First published in BanklessDAO’s Decentralized Law, Tokenization, August 31, 2022.
You’re an enterprising founder with a unique project in the Web3 space. You have received angel investment and set up your startup company using Stripe Atlas, Doola, or the like. Somehow, you found enough devs to build the project, and you’ve come up with a killer marketing campaign. You know the right people, and your cap table is ready to go for those first funding rounds. As you begin meeting with investors, they start asking about SAFTs and SAFEs, token warrants, ICOs, and what kind of SPV you will utilize to launch your token and in what jurisdiction. You then realize that you have no idea how the rest of this stuff works. Should you talk to an attorney? Where do tokens even come from?
This article is meant to provide a very general — non-legal advisory — overview of some of the steps and mechanisms involved in the funding and issuance of a token. There will, of course, always be distinctions and exceptions based on considerations such as whether a project is anon or doxxed, whether it exists as a fully on-chain entity or has one or more associated development companies (‘devco’) or other operational entities, whether the project is raising VC funding, and whether the project intends to establish a DAO or remain operating in a more centralized manner. Notwithstanding this multitude of considerations, however, obtaining funding and effectuating token issuance in the manner discussed below is a common journey for many projects.
According to Nic Carter, “Bitcoin benefited from an extremely rare set of circumstances. Because it launched in a world where digital cash had no established value, it circulated freely. That can’t be recaptured today since everyone expects coins to have value. Not only was it fair, but it was historically unique in its fairness. The immaculate conception”.
Unlike Bitcoin, most projects require investment and funding, with all of the attendant regulatory concerns and considerations for investor/founder exit. Digital tokens are expected to return value for investors. While Satoshi never had to worry about securities laws, almost every subsequent project does.
In 2017, spurred largely by the ICO boom, the then U.S. Securities and Exchange Commission (SEC) Chair, Jay Clayton, stated that cryptocurrencies are ‘intended to provide many of the same functions as long-established currencies such as the U.S. dollar, euro, or Japanese yen but do not have the backing of a government or other body’. However, he also noted that whether a given digital asset that is labeled as a cryptocurrency is a security ‘will depend on the characteristics and use of that particular asset’. While that sounds like an appropriately nuanced position, the current SEC Chair Gary Gensler stated in a 2021 interview that investors ‘buying these tokens are anticipating profits’, which is one of the conditions that any asset must meet to be deemed a security, and this causes them to fall under the SEC’s jurisdiction.
The ability to serve as a replacement for a sovereign currency can be difficult to achieve. As Scott Kupor, managing partner at Andreessen Horowitz, has previously written, “in the pre-network stage, tokens will generally be characterized as securities in light of the “reliance on the efforts of others” prong of the Howey test. However, post-network launch — provided that the network is sufficiently decentralized — the nature of the token can change from security to non-security, owing to the fact that the holder of the token is no longer relying on the efforts of others”. In that context, the token is seemingly transformed into an alternative currency or commodity. It is not clear, though, whether the SEC would agree that a token can cease to be a security.
In the United States, Section 5 of the Securities Act requires that market participants register ‘securities’ with the SEC prior to offering them for sale unless an exemption applies. Section 2(a)(1) defines the term ‘security’ by enumerating a list of financial arrangements that Congress expressly intended to capture within the purview of the statute. A digital asset may be deemed a ‘security’ and be subject to federal securities laws if the asset is one of the enumerated examples of securities. Unsurprisingly, blockchain-based coin and token offerings are not expressly listed among the enumerated examples of securities in Section 2(a)(1). However, alongside the enumerated examples of asset classes commonly referred to as securities, Congress curiously included but did not define a catch-all term—‘investment contract’.
According to the Howey Test, an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”. Because of this draconian default characterization as a security in the U.S. and other jurisdictions, most entities issuing tokens are, in function, attempting to recreate the aspects of Bitcoin’s issuance that allow it to be characterized as a currency or commodity and not as a security. Ultimately, the mechanisms to fund a project and launch a token in a manner that does not violate securities laws often require a behind-the-scenes legal shell game that results in what appears to be the immaculate conception of a token that is then bestowed upon an awaiting community for governance, investor exit, and whatever other purposes.
If you’re not doxxed or are somehow out of the reach of the more ‘oppressive’ regulators, you could certainly always drop a contract and issue a token, then conduct a sale on-chain. Unfortunately, most projects don’t have that option, if for no other reason than founders are concerned about liability or that the potential funding won’t be sufficient to achieve the project's goals.
Initial Coin Offerings (ICO) are probably the most well-known funding mechanism for projects in the crypto space. An initial coin offering, like an IPO, sells something to fund the creation or operation of a new cryptocurrency. An arguable and important distinction between an IPO and an ICO is that contributors to an IPO are investors who are acquiring shares of the company, i.e. equity. In contrast, ICO backers are acquiring what might more appropriately be characterized as a product in the form of the token, which does not generally represent equity in the token’s issuing company or network. However, despite what seems like a fairly clear distinction, in the U.S. the SEC requires projects to follow private placement and public offering rules when conducting an ICO. However, for the same reason that Special Purpose Acquisition Companies (SPAC) were incredibly popular in the 1990s and again in 2020 and 2021, most projects don’t want to deal with the hurdles and regulatory burden of registering a public or private offering. Ultimately, an ICO or SPAC merger is generally considered easier.
