This essay is part of The Token Handbook. It covers blockchain-based equity offerings. Several things make an equity token offering different from traditional “paper” equity and from today’s utility tokens (ICOs). Keep in mind that all equity products are securities and must comply with the laws of the jurisdiction in which they are offered and registered, and in many cases with the jurisdiction of the buyers as well.
Interested readers will enjoy a related essay of mine called It’s time for Smart Law.
This essay is not intended as a detailed and exhaustive treatment of the laws, rules and regulations governing the issuance and sale of securities in the United States or other jurisdictions. The offering and/or sale of securities to the public can result in significant criminal and civil liabilities. Consult with legal counsel before you undertake any token offering. A list of current providers is at the end.
In September 2016, Lykke Corp issued its own equity as tokens on the blockchain. I haven’t done extensive research, but I believe this was the world’s first equity offering using blockchain technology. I participated in that effort, which raised $1.2 million for the company at a valuation of around $55 million.
A few details: Lykke issued equity colored coins (using the Bitcoin blockchain) on its own just-launched exchange, the offering was open to the public (as long as they registered using standard KYC procedures), previous investors received tokens in their wallets, and the tokens have been trading on the Lykke exchange ever since. The one-year-old company effectively “went public” on their own exchange, so when they want to raise more money, they just sell shares from their treasury into market demand. After this initial event, the market forever sets the price of the company’s equity and determines the market cap.
One of the reasons Lykke went public so early is that traditional early-stage investors don’t understand the new economy we’re building. I have seen it after countless meetings with investors — they don’t see the potential of the new blockchain economy. There’s a huge gap between launching an open-source ICO to raise tens of millions of dollars from token hunters and just getting your company funded so you can bring products to market.
At 20|30, we will address the funding gap with equity token sales. To comply with most securities laws, we will only sell equity tokens to accredited/qualified investors (people who have significant assets and income). At 20|30, we are planning our own equity token offering for early next year, and we’re building our own exchange just for accredited investors. At the Pillar project, we’re also building the ICO wallet, which will help give people a much safer way to buy and store tokens.
Equity tokens are an important part of the future crypto-economy. While an ICO can be the right tool for project finance, it’s generally the wrong tool for company finance. Why? Because projects have a dedicated outcome or goal, and the money goes to achieve that goal or fail, whereas companies often pivot, create new product lines, cross categories, and may have several projects going at any one time. For startups, it’s better to apply risk capital in the form of equity, rather than a utility token. This essay covers how companies will do this and what comes after the sale. It’s meant for companies that are not building their own exchanges. I will cover it from a US legal perspective, here are the sections:
- About Dilution
- Dilutable Stock
- Non-Dilutable Stock
- Regulatory Compliance
- Side Bets
- A Single Class of Stock
- Voting & Control
- Tokenizing Equity: the Mechanics
- Insider Trading
- Paying in Tokens
- Token Troubles
- Tokenizing Governance
IMPORTANT NOTE: equity tokens are securities. This essay assumes all market participants have gone through the appropriate checks and markets are properly licensed.
1 About Dilution
In normal equity financing of new companies or projects, early investors are almost always diluted by further rounds. When Lykke had their ICO in September 2016, the market cap of the company was around $56 million. I thought that was “too high,” but a) the offering was successful, and b) I realized later that this was nondilutive financing with instant liquidity, and that’s worth a premium, and c) Lykke’s share price has gone up considerably since the offer.
In traditional venture financing, early investors get diluted as new investors come in and add money. In this excellent infographic by Mark Suster, angel investors who purchased 20 percent of a stock ended up, after several rounds of financing, with 6 percent, for a dilution factor of 3.3. In reality, this factor ranges from 2 to about 6.
Then there’s a liquidity event, and not everyone can sell immediately or they’ll trash the stock price. Shareholders have to play it out carefully, over a period of years, as new investors come in and replace many of the early investors. Managing liquidity is a matter of setting clear expectations and selling into demand.
So there are two stages:
- the private “locked up” stage
- the public liquidity stage
In token-based finance, you don’t need to have the first stage. You can plan on dilution later, or you can set up the stock to be nondilutable. You can go for liquidity early if there’s a market where your equity is tradable. I’ll explain each of these.
2 Dilutable Stock
In the dilutable version, you’re doing what most companies do: they authorize a lot of stock but only issue some of it to the public and other shareholders. They leave some shares unissued for later sale. When they later sell the unissued shares, this dilutes all existing shareholders.
