Looking to secure private financing for your blockchain project or crypto startup but unsure where to start? You are in the right place! This guide will walk you through the key aspects of private fundraising transactions, providing essential legal insights to help you navigate the process with confidence. While not a comprehensive manual, this article will equip you with the knowledge of fundraising essentials, best practices and legal tools that you need to understand before approaching investors and ensure your fundraising is legally secure and effective.

Which Fundraising Strategy is Best for Your Blockchain Project?

Choosing the right fundraising strategy for your crypto project depends on several key factors, such as your business model, growth stage, funding needs, and long-term vision. To maximise opportunities and attract the right investors and contributors, startups can explore innovative approaches that combine traditional and modern fundraising methods.

In this article, we will explore three most effective and widespread frameworks for blockchain financing to help you decide:

1. Equity investment,
2. Private token offering or pre-sale,
3. Combined fundraising (equity plus token).

When it comes to private fundraising, whichever strategy you choose comes with its own unique set of advantages and challenges. By carefully examining these nuances, such as differences in control, valuation impacts, investor involvement, and growth potential, you can make a well-informed decision that best supports your crypto startup’s long-term success.

Before raising private financing for your blockchain project, that project must be legally structured. This means that your crypto startup must be incorporated as a legal entity and have its baseline legal setup in place, which includes formalising intellectual property, major assets, the core team, and founder relationships, among other aspects. The corporate structure can vary dramatically depending on the chosen jurisdiction, applicable laws, corporate architecture, and other factors. Although we won’t cover this aspect in detail in this article, it remains critical. For further insights and details on the legal and corporate structuring of blockchain projects, please refer to other materials on our blog.

Equity Investments for Blockchain Projects: Key Insights and Legal Considerations

The equity investment strategy involves raising funds by offering investors ownership stakes in your company, whether in the form of shares, equity, or convertible instruments. This strategy allows you to attract experienced investors who not only provide capital but also bring strategic guidance, industry expertise, and valuable connections to your crypto project. However, it also comes with challenges that should be carefully considered before making a decision:

Type of Equity Offered and Company Control

When raising funds through equity, you can offer different types of shares, such as common (ordinary) or preferred shares. Each type provides distinct rights and benefits, making it essential to choose the structure that best aligns with your goals. For instance, common (ordinary) shares grant ownership in the company along with voting rights, allowing shareholders to have a say in decision-making. Preferred shares offer additional advantages, such as priority over common shareholders for dividends and asset distribution. They often come with veto rights on major decisions, giving investors a stronger role in company governance. Understanding these differences will help you structure equity in a way that meets both your needs and those of your investors.

Offering equity means sharing ownership of your company, which can dilute the founders stake and influence over decision-making, including future funding rounds, exit strategies, and daily operations. Some investors may seek active involvement in your company, potentially limiting your ability to make independent decisions, especially if they negotiate for board seats or veto rights. To maintain a healthy balance of influence, it is essential to clearly define and negotiate the extent of investor involvement in legal agreements from the outset.

Project Valuation and Amount Raised

Determining your company’s valuation is a crucial step in equity investment, as it directly affects the ownership percentage you offer in exchange for money. Setting a valuation too high or too low can lead to challenges, potentially deterring investors, creating negotiation hurdles, or impacting future funding rounds. Striking the right balance ensures a fair deal for both you and your investors while supporting long-term growth.

It is also crucial to consider that the more funds you raise, the larger the ownership stake you grant to investors. This is why some projects opt to raise smaller amounts at lower valuations in the early stages, preserving equity for larger funding rounds at higher valuations as the project matures.

Transaction Instruments

Early-stage equity investments are often structured using flexible instruments that grant investors a deferred right to receive company shares. Common options include convertible debts, simple agreements for future equity (SAFE) developed by the Y Combinator, and advanced subscription agreements (ASA). These structures are preferred for their flexibility, allowing startups to raise funds without immediately issuing shares and diluting controls. However, there are also cases where investors receive shares immediately upon purchase, for example, under direct share purchase agreements.

Regulatory Considerations

Equity offerings are generally considered regulated transactions, as they involve the issuance of securities. As a result, they must comply with the relevant exemptions under applicable securities laws for private offerings. Ensuring adherence to these regulations is essential to avoid legal risks and maintain compliance.

Private Token Offering for a Crypto Startup: Key Insights and Instruments

A private token offering, or token pre-sale, allows you to raise financing by offering future tokens to a select group of private purchasers instead of the general public. Beyond financial support, these contributors may provide valuable expertise or strategic value, and typically receive tokens at a discounted rate.

Although different timings are possible, typically, a private token sale is conducted before the token is issued and circulating. This means that, instead of tokens here and now, the purchasers get some form of a right to receive tokens in the future, normally after the token generation event. Almost always, the tokens will be subject to certain lock-up and unlock conditions, which helps the projects to manage their economy and token selling pressure.

This approach comes with challenges that you should carefully consider:

Tokenomics

A strong tokenomics model is vital for your project success. While this is a complex topic deserving for a separate discussion, we will focus on a few key aspects: total token supply calculation and lock-up schedule. Depending on project objectives, token supply can be defined in various ways, either including all tokens ever issued or excluding staking rewards and tokens issued through other inflationary mechanisms. Lock-up periods are equally crucial, as an absent or overly short lock-up can raise market concerns or lead to regulatory implications, signalling speculation rather than long-term value.

