Since 2017, companies utilizing blockchain technology to raise funds through security token offerings (also referred to as token sales, ICOs or token generating events) have made a qualitative leap toward compliance with the securities laws while selling their tokens to U.S. investors.
Now, majority of the token sales comply with the required disclosures and filings under one of the available exemptions from the SEC registration (Reg D, Reg S, Reg A, Reg CF). Token issuers make sure (we hope) that the investors have passed the KYC/AML checks and are otherwise qualified and properly informed to purchase tokens, that the investment amount and transfer restrictions, if applicable, are implemented into the formal token sale contracts and smart contracts, etc.
However, token issuers seem to have relaxed vigilance when it comes to issuing tokens not in exchange for investors’ funds – but as awards compensating the team, advisors and other service providers of the issuer. It will not hurt to remind again: most tokens are categorized by the SEC as securities, so token awards in exchange for services (or other value) are considered sales of securities and, as such, may be unauthorized offerings or sales of unregistered securities, unless structured in compliance with an exemption from registration. Thus, token awards should be carefully structured in advance and a few issues should be considered, including:
- Like equity-based awards, token awards to employees, officers, consultants or advisors should usually be issued pursuant to a written compensatory benefit plan or agreement to be exempted from registration under Rule 701 of the Securities Act of 1933.
- There is a limitation on the number of tokens issued as awards under Rule 701 within any 12-month period.
- Grant of token awards under Rule 701 over a certain threshold amount triggers additional disclosure obligations.
- Not all consultants and advisors are eligible to receive token awards under Rule 701.
- Not all services may be offered in exchange for a token award under Rule 701.
- State security regulations should be complied with when issuing token awards under Rule 701.
- Other exemptions from registration, alternative to Rule 701, are also available for token awards.
- While treated similarly, token awards may have to be structured differently from the equity-based awards because of the different liquidity, equity rights and tax treatment of tokens and cryptocurrencies.
- Awarding the team or consultants with tokens under one of the exemptions from registration does not dispose of broker-dealer issues attending any award related to sales of securities.
Written Plan/Agreement and Other Requirements under Rule 701
All offers of token awards under Rule 701 should be done under a written compensatory benefit plan or agreement delivered to each recipient and are subject to additional requirements and limitations.
The aggregate sales price or amount of securities sold under Rule 701 during any consecutive 12-month period must not exceed the greatest of the following:
- 15% of the total assets of the issuer, measured at the issuer’s most recent balance sheet date; or
- 15% of the outstanding amount of tokens offered and sold in reliance on Rule 701, measured at the issuer’s most recent balance sheet date.
If the company during any consecutive 12-month period issues token awards with the total token price or fair value exceeding $10 million, such company must deliver additional disclosure to recipients including, among other things, risk factors associated with the tokens, and GAAP-compliant financial statements. Valuation of tokens for the purposes of Rule 701, especially tokens denominated in cryptocurrencies, may create a separate issue, which is outside of the scope of this article.
Token awards may only be granted to consultants and advisors who are natural persons and provide bona fide services to the token issuer. Such services may not be in connection with the offer or sale of tokens in a security token offering and may not directly or indirectly promote or maintain a market for the tokens.
Token issuers relying on Rule 701 should also analyze the securities laws of each state where the recipients of the token awards reside, as Rule 701 does not preempt the state laws (many states adopted similar exemptions, however).
Other Exemptions Are Still Available
Token offerings under Rule 701 are not integrated with token offerings under other exemptions from registration, like Regulation D, for example. Under Regulation D, there is no limit on the aggregate amount of issued tokens, but the sales are limited to accredited investors.
However, directors and executive officers of the issuer qualify as accredited investors by statutory definition. Thus, the issuer’s directors and officers are entitled to receive token awards under Regulation D without affecting the volume limitations of the token awards issued under Rule 701.
Certain services providers may be high income or net worth individuals, which would allow them to receive token compensation exempted under Regulation D as accredited investors. Also, state securities regulations are preempted by Regulation D.
Tax and Other Structuring Considerations
Structuring token awards will largely depend on the intended or inevitable tax consequences, such as being taxed in the year when the award is granted; deferring taxation until the awarded tokens vest or are liquidated; or converting the increase in value of the tokens into a capital gain. In addition, some aspects of tax treatment of tokens and cryptocurrencies remains uncertain. Taxation-related issues deserve a separate detailed analysis and are out of the scope of this article.
Analogous to equity awards, token awards may include unrestricted tokens, restricted tokens, token options and restricted token units. However, structuring each of those in a token sale aspect will be different from planning equity-based awards of a startup company.
A major reason is that tokens are more liquid than stock of a startup and recipients of token awards may get liquidity for their tokens much faster than a team member of a traditional startup. At the same time, tokens often do not grant voting, management or other rights customary for classic equity securities. So, a lot of provisions of the stock incentive plans will have to be revised or removed while preparing a token-based incentive compensation plan.
Bonus Issue: Watch Out for Broker-Dealer Regulations
In addition, any renumeration (in tokens, crypto or fiat to the team members or third parties) that is related to soliciting investors or promoting token sales may require broker-dealer registration. Particularly, when such compensation is directly or indirectly transaction-based. Every compensation plan or arrangement should also account for the SEC’s broker-dealer regulations and exemptions.
For a private token issuer, compensating the team, consultants and advisors in tokens for their services is considered an offering or sale of unregistered securities, just like a security token offering to investors. Thus, token awards should be diligently crafted, usually pursuant to a written incentive plan, to comply with several requirements and limitations of applicable exemptions from the SEC registration.