ICOs first became popular in 2017 because they allowed entities in the crypto space to raise capital and fund development without having to go through the regulation-intensive processes mentioned above. Numerous projects sold tokens in the period between 2017 and 2018. According to a Harvard Business review article, the average amount of capital raised by a via ICO in 2017 was thirteen million, with the number increasing to twenty-five million through the third quarter of 2018. According to Coindesk, most of these sales netted less than $100 million, though projects remained eager to utilize the mechanism despite the looming regulatory risk. The success of these ICOs consequently attracted significant regulatory scrutiny, most notably from the SEC . As a result, ICOs have largely fallen out of favor as a funding mechanism due to the associated regulatory obligations and potential exposure to regulators. They are also just flat-out banned in certain jurisdictions like China.
For institutional investors, equity term sheets are a standard mechanism for investment in early-stage companies. Instruments such as a convertible or a ‘simple agreement for future equity’ (SAFE), which was initially popularized by Y-Combinator, are generally used to convey future equity to investors. However, when an investor receives a startup’s native token instead of equity, a simple agreement for future tokens (SAFT) is utilized. The SAFT was initially hailed as a novel way to carry out ICOs in a manner that complied with federal securities rules. As with the distinction between an IPO and an ICO, where a SAFE offers equity in exchange for an investor's early-stage investment, a SAFT provides for the delivery of fully functioning future tokens once issued.
In the 2017-2018 ICO boom, SAFTs were often utilized by institutional investors in conjunction with an ICO. As with ICOs in general, the two-step ICO + SAFT strategy quickly ran afoul of the SEC, which brought several high-visibility enforcement actions against offerings from the messaging app Telegram and rival messaging app Kik. In both instances, the SEC found that distributing tokens to investors in the form of a SAFT with a view toward onward distribution in the U.S. by those investors is not, in fact, a private placement but a preparatory step for a public offering via cryptocurrency exchanges, with the SAFT holders being regulated not as investors, but as statutory underwriters for onward distribution to the public. Due to the SEC’s creative assertions, this entire line of litigation is confusing, even to experts in the space.
Currently, at least in the U.S., the SAFT — instead of the yet-to-be created token offering — is characterized as a security that can be offered to accredited investors in a private placement. Outside the U.S., the necessity of restricting SAFTs or tokens to accredited investors will be determined by local legislation. In function, SAFTs are generally utilized when the project has already decided on the type of token it plans to issue, has already detailed tokenomics, and has created a token distribution plan (including prices and stages of distribution). This is because a SAFT cannot be signed without detailing the material terms of issuing and transferring tokens to investors.
SAFT terms usually include:
Total volume of the token issuance
Amount of investor allocation of tokens
Price of tokens at the time of transfer to the investor
Conversion event (the moment when SAFT is converted into tokens for the investor)
Information about vesting, lock-ups, and other encumbrances on the investor's tokens, which are important for the successful operation of the project's tokenomics.
Therefore, a detailed paper with a description of token use cases, tokenomics, and token distribution plans is generally considered necessary to prepare a full-fledged SAFT. In exchange for this promise of future tokens, Web3 startups can use funds from the sale of SAFT to develop their projects, mint their tokens, and issue their tokens to investors, who usually have an expectation that there will be a secondary market to sell these tokens.
More recently, token warrants have gained favor as an investment mechanism among Web3 venture funds. In a recent tweet, Su Zhu of the embattled Three Arrows Capital (3AC) accused 3AC's liquidators of failing to exercise StarkWare token warrants, causing 3AC to allegedly lose out on significant future returns from the putative StarkWare token. In doing so, he inadvertently dropped a whole lot of alpha regarding StarkWare’s plans for token issuance.
A token warrant is a broad instrument that secures investors' rights to tokens that will (or may) be issued in the future. Issuing warrants doesn’t mean a token will be issued — though it seems very unlikely that StarkWare is not issuing a token. While SAFE and SAFT documents are well known and widely utilized by investors, not all founders, retail, and non-institutional investors are familiar with the warrant mechanism. Token warrants can be distributed to equity holders in an associated devco or parent entity. They can also be issued from an entity specifically created to issue the warrants and tokens. Token warrants do not usually specify the amount of the issue, the allocation for the investor, the price, or any other significant conditions, but only establish the investor's right to receive these tokens proportional to the equity ownership percent times the token allocation percentage for investors (for example, in a situation where 25% of tokens are allocated to investors, a seed investor holding 10% of the company’s equity would acquire a right to 2.5% of the project’s tokens, or 10% x 25%). To further incentivize investors, protocols often include a significant discount from the market rate on the token purchase price when the warrant is exercised.
