the project, the demand between the network and the token, and the function of the token. Therefore, compared to token financing projects, token economics are very important.
(from: Connecting Web3 Wallet to Twitter Account)
We can take two examples to compare them visually.
(1) Twitter’s Web3 Hypothetical
The current Web2 Internet giant Twitter, in terms of creator ecology, operates through the organizational form of the company, and its goal is to maximize shareholder interests, reflecting shareholder capitalism. The value of investment lies in the company’s ability to obtain future cash flow, and the stock price reflects the value of future cash flow.
Imagine a Twitter based on the Web3 new economic model, in which tokens incentivize all participants (content creators, developers, validators, other market participants, etc.) in the network ecology to jointly maintain the Twitter ecosystem network and promote governance. The utility of the token is not only a medium of exchange, but also provides users with access to the Twitter ecosystem network, consumption of products/services on the Twitter ecosystem network, and governance of decisions on the Twitter ecosystem network.
This Web3 new economic model releases economic benefits and governance power from centralized entities to the entire decentralized ecosystem network, and all stakeholders involved in the participation can share the value they create, reflecting stakeholder capitalism.
In this model, Twitter’s equity may not be meaningful, and Twitter’s tokens will replace equity to capture greater value on the Twitter ecosystem network. Token prices reflect the supply and demand relationship between the ecosystem network and the token.
(2) Opensea and Blur
Once the world’s largest NFT trading platform, Opensea received $300 million in financing from Blockingradigm and Coatue in January 2022, with a valuation of $13.3 billion. Opensea’s cash flow is mainly supported by its transaction fees. These types of projects can be understood as typical equity investment and financing projects in Web3, and in many ways, they can apply traditional business models. Investors capture the value of the company’s future cash flow, and equity investment is more desirable.
In March 2022, Blur secured $11 million in financing from Blockingradigm. A year later, Blur activated the community by airdropping tokens to participants, and began a liquidity feast in the NFT market, achieving a shortcut overtaking of Opensea’s network effect. These projects, like Blur, can be understood as typical token financing projects in Web3. Investors capture the network effect of the Blur ecosystem. The larger the ecological application and user volume, the higher the market demand for the functional token, and the token price depends on the market value discovery.
However, considering the sluggishness of Blur’s tokens after listing and the limitations of Token functions, it can be seen that how to design the functions of the token and the token economic model is the top priority for the long-term operation of the project.
Therefore, the significant improvement of the value liquidity of Web3 projects puts forward higher requirements for the project party. They need to be able to describe the future mode of the project and the arrangement of the token economy relatively clearly in the white paper financing stage, otherwise it is difficult to connect with the later SAFT and development planning.
The purpose of SAFT is to avoid SEC regulations and only applies to professional investors, which is not suitable for most small and medium-sized investors, let alone investors who are all Chinese citizens.
As Chinese entrepreneurs, when financing in the early stage of entrepreneurship, SAFT is not the only, nor the best option. Equity financing + token terms (SAFE + Token Warrant/Side Letter) can also be used, which can also solve the purpose of SAFT to avoid US securities supervision, provide a way for project equity financing, and retain the possibility of token financing.
The most important thing is that the purpose of entrepreneurship is not only to raise money, but also to return to the basics of business, use the money raised to solve social problems, create more commercial value, and no amount of money can make up for our blind adventures.