Capital markets foe seeks an end run via blockchain

Patrick Byrne has long had a burr in his saddle, and the name of that enduring irritant is Wall Street.

Ever since his company, the e-commerce giant Overstock, went public in 2002, he has decried practices such as naked short-selling and attacked financial firms for what he sees as the manipulation of publicly traded stock. Since 2014, he has been on a mission to reform the capital markets with blockchain technology. Now, with a $250 million token sale, he hopes to get one giant step closer to his goal.

The funds are being raised by tZERO, a majority-owned subsidiary of Overstock that serves as an alternative trading system, known colloquially as a dark pool. TZERO wants to create a new kind of market, powered by blockchain technology, that would eliminate much of the opacity and potential for abuse that exist in the prevailing system.

Twenty-five million tokens are up for sale, each of which will count as preferred equity in the company. That means that unlike many blockchain projects in the past year, tZERO is making no attempt to persuade the Securities and Exchange Commission that its token is not a security.

There is precedent for tZERO's sale. In 2017, the legal framework was put in place for Delaware corporations to issue shares of stock on a blockchain. And Overstock, which owns 81% of tZERO, created a private blockchain security of its own — a $5 million bond — in the summer of 2015. Later, in December 2016, it sold blockchain shares of the company itself.

American Banker recently caught up with Byrne to learn more about the token sale and ask him why the capital markets need to be reformed.

What follows is our interview, which has been edited for length and clarity.

In the past year, a lot of startups and blockchain projects have raised funds through token sales, but many are trying to keep their token from being classified as a security. Why come right out and say your token is a security?

PATRICK BYRNE: I'm a small-l libertarian by nature, but if there is an area where I think there is room for government regulation, it's absolutely the world of finance. The common denominator of every financial business is, "You give me money today, and some day in the future when you need it, I give you that money back." So the financial industry by nature will draw a disproportionate share of flimflam guys. It used to be, in the 1920s, there were men driving around America in Model T's with a trunk full of stock certificates, and they'd stop in front of some farm and sell stock to some widow. And it was a huge flimflam. The SEC was formed so that we won't have that world again.

It seems to me, frankly, that a lot of the [initial coin offerings] involved people wiggling around that rule. When the SEC was formed, we said, "Okay, from now on when you sell stock the public, first there has to be a document that explains it and it has to have holy water sprinkled on it by the government." I believe in "guardrail libertarianism"—there's a tolerable amount of paternalism and then you let people be relatively free. So I do think these ICOs have wiggled around that by saying, "I'll sell you this token now, and use your money to build a machine that you come and put the token in later." The way I think of it is, you're coming to a town and saying, "I'll build a video arcade parlor, and I'll sell $1 million worth of little gold [arcade] tokens for $700,000." If what you're saying is, "I've got the video parlor built and you can come in tomorrow and start spending them," then that's one thing. But if you're saying, "I'm going to take the $700,000 and go build a video game parlor, and then you'll be able to come and start spending [tokens]," the SEC has said there's a line in there somewhere. That makes it a security — you're expecting something in the future. It's not a discounted revenue stream you're buying today.

With these ICOs, there were some people who wrote [the equivalent of] a term paper and posted it online and were raising tens of millions, or in some cases over a hundred million dollars — and I don't think that's healthy for society or for this [blockchain] revolution. For the revolution to stay on track, it needs not to get swamped in a lot of mischief like that.

Overstock itself, which owns a majority stake in tZERO, first issued shares via blockchain in December 2016. Are those early blockchain securities still out there? Are people still holding those 126,000 shares?

Yes, they are, and they trade by appointment. I think it was me and three other guys, last time I checked. Here's another difference: that was for Overstock; this is for a company that's not Overstock. We've always been Jonas Salk — the guy who invented the polio vaccine. Polio was so terrifying that no one would take the vaccine. He went on TV and gave himself the vaccine [to prove it was safe]. That's what we've done. So you could argue that the first time didn't really count, because we were doing it for ourselves. This is the first non-Overstock company to have done this.

How much did Overstock raise a year ago by selling those 126,000 shares?

We were doing it as a rights offering, and hence only people who were shareholders got the opportunity to participate in that round. But it was so novel that participating in that round included having to open a brokerage account. The lawyers ruled that the novelty and uniqueness and difficulty involved meant effectively that some shareholders would get the right [to participate] and others, practically speaking, wouldn't get this right. So we had to offer a conventional version of it, which we did. And altogether we sold $13 million, but of that $13 million I think only $1.5 million to $2 million actually went out on the blockchain, and the rest people bought as normal preferred shares.

That's a drop in the bucket compared to the fundraising you're looking to do now. You want to raise $250 million. How do you plan to use the funds?