To do this with smart contracts, you would create, say 100 million tokens in the smart contract, but then you would declare that only 10 million of those tokens currently represent 100 percent of the ownership of the company, and 90 million tokens are “in cold storage for later rounds.” This mimics the normal funding scenario by expecting future rounds to dilute all existing shareholders.
There’s a good reason to do this — it gives each party the appropriate ownership for the stage of the company. When a company is very young, angel investors want to own 30 percent. If something bad happens, they may get 30 cents on the dollar, possibly more. At the next round, angels usually have the option to pay more to “hold their position” and not be diluted. When the company is very mature, angel investors don’t mind owning a small amount of a much more valuable company.
3 Nondilutable Stock
In this approach, you issue say 100 tokens, and you promise those 100 tokens will represent 100 percent of the stock forever. If you sell someone one token, that person has one percent of the company as long as she holds them. This is possible using tokens. So let’s ask investors: “If you could check a box on the term sheet that lets you write in how much extra you’d be willing to pay for nondilution, how much would it be?”
The answer is: “not much.” For starters, paying for antidilution provisions doesn’t change the risk at all. An antidilution premium is really insurance. It gives you what you want later at a price today. So it should be priced like insurance — you might pay one percent of your investment for antidilution insurance, but you wouldn’t pay a lot more. Therefore, I believe most equity token sales will be for shares that can be diluted later.
Normally, early-stage investors get liquidity at 5–8 years after they invest. Token markets give investors early liquidity, which gives investors a choice: get out early or hodl and take your chances. In an equity ICO on our platform, we will require investors to hold for one year from the date of initial offering, which a) complies with US law and b) is the right thing to do for a new company trying to establish itself in the market. Funding early stage companies is for those who understand the risk and the reward, not speculators.
However, after a year, liquidity is valuable to all, and that’s what we’re trying to create. At the one-year point, I imagine most companies will have a second issue, raise more money, and then the market will determine the price thereafter. We want to see a full liquidity stack from 1-year-after first financing all the way to public markets. This will give us a much more efficient start-up market and eliminate most of the middlemen.
At 20|30, we plan to offer our own first equity round on the Pillar ICO platform and then help companies take their equity tokens to our accredited-investor market.
5 Regulatory Compliance
Equity tokens are a new territory for government regulators. The laws regarding control of equity tokens are evolving, but the trend appears to be that equity tokens will be subject to some form of government regulation. Anyone issuing equity tokens should be aware of applicable securities laws.
Most issuers of equity tokens will go the unregistered route and avoid the expense and filing requirements of registered securities. In recent years, the exceptions permitting unregistered securities have been substantially expanded. Most startups will find it possible to raise significant amounts of capital from a broad spectrum of the public without complying with registration requirements. For example, under SEC Regulation A+, an issuer can raise up to $50 million, subject to limitations regarding advertising, solicitation, reporting, and the nature and number of investors.
In the US, Regulation D, rule 506(b) allows hedge funds and other private offerings to raise money from accredited investors but not advertise. Marketing can only be done through word of mouth, which has spawned an entire industry of third-party marketers taking investors to lunches. This includes the famous “accredited questionnaire,” in which investors just state that they are, in fact, accredited, with no proof. In identity language, this is a self-sovereign declaration.
Fortunately, thanks to recent changes, US companies can use Regulation D, rule 506(c), which states that they can raise money for private deals and advertise as long as they go to further lengths to ensure that investors are accredited using bank statements, tax returns, and other evidence. In the identity world, these are called attestations. This is likely the best path for those in the US to raise more than a few million dollars.
Issuers in need of lesser amounts of capital can now take advantage of other exceptions available under the Crowd Funding portion of the JOBS Act, which has fewer compliance demands.
Canada’s restrictions are quite similar to those in the US. Other jurisdictions, including The UK, Switzerland, and Singapore, have their own rules — we plan to build a resource where people can learn all these restrictions.
Some groups are working on registering security tokens, including equity tokens, so they can be sold to the public via a regulated exchange. This effectively treats start-ups like public companies. Is this appropriate? Since this is my essay, I will say I don’t think it is. It could work in some cases, but I don’t think registering and complying with the rules for public companies is the right way to finance start-ups, 90 percent of which are gone within a few years. It could be great for private equity of companies that have significant earnings, but don’t think registering start-up stock properly addresses the risk for the average investor.