Geography and KYC\KYB

The legal status of virtual assets remains uncertain in many jurisdictions, with some imposing strict restrictions or outright bans. Identifying country-wide or territory-wide sanctioned jurisdictions, and those where virtual asset transactions are prohibited, is essential, but not always sufficient. Implementing robust compliance measures, such as KYC/KYB verification, ensures contributors are neither residents of restricted areas nor subject to personal sanctions, thereby mitigating regulatory risks. Conducting KYT checks is another good practice to employ, as it helps prevent the project from receiving crypto assets obtained from unlawful activities or otherwise red-flagged.

Token’s Regulatory Status

The application of specific laws and regulations depends on the proper classification of your token and its role within the project or protocol. If the token has features or characteristics similar to those of security or another regulated instrument, the token will be considered security, which qualification implies multiple restrictions on the token and its circulation, and obligations on the token issuer and promoters. Furthermore, conducting an unregistered securities offering without meeting the necessary registration exemptions may constitute a serious violation of the law. Registration exemptions typically allow limited, non-public offerings of tokens to sophisticated purchasers.

Since there is no universal legal framework governing investments, determining whether a particular token or token transaction is regulated can vary significantly across jurisdictions. It is also important to note that an assessment conducted solely under the laws of the project company’s or token issuer’s jurisdiction would be insufficient, as the securities regulations in the jurisdictions where the token purchasers reside are likely to apply to the relevant transactions.

To avoid potential violations of securities and investment laws, consulting legal experts is essential to determine whether your token may be classified as a security, or token offering — as an offering of unregistered securities. Importantly, in certain cases, even where the token itself is not classified as a security, transactions involving it may still be considered investment or similar contracts, entailing application of relevant regulations and restrictions.

Marketing and Promotion

You might be surprised, but the legal side of fundraising goes beyond purely legal paperwork, as it also concerns marketing and promotional activities. A solid corporate and legal framework alone is not enough, you must also be extremely cautious about how you present the project and token in marketing campaigns.

Anything the project or founders say or promise may have its impact on the regulatory status of the token and your private token offering, so any token-related public statements should be evaluated carefully. Notably, courts have even interpreted certain emojis, such as 🚀📈💰posted on accounts in social media as potential promises of token price appreciation and financial returns, reinforcing security classifications. By aligning your legal framework and marketing strategy, you can mitigate regulatory exposure and ensure that no unexpected or undesirable compliance implications and risks arise.

Tax Implications

Tax laws for virtual assets are often unclear and vary by jurisdiction. The token sales may have tax implications depending on the transaction structure and instrument used. For instance, it could trigger capital income tax or even VAT, depending on your company jurisdiction and status. Failure to properly report, collect, or pay taxes may result in penalties, fines, or even more severe legal consequences.

Transaction Instruments

Different token instruments suit different stages of project development. In early stages, when tokens are yet to be issued, a simple agreement for Future Tokens (SAFT) or warrant to purchase tokens (aka token warrant) may be viable options for structuring token offering transactions.

If tokens are already live, a private token sale agreement, like an OTC contract, could be more appropriate. SAFTs and token warrants are among the most commonly used instruments for crypto startups. A token warrant is essentially a contract granting a contributor the right, but not an obligation, to purchase tokens at a specific predetermined price in the future. This flexibility is a key difference from a SAFT, which typically imposes an obligation on both the contributor (to buy) and the issuer (to sell) under its terms. Since these instruments operate in a complex regulatory environment, some jurisdictions may classify them as securities or regulated instruments, requiring stricter regulatory and reporting compliance.

Combined Private Fundraising: Equity and Token Offering

The so-called combined fundraising approach, which involves an offering of both equity and tokens, can be an attractive option for investors seeking greater certainty. This method provides investors with ownership stakes alongside tokens, granting potential decision-making power and rights to liquidation proceeds in case of liquidation, dissolution or M&A events.

One way to structure this approach is by using a simple agreement for future equity (SAFE) alongside a token warrant. While the challenges of equity and token offerings still apply, this setup can help reduce regulatory risks, as the primary investment is in equity under the SAFE, which is a traditional transaction with rather clear regulatory implications, while the warrant offers the option to acquire tokens for a de minimus (nominal) price.

Where the project wants the investor to choose between equity and token, the transaction can be structured so that once the token warrant is exercised, the right to convert the SAFE into equity terminates. This way, investors still retain liquidation rights through the SAFE if a token generation event does not occur and the company undergoes liquidation, dissolution, or an M&A event. But once a token generation event occurs and the warrant is exercised, no further equity or shareholder-like rights remain in effect.

Conclusion

Navigating private financing for your blockchain or crypto startup might seem complex, but a clear, well-planned approach can make all the difference. Start by ensuring your project is on solid legal ground – proper incorporation, protected intellectual property, and clear team and founder agreements are essential. This not only builds investor confidence but also helps you manage the unique regulatory challenges that come with operating across different jurisdictions.

Remember, there isn’t a one-size-fits-all funding solution, and each option has its own benefits and hurdles. The key is to weigh these choices against your startup’s goals and current needs, and to stay flexible as the market and legal landscape evolve. At the end of the day, the right funding strategy is about aligning your long-term vision and strategy with the most effective legal tools.

At Aurum, we specialise in legal services and support for blockchain projects and crypto companies. Our team is dedicated to providing practical, tailored legal guidance that protects your interests and empowers you to focus on innovation and growth. Whether you’re refining your current legal strategy or preparing for your next private funding round, we’re here to help you build a fundraising strategy that effectively mitigates potential risks.