Investing in web3 is a regulatory minefield. Here’s what you should know.

Over the past few years, tech entrepreneurs and investors alike have flocked toward web3. Innovating and investing in blockchain projects is seen as a way to increase ownership, access, transparency, and efficiency – what’s not to like, right? On top of those promises, investors celebrate web3’s promises of early liquidity via token warrants (as opposed to traditional venture capital investments, which can take a minimum of 5-10 to become liquid).

While much of web3 still occupies a regulatory gray area (look no further than the recent Coinbase litigation), venture investors who dabble in web3 investing are still held to the same expectations (and limitations) of venture capital regulation. At the center of that regulation is Section 203(l) of the Investment Advisers Act of 1940 (known as the Venture Capital Adviser Exemption). Investors who pursue a “qualifying VC strategy” benefit from certain regulatory exemptions. A “qualifying VC strategy” means that more than 80% of the capital that it raises must be used to acquire equity securities from a private company directly. Read more on what it means to pursue a qualifying VC strategy.

Why this matters for web3

The determination of 1) who can invest in an SPV or fund, 2) what filings are required, and 3) the obligations of the sponsor comes down to two simple questions:

Is the GP receiving compensation (carried interest or management fees) in exchange for organizing the transaction?
Does the transaction involve contributing >20% to anything other than equity securities acquired directly from a private company?

Web3 investments typically occur via a SAFT or a direct purchase of cryptocurrency tokens, both assets which are not equity securities issued by a private company directly. If more than 20% of a fund or SPV’s assets are SAFTs or tokens, the fund is not considered a qualifying VC fund. The sponsors of these vehicles would no longer benefit from VC exemptions and they may be subject to additional requirements (reporting and filings) and restrictions (only raising funds from qualified clients). Finally (and perhaps most significantly), if the deal sponsor accepts capital from accredited investors (or non-accredited investors) and wants to avoid these restrictions, the sponsor may not be permitted to receive any compensation (carry) for organizing a deal. There has to be another way…

A proposed middle-ground for web3 investments

Can web3 VCs have their cake and eat it too? Perhaps!

As summarized above, structuring transactions through an SPV/fund that pursues a “VC” strategy permits the broadest base of investors and reduces overhead and complexity for the deal sponsor. By conforming web3 investments to the requirements of a qualified VC fund, deal sponsors may be able to avoid some of the requirements put on non-VC private funds.

Wait, what?

Let’s start with SPVs. A key requirement of a “good” VC is that more than 80% of the capital it raises is directed to the acquisition of a private company’s equity securities from the company directly. In a traditional web3 investment, a company issues a SAFT or tokens directly, which are not equity securities. So, in order to comply with the 80% requirement, the company must issue an equity security together with tokens (or an instrument that can later be exercised to acquire tokens). It is key, however, that at least 80% of the capital raised by an SPV be used to acquire the equity security, and that the exercise price for the tokens is less than 20% of the capital raised by the SPV.

A new standard for compliant web3 SPVs

VC investors can remain compliant and benefit from the relevant exemptions if web3 investments are structured in the following manner:

Standard stock, SAFE or convertible note sale in an original issue amount that equals or exceeds 80% of the capital raised in the SPV.
Standardized token warrant to acquire tokens for an issue price and aggregate exercise price that sums to an amount equal to or less than 20% of the capital raised by the SPV. Any cash that isn’t funded to acquire the equity (#1 above) or warrant at the SPV’s closing will be parked and utilized to fund the warrant’s exercise.
Bonus: Side letter between the web3 company and the SPV that ensures that if for any reason the SPV cannot exercise the Token Warrant in full to comply with regulatory hurdles (e.g. the value of the tokens underlying the warrant is deemed higher than 20% of the SPV’s value), then the SPV may assign a portion of the warrant rights to the SPV’s members pro rata.

It’s generally expected that the tokens purchased via a Token Warrant exercise (#2 above) will ultimately have a market value that far exceeds their exercise (strike) price. This could potentially occur as early as the expiration of the warrant lock-up.

So, how does this impact the 80% requirement? Well, under applicable law, the SPV sponsor (GP) generally determines how to value private assets and as long as the determination around fund reporting is consistent, then the GP can determine that both the value of the warrant and the value of the assets (tokens) being acquired (at purchase and exercise respectively) are equal to the original issue prices.

