Chapter One: Other People's Money, an Introduction.
Funding, by itself, is a mean to obtain funds. As early as history people have contacts others in hope to receive upfront assets or payments, and later return them in some form of payment with a premium for the incentivized risk. Where you need money to buy seeds for your wheat, you offer the person who fronts you the money a premium. The money to make one bag of wheat shall is not equal to the expected profits from selling that bag; therefore, you do have some spare money to offer your investor. On the other hand, your investor might not be certain that he will get his money back. In fact, there are drought, blight, floods, earthquakes or other disasters, you might just defraud him, or just be foreclosed by the bank first. So, as there is no thing as certain money, the investor factors his risk, and calls it interest.
(my 2014 Crypto Crowd Funding Basics / Hebrew)
In this chapter we'll review the options in investing other people's money. In the next chapter, hopefully, we’ll review the major frauds, and the reasons for consumer protection.
The act of investment in other people’s endeavors is quite ancient. In the Jewish Bible, interest bearing loans are prohibited just because such form of funding was widely abused by lenders. The “Neshech”, credited interest, was treated as a sin. However, the need for funds to establish businesses is widely accepted.
For people to enter into joint businesses, they need to set up a legal framework. This could be under several different legal structures.
The first and most simple is a Partnership. A partnership is where two or more persons act together towards a shared goal. They may choose whether one invests time and the other invests money, but they are acting in concert. The first rule of the partnership is that all partners, together, are liable for funds owed by the partnership. This means that if the partnership needs to pay for the wheat it purchased and one of the partners cannot pay, the other partners have to step in and provide the funds. Please note the two or more requirement. Less than two is not a partnership.
When you seek investment, a partnership is a terrible way to invest. It means that you bear not only the risk of losing all your investment, but also might lose other funds afterwards, if the partnership loses more funds.
In order to facilitate this, a limited liability entity is another way. In this way, the parties who set up the business are limited in the funds that they are required to pay; this limitation may either be by a limited liability company, or by a limited partnership. In such place, each shareholder or limited partner (these are the names of the participants) puts his investment in the joint account, and this is the only money he may lose.
You may notice the difference between these types of corporations by their names. A limited liability company has an LLC suffix, a limited partnership has an LP suffix, and an incorporated company (meaning that it also isn't transparent tax-wise) has an Inc. Suffix. This applies to the US. In the UK you may have PLC for publicly traded companies, LTD for limited companies, and LLP for limited liability partnerships. The names and specific guidances change by jurisdiction, but the general purpose remains the same
The downside of a limited corporation for an investor is that in most cases, the limited partners or shareholders do not have any managerial rights. They may only receive payments for their investment. Unlike a regular partnership, however, they may not be coerced by other partners to invest funds.
The point in both a partnership and a company is that each stakeholder holds both voting power in the business and a portion of the profits distributed. This, however, is not the only way to raise funds.
Another way is a joint venture. In such case, parties share risks and expenses, where each party has another kind of risk. If I own vast amounts of land, and my partner has the know-how in growing and selling oranges, we might enter into a joint venture where I let him use my land, he grows and sells the oranges, and I receive rent as a percentage of his revenues. This, revenue-share model, is a joint venture. (this is the case of SEC v. Howey Co., 328 U.S. 293 (1946) which we'll discuss in future chapters).
The other option is debt. Debt means that the business borrows money from the investors and provides them interest (meaning a part of the money as a reward for risk). With the expectation that the funds shall be returned, the investors do not receive a stake in the business, but only the future right to receive funds. The debt could be, later on, traded.
If I know that person A owes me one dollar, and I owe person B one dollar, I can ask person B to buy person A’s debt from me. However, Person B may require some assurances from me, or even buy the debt at a lower value, as he does not believe that person A shall repay this debt.
If a business wants to raise money in a form of a debt, they issue bonds. In some cases, these bonds may be converted later to shares, participation units in a company. The bonds may have a payment date, and may have coupons (meaning physical parts of the bond which may be redeemed for payment). They may be adjusted with interest or without.
Not only businesses offer bonds, but also governments. Until the end of the gold standard in 1971, a US Dollar was actually a bond. The United States government loaned funds to buy gold from its citizens, where each person who wanted to cash his gold out, could do so at any time.
During times of war or other disasters, where cash supply was low, people traded with their debt in other forms (1, 2).
Debt, however, may not only be in a form of a loan per-se. If I’m a consumer of some business, and I want to front the costs for that business in order for them to manufacture something, I can do that by lending the business the money. When doing so, I front the money and get a promise to provide me later on with a good or service. This is, in some cases, the business model of many crowdfunding campaigns.
An investment that has voting power (managerial rights) and profit sharing is called a “equity investment”, an investment in debt is a “loan”.
These different forms of investment are not unique to the world of cryptocurrency and have been there since the beginning of time. People lend money to others in expectation of profit since the early days. The only question, is how do these models adapt to the cryptocurrency world.
Usually, these models require trust. I lend money to my family when they are in need; I ask my friends for money, or when I open up a business I look for partners who have knowledge. When I want to sell shares in my company, I first reach out to investors who are known in my field and I ask them to put some money in.
In the bitcoin world, however, the lack of trust between people and parties is the first and most important issue. A decentralized culture, where there is no trust between people, is the basis of the blockchain technology. Therefore, why would you use old-world business models for investments in such world?
The answer is that the future model was not yet found. The old world models could be set up on the new world technology quite easily.
An equity investment follows an equity or security token. Meaning, that your smart contract or cryptographic asset represents a method to vote on the project’s future and to receive the payouts. This is quite simple to understand. There are 100 tokens for a specific project, and each token provides you one percent of the votes on how to continue developing the project.
The debt issue is also easy. It is usually a utility token. If you have a token that represents a right to receive future services from the network, it means that the network is in debt to you.
The only thing that still may be missing is the way to actually manage partnerships: tokens that both require you to put more money in when required, and to have more managerial power than assumed under the security tokens.
In the future chapters we’ll discuss first the frauds related to different investments and why they exist. We’ll later deal with why investor protection exists and how it applies. Then we’ll get technical and deal with how ICOs are performed technically; what is a token. Following that we’ll get to the legal background and recommendations.
Previous Chapters:
Preface
*I'm Jonathan Klinger, I'm a master of law, certified to practice in Israel. I've explored the blockchain, and now I'll be helping you in deciding on whether you should raise funds via a token generating event. I highly recommend you avoid it. Read my Blog for more info. *