Beyond the Red Tape: The Path Ahead for Token Sales
Mason Borda is a tech entrepreneur focusing on blockchain infrastructure and security. He is currently the CEO and co-founder of TokenSoft Inc, a crypto treasury management and white label token sale platform.
The following article is an exclusive contribution to CoinDesk’s 2017 in Review.
It began with some source code and a white paper.
Bitcoin, initially launched as a technical curiosity with no ascribed value beyond its merits as a digital currency, designed to solve the Byzantine Generals’ Problem. The ease of transfer inherent in the cryptocurrency made it a popular currency of choice for crowdfunding the ethereum platform in 2014. Since its launch, the platform as become a popular tool for crowdfunding or building our other crowdfunded projects like Augur, Gnosis or Aragon.
In 2015, the Augur crowdsale was the first cryptocurrency project to collect funds in exchange for a promise to build a platform on top of ethereum. The model was still young. But with a white paper and a website to collect funds, the project was able to raise $5 million. Since then, the model has been replicated in a process called an ICO (initial currency offering), an acronym and process somewhat similar to a stock’s IPO (initial public offering).
Projects like Golem, Gnosis and Aragon have all raised funds with the promise of creating a peer-to-peer platform built on top of ethereum. As the price of ethereum skyrocketed from $8 to $40, then settled in the hundreds within a span of six months, the wealth created seemingly overnight gave way to the summer of ICOs in 2017.
The entry of well-established law firms brought a more formalized approach to the space and gave birth to the concept of the “utility token” and the security token, a reference to with the token issued in an ICO was a “security” that needs to be registered or exempt from registration with the SEC.
The following pertains to US laws and regulations and is not legal advice.
Why differentiate between utility tokens and security tokens?
A utility token is one that is interpreted to pass what’s known as the Howey Test, the precedent set by SEC v. Howey Co., 328 U.S. 293 (1946).
The Howey Test interprets the sale of a token to be an investment contract if:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party.
A security token is a token which must either be:
- Registered with the SEC and be subject to ongoing financial and material event reporting requirements
- Fall under an exemption from registration that is traditionally used by private companies such as Rule 506 of Regulation D, Rule 506(c) of Regulation D, Regulation S or Regulation A+.
Technology that exists at the intersection of supply and demand gives birth to regulatory innovation.
In the case of ICOs, the relevant parties generating the supply and demand are blockchain startups, crypto investment funds and the related law firms. The demand generated by the crypto investment funds and those with significant liquidity in cryptocurrency created the greatest source of deployable startup capital we have ever seen. This demand generated an unprecedented amount of attention and supply from entrepreneurs crowdfunding for pre-functionality projects.
While nothing is atypical about this, it led to a large amount of entrepreneurs taking advantage of the opportunity to raise capital with little disclosure or diligence.
There’s a nice SEC ruling that impedes investment groups from simply purchasing tokens. If the token is construed as a security, then the investment fund will need to hold the tokens with a qualified custodian, and this led to the need to define a token as a utility token or protocol token. From the fundraisers’ perspective they can be subject to increased disclosures the costly legal fees associated with performing a Regulation D SAFT offering or similar.
Theoretically, if the token is a utility or protocol token, then there is no need for a qualified custodian to hold the tokens. This concept led to a plethora of entities branding themselves as protocol funds or operations such as Protocol Capital Fund I, Protocol Ventures, and Protocol Labs. Of the less explicitly named funds, we have Polychain Capital, Pantera Capital, and Metastable.
The protocol token effect
As budding ICO token sale founders began making their rounds in Silicon Valley in 2017, many were drilled with the line: “Sorry, we only invest in protocol tokens.”
So it began. The mad dash to interpret a token as a protocol token. This briefly mythical token stood between hundreds of millions in funding and layers of red tape, hallmarked by the requirements for a token sale to impose accredited investor checks, minimum purchase limits (of at least $50,000), and a general unwillingness of the traditional investment funds to put in the cash.
The reality behind protocol tokens, is that they require highly technical teams that understand the low level mechanisms that make popular blockchains like bitcoin and ethereum work. Sadly, the human capital capable of creating a utility token is very limited due to years of general dismissal of bitcoin as a taboo.
Developers capable and engaged in the space sought their own blockchain startups or have already successfully launched their own token sales. But while the human capital that can undergo a token sale is limited, the demand has only increased.
There are currently a handful of public companies, private equity firms, and hedge funds that are seeking to enter the blockchain space by means of doing their own token sale. After speaking with investors, many are left with the mistaken impression that they must launch a utility token. Given the genetic makeup of their business, it is by no means possible nor practical. What emerged as a regulatory survival instinct of the crypto hedge funds has manifested into a mental roadblock for mainstream companies.
So what’s the solution?
With the high number of new entrants to the space, registration and best practices can assist in thinking about the risks and rewards involved in undergoing an ICO.