To bring it all home, an SPV sponsor can leverage an SPV to acquire web3 assets and stay within the VC fund exemption by: (a) packaging any non-equity assets (tokens) together with an equity investment (e.g. a SAFE); (b) ensuring that the value of the qualifying equity investment is at least 80% of the SPV’s raise; and (c) remaining consistent on how the assets are valued for accounting purposes and reflecting all SPV assets at their original issue/exercise price.

A new standard for compliant multi-asset funds

Multi-asset funds generally have more flexibility than SPVs as the 80% requirement applies across the entire fund. This means that up to 20% of the fund’s total capital raise can be contributed to non-VC qualifying assets, such as SAFTs or tokens. A multi-asset fund can generally acquire a SAFT or a Token Warrant without having to package the transaction with a qualifying equity issuance (...as long as the sum of all of its non-VC qualifying assets represent less than 20% of the fund’s capital raise).

That said, web3-focused funds might want to consider the strategy laid out above for SPVs when executing investments in order to avoid having to register as an RIA. If a web3-focused fund embraces a standard protocol of packaging a (sometimes nominal) SAFE/equity purchase with a SAFT/Token Warrant, then even web3-focused funds can remain qualified VC funds and enjoy all of the benefits of a VC fund while investing primarily in web3 assets (e.g. continuing to work with accredited investors, avoidance of RIA status and the onerous audit/compliance obligations it presents). By standardizing this process at the fund level, web3 investors have a better chance of maintaining their VC status even as web3 and crypto regulations evolve.

Over the past few years, tech entrepreneurs and investors alike have flocked toward web3. Innovating and investing in blockchain projects is seen as a way to increase ownership, access, transparency, and efficiency – what’s not to like, right? On top of those promises, investors celebrate web3’s promises of early liquidity via token warrants (as opposed to traditional venture capital investments, which can take a minimum of 5-10 to become liquid).

While much of web3 still occupies a regulatory gray area (look no further than the recent Coinbase litigation), venture investors who dabble in web3 investing are still held to the same expectations (and limitations) of venture capital regulation. At the center of that regulation is Section 203(l) of the Investment Advisers Act of 1940 (known as the Venture Capital Adviser Exemption). Investors who pursue a “qualifying VC strategy” benefit from certain regulatory exemptions. A “qualifying VC strategy” means that more than 80% of the capital that it raises must be used to acquire equity securities from a private company directly. Read more on what it means to pursue a qualifying VC strategy.

Why this matters for web3

The determination of 1) who can invest in an SPV or fund, 2) what filings are required, and 3) the obligations of the sponsor comes down to two simple questions:

Is the GP receiving compensation (carried interest or management fees) in exchange for organizing the transaction?
Does the transaction involve contributing >20% to anything other than equity securities acquired directly from a private company?

Web3 investments typically occur via a SAFT or a direct purchase of cryptocurrency tokens, both assets which are not equity securities issued by a private company directly. If more than 20% of a fund or SPV’s assets are SAFTs or tokens, the fund is not considered a qualifying VC fund. The sponsors of these vehicles would no longer benefit from VC exemptions and they may be subject to additional requirements (reporting and filings) and restrictions (only raising funds from qualified clients). Finally (and perhaps most significantly), if the deal sponsor accepts capital from accredited investors (or non-accredited investors) and wants to avoid these restrictions, the sponsor may not be permitted to receive any compensation (carry) for organizing a deal. There has to be another way…

A proposed middle-ground for web3 investments

Can web3 VCs have their cake and eat it too? Perhaps!

As summarized above, structuring transactions through an SPV/fund that pursues a “VC” strategy permits the broadest base of investors and reduces overhead and complexity for the deal sponsor. By conforming web3 investments to the requirements of a qualified VC fund, deal sponsors may be able to avoid some of the requirements put on non-VC private funds.

Wait, what?

Let’s start with SPVs. A key requirement of a “good” VC is that more than 80% of the capital it raises is directed to the acquisition of a private company’s equity securities from the company directly. In a traditional web3 investment, a company issues a SAFT or tokens directly, which are not equity securities. So, in order to comply with the 80% requirement, the company must issue an equity security together with tokens (or an instrument that can later be exercised to acquire tokens). It is key, however, that at least 80% of the capital raised by an SPV be used to acquire the equity security, and that the exercise price for the tokens is less than 20% of the capital raised by the SPV.

