Recently, more and more companies are looking to leverage non-fungible tokens (NFTs) to generate funding. NFTs’ adaptability, flexibility, and structure allow for the authenticated transfer of ownership of unique goods on the blockchain and make them a viable alternative to traditional and corporate venture capital, debt financing, and equity sales as a means for raising capital. NFTs can be made or minted from almost anything—a digital image of a sneaker, an athlete, or even a tweet. However, these and other characteristics inherent in NFTs can create complications. This article examines the legal considerations that businesses should keep in mind before using NFTs for crowdfunding or raising capital.  

Background

Crowdfunding campaigns, whether equity- or non-equity-based, invite people to participate by contributing money to help an enterprise reach specific campaign goals such as building a prototype, launching a product, or creating a marketing campaign. These acts of participation can be encoded as NFTs that document the contributions and are owned by everyone who invests in the fundraising campaign. Recently, not-for-profits such as UNICEF and the World Wildlife Fund have used NFTs for fundraising. UNICEF has launched 1,000 NFTs to celebrate the United Nations’ 75th anniversary and to raise money and awareness for education and children’s charities. For-profit businesses can adopt similar tactics to secure capital from NFTs. However, they should keep in mind several key legal considerations:

• NFTs as Securities

The Securities and Exchange Commission (SEC) is investigating whether the use of NFTs to raise money can closely resemble—and therefore should be regulated as—traditional securities. To determine whether an NFT falls under the definition of “security,” regulators apply the seminal guidelines established in SEC v. Howey. In this decision, the US Supreme Court laid out a four-prong test (subsequently known as the ‘Howey Test’) for determining whether a transaction qualifies as an “investment contract” and is thus subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934:

1. Is there an investment of money?
2. Does the NFT represent a common enterprise?
3. Do contributors invest with the expectation of earning profits?
4. Would those profits accrue solely from the efforts of others?

Answering “yes” to all four questions would categorize an NFT as an investment contract subject to SEC laws. It is easy to see how NFTs used for crowdfunding purposes could fall under this definition. It is recommended to consult a securities lawyer experienced in the NFT space to determine whether compliance with securities law is necessary to raise money via NFTs.

• NFTs as Collateral

One of the biggest advantages of using NFTs for crowdfunding or other fundraising activities is their status as collateral for securing loans. Like other secured loans, if the borrower fails to pay back the loan, the lender can seize the collateral. With NFT loans, however, the NFT owner offers his or her token as collateral to borrow money in the form of ERC20 tokens, stablecoins, other cryptocurrencies, or fiat currency. If the borrower fails to pay back the loan, the borrower risks forfeiting ownership of the NFT. In the event the borrower defaults, the NFT will be transferred to the lender, who becomes the new owner. In general, any default should be advantageous for the lender as the amount lent should always be less than the value of the NFT.

Currently, few platforms facilitate startups’ efforts to raise capital via NFTs. As the trend toward NFT loans grows, however, several established platforms are becoming involved. One such platform is Arcade which provides private individuals and startup companies a means to raise capital from independent lenders and angel investors by using NFTs as collateral. The idea is to give people holding significant NFT collections a way to leverage them for investment without forcing them to sell their digital assets outright. The borrowing terms and conditions vary from platform to platform.

• Using NFTs to Attract Investors and Maximize Investor Value

On a very broad level, startup founders hope to achieve three major goals: attracting investors, increasing market share, and maximizing exit value. NFTs can assist entrepreneurs in furthering one or more of those goals. A video game startup, for instance, could use NFTs to limit and track the distribution of its software. By authenticating ownership of the intellectual property tied to the NFT, the company can distinguish pirated software from legitimate, licensed versions. This can be used to protect and increase revenue to the benefit of both the company and its shareholders. Startups, particularly those selling software, may wish to leverage NFTs as temporary substitutes for formal intellectual property protection. At the same time, it is important to understand that NFTs cannot replace traditional copyright and trademark protections and do not grant ownership over the underlying content unless explicitly stated in their terms of sale or licensing.

Any business or startup can use NFTs to raise money. The notification issued by the SEC on NFTs as securities suggests that the definition of a security under US law can be quite broad. However, commentators have suggested that the basic logic behind the Howey Test should not apply to digital assets such as NFTs. In light of unsettled business and legal questions, emerging technologies companies intending to use NFTs to raise money for their business should consult a lawyer to ensure that their use of NFTs does not run afoul of US securities laws and regulations. SEC Commissioner Hester Peirce has cautioned that certain digital assets can be considered investment products and thus subject to US securities law. This is a legal gray area and companies should proceed carefully.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.