Where do we go from here?
As we enter 2018 with a number of established businesses planning token sales, we are seeing several trends at TokenSoft. When established businesses are launching token sales, a majority are taking one of the following routes:
- Rewards tokens : Tokens embedded into the platform to encourage user behaviors found to be beneficial to the platform (e.g. Kik’s Kin token).
- Equity-linked tokens: Tokens that allocate a portion of their cap table to the token sale (e.g. Finova Financial).
- Dividend tokens : Tokens that entitle the holder to a percentage of profits (e.g. Finova Financial).
- Distribution tokens : Tokens that entitle the holder to a percentage of liquidated assets at the end of the fund’s lifecycle or upon a pre-determined liquidation event (e.g. the Apex Token Fund).
Let’s take a look at each model.
Rewards tokens can be integrated into an existing application to encourage users to interact with other users and/or the application in ways they would otherwise have no incentive to undergo.
Basic applications can be similar to Yelp and interactions can manifest into performing an act for a bounty or writing a review for a reward. The benefits of the rewards token are simple integration to existing infrastructure, the potential for interpretation as a utility token, and the potential for a technologically conservative roll out of the tokens.
This is a very practical option for established businesses as many have an in-depth understanding of customer acquisition costs and the types of interactions that they would like to reward. From an integration stand point, there is the opportunity to leverage well-tested wallet architectures such as pooled wallets and individual, client-side wallets as the needs of the platform scale.
Equity Linked Tokens
We saw the launch of the first equity linked token with the launch of the Finova Financial token sale (or Jobs Crypto Offering). The company is seeking to allocate a portion of their cap table to the token sale.
The tokens represent a fixed number of shares in the company, and the transfer of the token results in a transfer of equity (i.e. rights to future profits and liquidation rights). The benefits of the equity-linked token are that the ERC-20 standard allows not only traditional secondary market exchanges to accept the token but also traditional crypto exchanges to easily accept and integrate the token.
We have yet to see this play out with exchange listings; however, chances are that greater accessibility will lead to greater interest in an asset backed token. There remain several challenges with the model as it is still uncharted territory.
There are several complications embedded in this model that the token contract should include. For example, equity sales generally include transfer agents and KYC/AML requirements. Solving for these problems in smart contracts is simply the beginning of the blockchain world entering the world of traditional finance.
While these requirements can be accounted for at token issuance, private secondary market trades and public exchanges need to adapt to integrate these tokens as the companies continue to mature and permeate into traditional capital markets.
One very common model, intuitive to those that emerge from the traditional world of finance are dividend paying tokens.
After users purchase a particular token, they are eligible to receive an air-drop in the form of ethereum as a percentage of quarterly profits due to investors. The company may use its quarterly profits and pay a percentage of these profits back to the token holders. Once the payment per token has been determined, the payout is rather trivial as the token tables for all token holders is publicly available.
Many of the dividend token challenges are the same as equity tokens with the added complexity of KYC/AML requirements on investors receiving the dividend for tax reporting in a 1099-div and tax of the profits prior to receiving the dividend. KYC/AML is in particular an issue with Cayman based funds that are seeking to issue dividend paying tokens to US investors and investors in other taxable jurisdictions.
Again, the token world needs to adapt to meet these regulatory requirements.
An emerging model that works best with actively managed funds, distribution tokens provide the token issuer with the flexibility to invest over a longer term, while providing a guaranteed payout to token holders at a particular date.
A dividend token may provide a periodic payout to token holders in the form of ethereum or other currency. The difference between distribution and dividend tokens lies in the source of funds as well as the payment schedules. Regulatory requirements for both styles of tokens are similar,
The token issuer may raise funds through a standard ICO with the promise to take these funds and to invest them based on the fund mandate. The fund may have a strategy that allows them to take the funds and invest them in other cryptocurrencies, or one that makes investments in other funds.
The latter is known as a fund of funds and is currently being pioneered by Apex Token Fund. The fund will have a liquidation and distribution date, at which point the investments will be liquidated and proportionally distributed to token holders.
The intrigue of the model is in the speculation that will occur between the issuance, the performance reporting during the fund’s lifecycle and ultimately the distribution date. The performance of investments will be closely monitored and reflected in the price of the token in near-real-time. Whether the value of what is distributed will be equivalent to the token price will depend on fund performance and free-market value discovery.
Tokens grow up
As we exit the experimental stage or token sales, we enter a world where tokens will be adapted to existing regulatory frameworks of financial services.
While 2017 was full of demand generated by innovative blockchain developers with a move fast and break things mentality, 2018 will be marked by demand from the world of finance with a taste for compliance.
This infrastructure will be driven by regulatory requirements that financial institutions meet today, such as the Custody Rule, Alternative Trading Systems, Broker Dealers and Transfer Agents; and will reinvigorate the world of traditional finance.