However, I believe that once we have our accredited-investor market running, we’ll then be able to create “index” products that combine many high-risk investments into a single token, and those should be suitable for the public. We’ll be working on registering those and taking them to market.
When I use the term “Paper offering,” I’m referring to the way things are done today, even though the actual stock certificates may not exist. In fact, two companies — Eshares and CapShare —keep track of cap tables for investors and private companies. But for our purposes, these are equivalent. They aren’t tradable. Tokens will be tradable and held by the rightful owners, with no beneficiary in the middle.
8 Side Bets
As tokens are digital assets, they can be pledged and managed by smart contracts. Already, we’ve seen futures markets that try to price the future value of various tokens when they hit the market. This will undoubtedly be part of the token economy. A token may not be liquid, but you’ll be able to buy naked options or futures on it, or hypothecate (pledge) your tokens as collateral, and the market will have its say.
We could definitely see restrictions programmed into the smart contracts. For example, those who paid money may have liquidation preferences ahead of founders and others who don’t pay. Vesting, options, high-watermark, ratchets, control, and other features could be built into the smart contracts. But once a token is unencumbered, it’s tradable.
10 A Single Class of Stock
In a paper offering, investors get preferred shares, while founders and employees get common shares. Later, before a liquidity event, the preferred shares convert into common shares.
In a token offering, all tokens are the same “class,” and they are all locked up (untradeable) for one year. In lieu of liquidation preference, investors get liquidity. There can still be restrictions and preferences, but these can (to the extent allowed by law) be traded. We still need more exchanges to list more tokens, but eventually there should be a single market with worldwide liquidity, which will open up a range of new financing possibilities.
11 Voting and Control
In a token-based market, it will be a good idea to give shareholders voting rights, so they can vote to save the company in case a serious haircut is needed. HOW will tokenholders vote? On our exchange, we will be able to build various kinds of voting into the tokens. In a completely decentralized exchange, voting will cost a bit of money to execute the contracts, and the cost of voting will have an effect on the outcome.
There are also issues of control — if an entity acquires 51 percent of your tokens, can they take over your company? Can tokenholders replace management or change strategy? Several companies are working on governance tools, which I’ll cover in another essay.
As we know, most startups pivot, and a few of them even survive. It’s not uncommon for a company to have a “down round” or other unpleasant shareholder event. In a down round, previous investors are often treated like second-class citizens, their initial investment reduced to a few cents on the dollar. In most cases, that’s preferable to certain death.
There are other dangers of being “public” early. Entrepreneurs will have less flexibility in doing deals and being creative with their cap table. But in a future world of global liquidity, industry practices will change. I expect we’ll have more flexibility in the world of early liquidity than we do today.
13 Tokenizing Equity: The Mechanics
Securities laws don’t allow for tokenizing stock; authorities and regulators recognize paper as the ultimate “truth.” While I hope we’ll be able to tokenize public shares within a few years, for now we’ll have to rely on documents that bind tokens to shares using legal language.
The documents of an offering include the shareholder’s agreement, operating agreement (usually includes a business plan), subscription agreement, and bylaws. On the token side, you usually have a white paper, terms and conditions, and a smart contract. To tokenize your stock, you want all these documents to use the same language and concepts that will tie your stock to your tokens. Use a qualified lawyer, but here are a few tips:
Token sales don’t have paper signatures. Your token buyers agree to everything in your document by sending their money to your smart contract. Technically, I’m not sure any country’s laws recognize a signed blockchain transaction as a legal signature. Many countries do recognize passwords and PINs as legitimate signatures. The next step is to pass legislation that if you send your money to a smart contract, the smart contract determines the outcome of that transaction. More progressive countries like Gibraltar, Estonia, and Dubai will probably be first, but we’ll see if they take baby steps or a giant leap toward “code is law.” My guess is we’ll see it happen piecemeal, which means tying equity to tokens could be a specific piece of legislation.
At 20|30, we plan to create a generic set of offering documents and give them away for all to use. I can’t tell you when, but if you want to work on that with us, please get in touch.
Create far too many tokens and keep them “on the shelf” for future dilution. We’ll try to establish some best practices for this.
Retrofitting an existing cap table involves passing a resolution, which may require a supermajority of existing shareholders to change the language of the bylaws and operating agreement. I recommend you get 100% of shareholders to agree before converting to tokens.