Entities like SporosDAO are now utilizing token warrants in their startup solutions to provide compliant sweat equity distribution mechanisms to contributors. The mechanisms utilized by Sporos track contributions in a manner that is meant to limit a startup's legal considerations by allowing tokens or future tokens to remain non-transferable, or illiquid, until the occurrence of a liquidity event. This arguably shields distribution of tokens or equity from securities registration for the timeframe leading up to the liquidity or token generation event.
One of the main motivations — and struggles — for DAOs to associate with or ‘wrap’ in a legal entity is due to the creation of fictional legal personhood, which provides liability protection and the ability to contract and act as a counterparty to a warrant, SAFT, or other agreements. For anonymous teams, this similarly creates a variety of issues. To the extent a project has a devco or other entity in place while it is seeking funding, that entity can contract on behalf of the startup or putative DAO. However, even if there is an entity in place, most projects ultimately utilize multiple distinct entities in a ‘stack’ to facilitate conducting a raise or token sale, issuing a token, and managing the project after the token generation event. This arguably provides optimal risk mitigation because it silos function and liability. This structure may also seem familiar as it is generally analogous to structuring in legacy financial offerings and investment funds.
In addition to the startup entity/devco or unregistered DAO, an ‘optimized’ legal stack that provides the most potential insulation often includes: 1) a special purpose vehicle (SPV) that issues or countersigns funding instruments (the SAFT/warrant/options/conducts the ICO, etc.); 2) an entity that stewards the project or community after the token generation event (often a foundation as the sole beneficiary of the SPV or other nonprofit structure); and 3) an entity that performs necessary development or service work on behalf of the project or DAO (this is often the devco). In some instances, separate SPVs are utilized to manage fundraising and token issuance.
In addition to acting as a counterparty, the SPV’s primary purpose is to establish a limited liability shield between token creation and distribution events and the potential personal liability of the project founders and investors. Once the token distribution event is completed, the SPV transfers its assets, generally consisting of the balance of the tokens initially issued and proceeds of any token sale, to a foundation beneficiary or other entity. After assets have been transferred to a foundation or other appropriate entity, the SPV is dissolved to avoid non-fraudulent regulatory issues or legal risks associated with token sales and issuance that might carry over to the entity that is now managing the token treasury.
A common combination is a British Virgin Islands (BVI) Company as an SPV and a Cayman Islands Foundation Company, which can also be made ‘faceless’ if formed without founders and members. It is worth noting that while these solutions are often considered optimal, they are generally cost prohibitive for many projects. Arguably, this is because organizations and protocols utilizing these structures have historically been in the financial sector, where cost is not a significant barrier to entry.
Broken down for clarity, the sequence of funding and token issuance is generally as follows:
Creation of startup devco entity and/or DAO (the DAO may or may not be initially registered in some jurisdiction). The devco or registered DAO can enter into certain initial agreements.
Individual contributors may consider creating their own entities (state LLCs for U.S. citizens, for example) to contract with the DAO or devco, as opposed to being directly employed by the devco.
Creation of an SPV to act as a counterparty or issuer for warrants, SAFTs, or other investment and funding mechanisms.
The SPV receives the aggregate funding collected and holds these proceeds.
Funds are utilized by the SPV — often through a grant to the devco or contractors — to facilitate any further development, audits, and infrastructure for the protocol or token before a sale or issuance.
An additional SPV may be established solely for the purposes of token issuance to provide further layers of liability protection.
Once token issuance and any sale is completed, the SPV(s) transfer any retained funds or assets to an operational entity and dissolve.
If the project is structured as a DAO, handover of governance can be effectuated.
There are a variety of iterations of the project development, pre-token funding, and token issuance processes that will ultimately be specific to the project based on the jurisdictional tethers of the team, investors, and requirements of jurisdictions where associated entities are registered.
Tokens are a tool for successfully distributing a project's core value. While token distribution can incentivize participation, create (non-equity) value, and aid in the development of credible decentralization, the mechanisms that facilitate investment in the protocol, the function of token issuance, and distribution of those tokens, are often complex and compartmentalized or operating in regulatory gray areas.
Due to regulatory uncertainty, most crypto ventures strive to achieve the holy grail of decentralization. From Ethereum to decentralized finance platforms like Compound, Synthetix, and Maker, these protocols emerged under the centralized leadership of core teams who gradually relinquished control to a larger community. However, these protocols and core teams required significant initial seed capital that could not be easily raised in a decentralized manner at the time, or likely even now. Behind every decentralized protocol, there was a startup entity, foundation, SPV, etc. that could contract with investors and secure appropriate funding to achieve the project’s goals. However, externally, it often appears that the project token was immaculately co[i]nceived from the ether, à la Bitcoin.
lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at firstname.lastname@example.org.