The Two Token ICO

Last week SEC Chairman Jay Clayton made a speech at Princeton and said that utility tokens can be securities, and that eventually these tokens can also be utility tokens. This kind of back and forth rhetoric is confusing at best. However, once again Chairman Clayton has spoken, and it is up to us to decipher what he really means. After all, the SEC is the most powerful financial regulator in the world.

The real issue for blockchain companies or projects that want to raise capital from its users or from investors is that their token is immediately going to be classified as a security token, which means a set of new problems that may make the blockchain company unworkable. Why?

Blockchain projects are mostly protocols that use tokens to operate the supply and demand side of the service. Having a security token means that everytime the token is being used, it needs to identify the user and run a set of required reviews, per the securities rules. How strange is it for a user to be asked all of those questions just to pay with a token for a service?

Imagine walking into a Starbucks store with a stock certificate issued for Starbucks shares and paying for coffee in shares. The barista will need to first verify your identity, a.k.a. KYC, and then verify those shares are still yours. Then the barista must run this transaction through a list of checks before accepting it and then issue a new certificate with fewer shares, notifying the transfer agent of the transaction before finally giving you the coffee. Not feasible, and this is essentially how transactions with security tokens work.

So how do tokens issued as securities work within the blockchain protocol? If it’s not already clear, they don’t. What has happened is a classic mob mentality following any sign of riches. Early on, ICOs raised considerable amounts of money with what were perceived as paper idea companies with no dilution. The gold rush started, and everybody wanted in.

But in reality, these structures were flawed because these companies were violating a long list of securities laws. Once the SEC started the enforcement, most entrepreneurs realized they needed to find an exemption from registration under the Securities Act of 1933 and raise the money with security tokens. This shift was important, but it wasn’t thought through with the right amount of attention. What was needed was a new structure to accomplish both goals: raise capital and launch a successful blockchain protocol.

So what should companies do? The best solution is to think of these two goals as two independent events. The first event is to raise capital. It turns out the best way to do that is to offer equity to investors. The equity is similar to tokens because it is limited in its issuance and can only be increased with a consensus of the shareholders. Yes you read that right. We are talking about the original governance token with hundreds of years of experience and improvements.

The best way to issue this equity token is to use one of the SEC exemptions from registration under the Securities Act of 1933. This means using the JOBS Act and picking either section 506(c) of rule Regulation D, Regulation A+, Regulation Crowdfunding, or a combination of the three. This is not difficult, and it is best to use one of the portals that also handles the proper due diligence, which includes investor verification (Reg D only), Know Your Customer (KYC), OFAC check, and Anti-Money Laundering review.

The second goal is to launch a successful token to operate the blockchain protocol. This one is the harder goal to achieve because it requires technology development, which includes feasibility risks and technologists to focus on achieving the successful release of the protocol. The good news is this: a company can give away the tokens to anyone interested in using the protocol and build a strong community of partners and users.

This is only possible if the token is not a security. Therefore it cannot be sold prior to its existence nor can it be listed on any exchange. If a company follows these two rules, then with the right legal counsel it is safe to assume that the token is indeed a utility token.

Combining the equity token with the utility token is the right structure for achieving two critical goals: raising capital to build the protocol and building a large community of users and partners for the success of the protocol.

New structures for investors are being proposed that provide both of these tokens. One of them is called the RATE, which is the Real Agreement for Tokens and Equity. This allows a company to issue two tokens, one as equity, represented by the capital table of the company and issued in accordance with securities laws. The second token is offered to the investors as a perk.

If and when the utility token is available, it is offered in addition to their equity as a bonus but not as the main purpose of the investment. The main benefits of the RATE are that the investment received is tax free because it is an equity investment and that the token used for the protocol is free of any securities regulatory requirements and has the best chance of succeeding. Another structure that offers two tokens is called the DATE, or Debt Agreement for Tokens and Equity. This structure offers a convertible note or straight debt token with the utility token as a perk.

The reason the SEC may like these new structures is because they rigorously follow the rules of the Securities Act of 1933 while allowing companies to innovate with their protocols. In a way, this is a big win for both the entrepreneurs seeking capital, and the investors who need to make informed investment decisions.

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The Two Token ICO was originally published in Hacker Noon on Medium, where people are continuing the conversation by highlighting and responding to this story.