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Starting a Crypto Hedge Fund in the U.S. in 2018 | Corporate Attorney Explains - YouTube
Channel: Brett Cenkus
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Hi this Brett Cenkus, the right-brained
business attorney and today we're going to
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talk about setting up crypto asset
hedge funds. So something that, at this
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time, is increasingly popular. So this is
a one on one about hedge fund setup; just
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to help you understand the lay of the
land, because it's very confusing.
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There's regulation and securities law
and pieces that intersect and can very
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easily get your head turned around. So
I'm going to try and demystify some of that
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and just give you a broad overview of
hedge fund set up, generally; and then a
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few specifics that make crypto asset
hedge funds a little bit different than
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some other types of hedge funds. So I'm a
corporate attorney and part of my
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practice is around securities offerings
and fund work; so fund work has a
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heavy securities offering piece, which
we'll get into in a minute
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So hedge funds, private equity
funds, real estate funds, that's part of
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what I do and I'm seeing a lot of
activity and I've had a number of
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clients in the crypto space, including
setting up crypto asset hedge funds; so
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those are fundamentally a lot like other
hedge funds, in certain ways and we'll
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get into that they're a little bit
easier, depending on what you're trading,
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but this is something then in
the post ICO days after that's sort of
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cooled, we're still seeing a lot of
activity around setting these up and
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people wanting to trade tokens and raise
money to do it. So any fund, so it could
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be a real estate fund, it could be a
private equity fund,
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it could be a crypto asset fund, a
venture capital fund; I think about in
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three broad separate
projects, okay I'm gonna think about it
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three different phases or aspects to
the project. One is the funded founder
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formation piece, so that's setting up the
actual entities; choosing where they're
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going to be set up;
what type of entities we're gonna
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use; figuring out the deal among the
founders, the principals, the sponsors,
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whatever
you want to call those, the people who
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are making the fund happen, the
interaction between the entities we set
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up; so usually there will be a general
partner and a limited partnership the
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general partner manages the limited
partnership, which is the fund. It's more and more
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common to see two LLC's; so the fund
is an LLC and the
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manager of that LLC is another LLC; so
but fundamentally you've got two
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different entities: one is the fund and
one is the manager or the general
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partner. Now sometimes there's a reason
to have a third entitiy an investment
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manager; there is in Texas for example
because it's tax driven, it has to do
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with franchise tax, but you don't have
that in every state, it just depends on
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where you are usually. But you're
always gonna have two entities; the
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partnership, the fund entity is often a
Delaware entity, doesn't have to be--we're
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not gonna get into that, but feel free to
call me if you have questions about that and we
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talk about why you would do that and not
do that--but you've got your two entities;
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you've got your deal among the founders;
you've got their deal to the investors;
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and how the partnership, how the fund all
works, that I call founder in formation.
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And that exists in any business set up,
I mean a fund is no different. So
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when a technology startup comes to me,
we're doing a formation and founder
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piece; it's simpler in ways and it's more
common and more lawyers should do it but
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that piece exists in almost any kind of
initial business relationship
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creation then you have a piece that's a
securities offering and be very
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careful to distinguish this piece from
the next one, which is the regulation
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around managing the money; so you've got
a piece that, think of the securities
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offering to get the money. So the fund
issues interests in it, partnership
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interests or if the fund is an LLC,
membership interests, in return for
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capital contributions. So those limited
partners in the fund make capital
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contributions, they get an interest in
the fund, that's a securities offer. So
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you have issued a security, which you're
getting money and there's an expectation
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of profit from the investor off your
efforts, that how we test its 70/80
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years old, that's clearly there; so you
have to figure out how do you
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do that? And there's only two ways to do
that in the United States: one is to
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register the securities with the SEC,
which is time-consuming and expensive;
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another's to find available
exemptions. The most common fund
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exemption we use is 506 B, its Regulation
D 506 B;
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it's considered a safe harbor for a
private offering. And if you don't take
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in accredited investors, excuse me, if you
only take in accredited investors, which
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you absolutely should only take in them
or higher--and we'll get to that in a
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minute and there's a different standard
called a qualified client that you may
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actually need to be taking them in for a
different purpose for that third piece
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the money management piece--but again
stay in the second bucket here; we have
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founder formation now on securities
offering to get the money. 506 B is the
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most common one we use and it's a very
easy hoop, they're very easy hoops to
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jump through to get the benefit of the
safe harbor, if you only take money from
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accredited investors; there are no
specific disclosure requirements if
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there's no non-accredited investors,
although it's very common that we put
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together in fund world a private
placement memorandum, which is a 50 or 60
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or something page document that's quasi
business and legal and lays out how
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everything's gonna work; the kind of
people you're taking, the investors
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you're taking money from; their rights; their
obligations; the risks, you know what
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you're gonna invest in, things like that.
So that's universally produced for in
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fund world; is it in actual requirement
of 506 B? It's not but there's a reason
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you would want to do it, I mean there's a
few reasons. But that's all the
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securities offering piece, so you're
jumping through a hoop in order not to
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register the interest that you're giving
out, you're finding available exemptions
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from the SEC and 506 B is the most
common one. And 506 B is a federal
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exemption but the securities that are
issued pursuant to it are called covered
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securities and what it means is the
states can't impose their own
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obligations on the offering; you don't
have to worry about finding state by
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state by state exemptions; you have to do
notice filings in each state and it's a
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chance for the state to grab a couple
dollars from you, but you don't have to
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worry about complying with every
individual state, which makes it really a
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lot easier if you're casting a wide net
and bringing a lot of limited partners
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and that's what most funds expect to do.
The third piece is money management; so
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remember that second piece is getting
the money,
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the third is putting the money to work.