A new standard for compliant web3 SPVs

VC investors can remain compliant and benefit from the relevant exemptions if web3 investments are structured in the following manner:

Standard stock, SAFE or convertible note sale in an original issue amount that equals or exceeds 80% of the capital raised in the SPV.
Standardized token warrant to acquire tokens for an issue price and aggregate exercise price that sums to an amount equal to or less than 20% of the capital raised by the SPV. Any cash that isn’t funded to acquire the equity (#1 above) or warrant at the SPV’s closing will be parked and utilized to fund the warrant’s exercise.
Bonus: Side letter between the web3 company and the SPV that ensures that if for any reason the SPV cannot exercise the Token Warrant in full to comply with regulatory hurdles (e.g. the value of the tokens underlying the warrant is deemed higher than 20% of the SPV’s value), then the SPV may assign a portion of the warrant rights to the SPV’s members pro rata.

It’s generally expected that the tokens purchased via a Token Warrant exercise (#2 above) will ultimately have a market value that far exceeds their exercise (strike) price. This could potentially occur as early as the expiration of the warrant lock-up.

So, how does this impact the 80% requirement? Well, under applicable law, the SPV sponsor (GP) generally determines how to value private assets and as long as the determination around fund reporting is consistent, then the GP can determine that both the value of the warrant and the value of the assets (tokens) being acquired (at purchase and exercise respectively) are equal to the original issue prices.

To bring it all home, an SPV sponsor can leverage an SPV to acquire web3 assets and stay within the VC fund exemption by: (a) packaging any non-equity assets (tokens) together with an equity investment (e.g. a SAFE); (b) ensuring that the value of the qualifying equity investment is at least 80% of the SPV’s raise; and (c) remaining consistent on how the assets are valued for accounting purposes and reflecting all SPV assets at their original issue/exercise price.

A new standard for compliant multi-asset funds

Multi-asset funds generally have more flexibility than SPVs as the 80% requirement applies across the entire fund. This means that up to 20% of the fund’s total capital raise can be contributed to non-VC qualifying assets, such as SAFTs or tokens. A multi-asset fund can generally acquire a SAFT or a Token Warrant without having to package the transaction with a qualifying equity issuance (...as long as the sum of all of its non-VC qualifying assets represent less than 20% of the fund’s capital raise).

That said, web3-focused funds might want to consider the strategy laid out above for SPVs when executing investments in order to avoid having to register as an RIA. If a web3-focused fund embraces a standard protocol of packaging a (sometimes nominal) SAFE/equity purchase with a SAFT/Token Warrant, then even web3-focused funds can remain qualified VC funds and enjoy all of the benefits of a VC fund while investing primarily in web3 assets (e.g. continuing to work with accredited investors, avoidance of RIA status and the onerous audit/compliance obligations it presents). By standardizing this process at the fund level, web3 investors have a better chance of maintaining their VC status even as web3 and crypto regulations evolve.

Over the past few years, tech entrepreneurs and investors alike have flocked toward web3. Innovating and investing in blockchain projects is seen as a way to increase ownership, access, transparency, and efficiency – what’s not to like, right? On top of those promises, investors celebrate web3’s promises of early liquidity via token warrants (as opposed to traditional venture capital investments, which can take a minimum of 5-10 to become liquid).

While much of web3 still occupies a regulatory gray area (look no further than the recent Coinbase litigation), venture investors who dabble in web3 investing are still held to the same expectations (and limitations) of venture capital regulation. At the center of that regulation is Section 203(l) of the Investment Advisers Act of 1940 (known as the Venture Capital Adviser Exemption). Investors who pursue a “qualifying VC strategy” benefit from certain regulatory exemptions. A “qualifying VC strategy” means that more than 80% of the capital that it raises must be used to acquire equity securities from a private company directly. Read more on what it means to pursue a qualifying VC strategy.

Why this matters for web3

The determination of 1) who can invest in an SPV or fund, 2) what filings are required, and 3) the obligations of the sponsor comes down to two simple questions:

Is the GP receiving compensation (carried interest or management fees) in exchange for organizing the transaction?
Does the transaction involve contributing >20% to anything other than equity securities acquired directly from a private company?