The funds are for tZERO, which owes [Overstock] a small amount of money, because we've been capitalizing them. So there may be some small single-digit percentage that may flow back to Overstock, the holding company. But otherwise this is for tZERO to use. TZERO has so many opportunities. Some of those opportunities involve providing trading services — and for that you need to have some book value, because you can't have $1 billion or $100 billion of trading run through a desk that isn't capitalized. We have about five projects that we need to build, and these projects are individually sort of two months each. What we really need to do is staff up the company and get more technologists. We are right at the crossroads. People don't see our business plan yet. You'll see some crazy stuff unfold over the next few months. We already have what we need in the ecosystem, but we don't have everything we want. There are a couple of companies we would like to buy which would really make all of this sing.

We know that $2 million from the first issuance was a drop in the bucket, but we called what we were working toward that whole year "the Chuck Yeager Project." Chuck Yeager broke the sound barrier — I think he only did it for seven seconds. But it was just about creating the first sonic boom. So we did. We knew it wasn't much, but it was a sonic boom — the first public blockchain security. There were outside people who bought it and sold it back and forth. It happened.

But tell me about tZERO today. What is tZERO's purpose as a company? And how will the tokens function?

To bring the blockchain to capital markets is, ultimately, the mission. If Overstock gave itself the polio vaccine, this is giving yourself the Ebola vaccine. It's really exciting. It's the first company that is getting capitalized in the public market [via the blockchain]. The token has an interesting characteristic, in that, under certain conditions, it's a share of the adjusted top line of tZERO. And a substantial share, something that we think represents a substantial fraction of the future profitability of tZERO. We designed it so that when it's live, stable and all in equilibrium, and if [the venture] is as profitable as we think we will be, the royalty that comes to this token will be a non-negligible fraction of that profitability. And it will be spendable on the products that we are bringing to market. So, for example, we already have in the market a securities lending system. We're going to have routing fees in this blockchain market; you can pay those with this token. We may even be able to make it spendable to Overstock, but that's the kind of thing that we've still got lawyers scratching their heads about. We indicate in the paperwork that we will be announcing various benefits and uses of these tokens, and that there are more to be named.

So it sounds like on the one hand you're saying these are going to be shares of tZERO, and you're admitting it's a security, but on the other hand you're saying it is going to have other kinds of utility.

That is correct, with the addendum that while it is like a share of stock, normally shares of stock represent ownership in the bottom line of a company, whereas we are making this a share in the top line of the company — payable in more tokens. Just by owning these, you can collect dividends in more tokens. We're planning to issue about 25 million tokens; they're basically being priced at $10 apiece, although the earliest money that comes in has some incentive and gets some bonus tokens, so it will be somewhat more than that. But in theory these are $10 apiece. And there's a greenshoe to $300 million. These kinds of details of what we can do and what we can't were changing right up to the last minute, so I can't really be definitive, as crazy as that might sound.

How much are you looking to raise in the presale?

We want to raise $100 million, of which [investors who provide] the first $10 million get a 100% bonus [on their investment]; from $10 million to $50 million gets a 50% bonus; and $50 million to $100 million gets a 25% bonus. And people are capped in that first $10 million. I think the individual cap is like $250,000. There are people who got us in business and helped us, industry insiders and hedge funds and companies that have been helping our development, and we felt we owed something to them. And then the general public is the next $150 million.

What sort of response have you had?

When the news finally went out on Monday night [Dec. 18, 2017] by Tuesday morning at 10:30, 2,000 accredited investors had applied. I can't tell you how many phone calls we're getting. That first day we had over 1,000 phone calls. In fact, when it came out a few months ago what we were doing, once we pointed out, "Hey, we have a blockchain exchange and an ATS that is SEC-compliant," we had 1,000 phone calls in the three days after that. But I'm told that on [December 18] we had over 1,000 phone calls — the kind of calls where people were saying, "I'll take $5 million, I'll take $10 million." When we go to the wider world, I think it's going to sell out pretty quickly. We say in the documents that we're going to take 60 days to do this — 30 days for the presale and 30 days for the public sale — but if it weren't for the fact that there's a logistics thing — people come, they have to download the documents, they have to sign paperwork and send the paperwork in and get certified as accredited; and it takes 48 or 72 hours for the company we're using [to vet investors] — if it weren't for that friction, I think based on the phone calls that we could have had $300 million by 10:30 the next morning. There's a lot of demand for this, is my point.

How does it feel to be involved in building something that may fix or eliminate the aspects of the financial markets that have vexed you for so long?

This blockchain capital market fixes or addresses all those issues I was worried about 12 years ago, which were all settlement issues. My thing 12 years ago was mischaracterized as, "Oh, Byrne's mad his stock went down." In fact it was, "Hey, we have this very fragile settlement system that has all kinds of slop in it, which, A, creates room for manipulation, so it's not good for entrepreneurship in America, because people can stifle companies' capital formation process; and B, it was creating a huge systemic risk to have unsettled trades, which is what exactly what Alan Greenspan said in 2008 when everything melted down. He pointed out that this was a settlement failure. A blockchain capital market addresses all of that stuff I went crazy about. So there's a real Shakespearean irony to the fact that I'm coming back to town with this technology.