Now this differs, depending
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whether you're a venture capital fund or
a private equity fund or in our case a
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hedge fund, a crypto asset hedge fund. Now
crypto assets, the worlds struggling to
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understand exactly what they are and how
they should be regulated, but it's clear
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that the SEC is taking the position that
just about every initial coin offering
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is a security, but things like Bitcoin and
ethereum and litecoin, things that are
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coins that are well established, that are
traded heavily on exchanges that are
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flipped around the world; they have
utility outside of outside of the ICO
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context, when people are just, you know they just
want to get money and people are just
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buying a coin to flip it,
there's really not utility usually. In
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this context there's a lot, you know
bitcoins a store of value, etherium is,
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you know ether is something that you can
build off of, it's becoming sort of the
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underlying kind of protocol if you will
for smart legal contracts and things;
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those things are pretty clearly, at least
today, not considered securities, they're
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commodities, which means if that's all
you're trading--and not just those three
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there's others--but there's a universe of
tokens or coins that if
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you're only buying those you're a true crypto asset hedge fund, then you have very
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light regulation on the money management
side. You do have to think about
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commodity pool
issues and the commodity futures trading
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Commission, the CFTC regulates those
things, but if you only take money from
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accredited investors, there's really
pretty easy exemptions there; there's not,
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it's not terribly difficult
today to navigate that world. Now if you
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want to start buying into other things
so other companies, you know if you could
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buy into ICO--that's really hard right
now to do--but other things that aren't
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crypto assets that aren't commodities,
they're clearly securities; so let's say
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for example there's a company who is a decentralized technology company
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and they're raising money; it's just a
private offering of securities and you
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think that's within the the the thesis
that you've laid out for investors,
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because you're not just trying to flip
coins you're also trying to get
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investment into some of the
protocols and properties that are going
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to kind of run this decentralized
universe, right; so let's say that's what
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you're doing.
That's a security so if you're taking in
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money and then you're going to buy
securities, now you're in the world of
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registered investment advisors.
An investment advisor is someone who
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advises people, they're in the business
of advising people on buying and selling
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securities; so their stock brokers,
their most private
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equity fund managers, hedge fund managers,
who are trading in the markets, the
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public markets; they're buying and
selling securities so you're in registered
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investment advisor territory.
So again, on this third piece if all you're
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buying and selling is crypto assets; or
to take it out of this context if all
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your buying and selling is actual real
estate, then you're not buying
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and selling securities. So in those two
contexts, those two types of funds; crypto
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assets in our case, that could keep you
out of the registered investment advisor
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world and it's nice to not be in that
world, because that's a really
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mind-numbingly dense regulatory regime
and it's a kind of state-by-state thing.
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Now private equity and venture capital
funds have, over the years, developed very
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strong lobbies and they have a lot of
money and they have, there's something
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called a private fund advisers exemption
that effectively makes they're dealing
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with that regime pretty easy relative to
say just a straight-up normal hedge fund
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that's playing the public markets; but
and this is a state-by-state thing and
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it's going to depend on a number of
things but first and foremost where
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you're providing
the advice from, like where's the seat of
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your primary office, where are your
co-founders; that's going to drive some
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of this, but you can assume to take
something away that if you only trade
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in crypto assets it's pretty easy; if
you were to be a private equity a real
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estate or venture capital fund, also
pretty easy for a bunch of reasons; but
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if you're going to be a hedge fund that
trades securities, you're very likely
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going to have to only take in qualified
clients. So an accredited investor is
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someone who has a net worth, not
including their primary residence, of at
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least a million dollars; or makes, made at
least $200,000 each of the last two
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years or three hundred with the spouse
and has a reasonable expectation
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of making the same this year; that's
accredited duster territory. Qualified
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clients double that from net worth so
2.1 million actually; so it's a much
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higher standard of a client. Again,
this is state-by-state and it's
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kind of confusing, but just assume you're
gonna have a lot more sort of red tape
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to deal with in hedge fund world, if
you're trading securities and that's
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this money management piece and it's
nothing to do with founder formation,
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nothing to do with securities offering,
okay? Securities offering you might be
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able to just take in accredited
investors, that's fine, you complied; but
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over here money management, if in order
to not be regulated as a full on
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registered investment advisor, which
means you need to pass your--I guess it's
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series sixty five and seven or just
sixty six, I mean there's one that,
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there's two that are separate and then
there's one that covers book--but it's
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you know, a bunch of licensing and tests
and stuff like that in order not to have
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to do that, you're gonna need to find an
exemption and if you're not a private
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equity fund or
venture capital fund those exemptions
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can be pretty hard to find. So in Texas
the way you get it is to only have
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qualified clients. So again, it helps to
kind of compartmentalize this whole
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thing into three big buckets and to keep
that securities offering separate from
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the money management advisor piece and
if you want to be a true crypto asset
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hedge fund, at least at the time
I'm recording this, you can avoid a lot
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of this altogether, really could be
pretty simple. For that whole package you
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could expect to pay, you know, big
law sixty, seventy grand you could
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expect to pay someone like me less than
half that, but it's still a whole lot of
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work and you know it's gonna take you a
few weeks at the very least and if
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there's a licensing piece obviously
that's a gating item and that's a whole
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lot of work to, but general, if you could
stay in crypto asset space, it's quicker and
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it's faster you can be up and out there
in about three weeks. There's
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custody issues, there's some other stuff,
you need some policies, but that's the
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broad scope of what goes into forming a
crypto asset hedge fund. So if you have
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any questions about any of this, any
feedback, anything I did touch on that
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you'd like me to say more about send me
an email, drop me a line, put a note
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underneath the video, if you liked it
tell me that. Appreciate you listening
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today.
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