Web3 investments typically occur via a SAFT or a direct purchase of cryptocurrency tokens, both assets which are not equity securities issued by a private company directly. If more than 20% of a fund or SPV’s assets are SAFTs or tokens, the fund is not considered a qualifying VC fund. The sponsors of these vehicles would no longer benefit from VC exemptions and they may be subject to additional requirements (reporting and filings) and restrictions (only raising funds from qualified clients). Finally (and perhaps most significantly), if the deal sponsor accepts capital from accredited investors (or non-accredited investors) and wants to avoid these restrictions, the sponsor may not be permitted to receive any compensation (carry) for organizing a deal. There has to be another way…

A proposed middle-ground for web3 investments

Can web3 VCs have their cake and eat it too? Perhaps!

As summarized above, structuring transactions through an SPV/fund that pursues a “VC” strategy permits the broadest base of investors and reduces overhead and complexity for the deal sponsor. By conforming web3 investments to the requirements of a qualified VC fund, deal sponsors may be able to avoid some of the requirements put on non-VC private funds.

Wait, what?

Let’s start with SPVs. A key requirement of a “good” VC is that more than 80% of the capital it raises is directed to the acquisition of a private company’s equity securities from the company directly. In a traditional web3 investment, a company issues a SAFT or tokens directly, which are not equity securities. So, in order to comply with the 80% requirement, the company must issue an equity security together with tokens (or an instrument that can later be exercised to acquire tokens). It is key, however, that at least 80% of the capital raised by an SPV be used to acquire the equity security, and that the exercise price for the tokens is less than 20% of the capital raised by the SPV.

A new standard for compliant web3 SPVs

VC investors can remain compliant and benefit from the relevant exemptions if web3 investments are structured in the following manner:

Standard stock, SAFE or convertible note sale in an original issue amount that equals or exceeds 80% of the capital raised in the SPV.
Standardized token warrant to acquire tokens for an issue price and aggregate exercise price that sums to an amount equal to or less than 20% of the capital raised by the SPV. Any cash that isn’t funded to acquire the equity (#1 above) or warrant at the SPV’s closing will be parked and utilized to fund the warrant’s exercise.
Bonus: Side letter between the web3 company and the SPV that ensures that if for any reason the SPV cannot exercise the Token Warrant in full to comply with regulatory hurdles (e.g. the value of the tokens underlying the warrant is deemed higher than 20% of the SPV’s value), then the SPV may assign a portion of the warrant rights to the SPV’s members pro rata.

It’s generally expected that the tokens purchased via a Token Warrant exercise (#2 above) will ultimately have a market value that far exceeds their exercise (strike) price. This could potentially occur as early as the expiration of the warrant lock-up.

So, how does this impact the 80% requirement? Well, under applicable law, the SPV sponsor (GP) generally determines how to value private assets and as long as the determination around fund reporting is consistent, then the GP can determine that both the value of the warrant and the value of the assets (tokens) being acquired (at purchase and exercise respectively) are equal to the original issue prices.

To bring it all home, an SPV sponsor can leverage an SPV to acquire web3 assets and stay within the VC fund exemption by: (a) packaging any non-equity assets (tokens) together with an equity investment (e.g. a SAFE); (b) ensuring that the value of the qualifying equity investment is at least 80% of the SPV’s raise; and (c) remaining consistent on how the assets are valued for accounting purposes and reflecting all SPV assets at their original issue/exercise price.

A new standard for compliant multi-asset funds

Multi-asset funds generally have more flexibility than SPVs as the 80% requirement applies across the entire fund. This means that up to 20% of the fund’s total capital raise can be contributed to non-VC qualifying assets, such as SAFTs or tokens. A multi-asset fund can generally acquire a SAFT or a Token Warrant without having to package the transaction with a qualifying equity issuance (...as long as the sum of all of its non-VC qualifying assets represent less than 20% of the fund’s capital raise).

That said, web3-focused funds might want to consider the strategy laid out above for SPVs when executing investments in order to avoid having to register as an RIA. If a web3-focused fund embraces a standard protocol of packaging a (sometimes nominal) SAFE/equity purchase with a SAFT/Token Warrant, then even web3-focused funds can remain qualified VC funds and enjoy all of the benefits of a VC fund while investing primarily in web3 assets (e.g. continuing to work with accredited investors, avoidance of RIA status and the onerous audit/compliance obligations it presents). By standardizing this process at the fund level, web3 investors have a better chance of maintaining their VC status even as web3 and crypto regulations evolve.