Binding shares to tokens. For the next few years, it will be common for the company’s treasurer to hold all paper shares in a safe (or digital shares in a data center) and the company will promise in its documents to maintain a one-to-one relationship between shares and tokens. Eventually, we’ll get rid of the paper shares entirely. This is just language in contracts. The SAFT Project came out of Protocol Labs’ successful token sale on CoinList.
Divisibility. As we have seen, more divisibility is better. You may think no one needs more than 1/1000th of a share of stock, but the markets work differently. Someone who wants to buy 10 ether worth or $100 worth will end up with several decimal points of stock, and that’s fine — there’s no reason not to give 18 decimal places of divisibility.
Because of this high degree of divisibility, the number of shares to issue is purely psychological. You can divide your equity into 100 million or 100 tokens. If you divide into 100 tokens, it’s still incredibly tradable because you can own 0.00000001 of a token. I think if Warren Buffet were starting over, he might take this approach to his company and just issue 100 shares and keep it simple. But people also like to “collect” stock and think in terms of round numbers, so you may want to choose 100,000 or 100,000,000. There’s one good reason not to go too high — people make mistakes typing in numbers, and a fat-finger mistake on a stock transaction can be costly. Having made such an error once, I can say that it helps to use numbers people can manage in their heads.
14 Insider Trading
Just as today’s startups using paper equity have to pay attention to insider trading, tomorrow’s token-based startups will have to be even more careful. As we add liquidity to token markets, we’ll need clear standards for what insiders can and can’t do. Some people may get restricted tokens, and a company may well want to freeze certain amounts of stock to keep them off the market for a period of years, which gives markets comfort that the company won’t try to sell too many at once. Good news — we can do much of this with smart contracts.
If this market is going to become a reality, we’ll need something like XBRL — the business reporting standard — for small companies and projects. The ICO Monitor, Token Filings, and other projects will help add the necessary transparency.
16 Paying in Tokens
You can pay employees in stock tokens, but it’s a huge risk for them. Employees must assign a market value to the stock on the day of receipt and must declare that amount as income (you’ll need the exchange rate for that day so you can compute the income). Unless employees can afford to pay the tax and hold onto the tokens, I recommend paying in a mix of mostly cash and perhaps a few tokens.
17 Token Troubles
What if a token holder loses the private key to her wallet? Since the shares are kept by the treasurer, surely she could get them back — no? What if your blockchain forks? These problems show that we are half-in and half-out of a true token economy. Better to have answers ahead of time than figure them out later.
18 Tokenizing Governance
In the interest of saving time and getting this piece up, I’m going to defer bylaws, voting, control, further fundraising, and governance issues to another essay. Just because you tokenize your equity doesn’t mean you aren’t every bit as responsible to shareholders as you would be in the old world. Governance will change. I’m looking forward to writing about how it will change as soon as I can.
Companies working on tokenizing equity:
- Gibraltar’s Crypto Harbor
- Polymath’s core equity token design
- Gibraltar Stock Exchange
- The R-token white paper
The Multi-Stage Coin Ofering, by Denis Petrovcic
We’re going to see more and more equity-token offerings. This is a good thing — most of today’s token offerings should probably not be the utility tokens we’re using to raise money now. We’re doing our best to craft legal language that links tokens and equity. Within a few years, I hope, the smart contracts that issue equity tokens will refer directly to e-regulations that help us put tokens on a firmer legal footing. Eventually, all securities could be represented by tokens and probably should be. As the old saying goes: first they ignore you, then they laugh at you, then they fight you, then you win.
At 20|30, we’re dedicated to building a true token market for accredited investors and start-ups. We’re building a machine we hope will take thousands of start-ups and projects to market. We need help! If you want to help us create this ecosystem, either on the buy side or the sell side, please contact me. Law students and interns are particularly appreciated.
My thanks to securities lawyer Eric Lieberman for help writing this.
Now you can go back to The Token Handbook.
David Siegel is a serial entrepreneur from the United States living in London. He is the CEO of 20|30 and the Pillar project, both of which have newsletters you may wish to subscribe to. He is the author of The Token Handbook and an essay on cryptocurrency bubbles. His full bio is at dsiegel.com. Connect to him on LinkedIn.
Disclaimer: The information in this article is for informational purposes and does not constitute legal advice or instruction. You take your own risks when issuing, selling, or buying cryptocurrencies and tokens.