Robert Moore is an associate in the Santa Monica office and a member of Orrick’s Technology Companies Group. His practice focuses on advising high-growth startups and innovative venture capitalists.
Robert represents startups throughout all stages of their lifecycle, including formation, corporate and securities law, venture capital financings and corporate governance matters. A Silicon Valley native, he’s passionate about counseling founders to best position their businesses for success. In addition to advising startups, Robert advises investors in connection with their investments in private companies.
Prior to joining Orrick, Robert received his Juris Doctor from the UCLA School of Law and a Bachelor of Science from the University of Southern California’s Marshall School of Business.
As any founder knows, operating in the blockchain space requires navigating a myriad of regulatory regimes. While every product and token are different, below are 6 key questions that any founder should ask themselves as they launch their product or token:
- Are you advertising to the public? If a company advertises to the public, anti-fraud and consumer protection laws are relevant. Regulators in the U.S. from the Federal Trade Commission and the Consumer Financial Protection Bureau, along with state attorneys-general, enforce rules to ensure advertisements and public statements do not contain (among other things) statements or promises that are false, misleading, or deceptive. Companies should screen public messages with their counsel before publishing them.
- Where do you plan to launch your product or token? Companies should be aware of sanctions programs in jurisdictions in which they plan to operate. In the U.S., the Office of Foreign Asset Control (“OFAC”) enforces compliance with U.S. sanctions programs. Conducting transactions with sanctioned persons or in a sanctioned jurisdiction is an offense and OFAC may impose penalties on a “strict liability standard.” This means that OFAC can hold violators civilly liable regardless of whether they knew they participated in a transaction with a sanctioned person or entity. Many companies have policies and internal controls (e.g., customer screening and IP address blocking) meant to prevent prohibited transactions.
- Would a person reasonably rely on the Company’s efforts to profit from their purchase? If a blockchain company issues or plans to issue tokens or other digital assets, it is imperative that the company complies with securities laws. The lodestar for determining whether a token is an “investment contract” (one type of security) is the Howey Test. In short, pursuant to the Howey Test, a token is a security if a purchaser could reasonably depend on the efforts of a third party (i.e., the company) to generate a profit. While the interpretation of the Howey Test is more nuanced than that, understanding how consumers are going to think about your token is important in assessing the level of risk that launching the token might impose. The actual application of the Howey Test is fact intensive, and therefore requires comprehensive review and application of the token and the Company’s distribution plans.
- Will employees have access to sensitive information that could impact prices? If a company’s employees will have access to material, non-public information regarding prices of the company’s publicly traded digital asset or any other asset trading on a platform controlled by the company, the company should implement policies to prevent employees or other insiders from profiting off of that information (by implementing, for example, insider trading policies). These policies should dictate how and when an employee, consultant, or director is allowed to buy and sell the company’s digital assets or any other asset trading on the company’s platform.
- Will the Company transmit someone’s money? Blockchain companies acting as an “administrator” or “exchanger” of “convertible virtual currency” (“CVC”) may be deemed a money transmitter under federal law. In short, if a company has the authority or power to issue, remove, or exchange a cryptocurrency or virtual currency, the company may be required to register as a “money services business” under the federal Bank Secrecy Act, which requires companies to assist the U.S. government in detecting and preventing money laundering. In addition, 49 states also have “money transmission laws.” Each state has different laws with respect to CVC, so a state-by-state analysis will be required to determine where the company should file for money transmission licenses.
The 6 questions above will help frame some of the more common regulatory issues that companies in the blockchain space need to pay attention to, but that list is certainly not exhaustive. With an increased focus on blockchain companies by regulatory agencies, it’s important that founders operate within and understand existing regulations, and also make a plan for how they will adapt as those regulations change.
Venture investments in blockchain companies are often similar to investments in traditional, high-growth technology startups. However, there are a few differences any company or investor should know about:
- Board Seats: Lead investors in venture backed companies often require a right to designate a member of the company’s board of directors. Having a seat on the board lets investors exercise corporate governance oversight and influence the overall company’s strategic direction. However, given the complex and evolving regulatory and enforcement environment in blockchain, as well as difficulties of blockchain companies in obtaining cost-effective directors and officers liability insurance, investors often decline to obtain or fill a seat on the board. Investors may prefer board observer rights or stockholder-level approval rights.
- Token Rights: Blockchain-based companies can provide returns to investors via capital appreciation of the preferred stock investors purchase and/or via tokens or other digital assets tied to the target company’s products. As a result, investors often require secure rights to tokens in the future via token warrants, token side letters, or simple contractual covenants. The features of token rights investors negotiate for is often specific to a company’s business and stage of growth.
- Blockchain-Specific Diligence: Investors often conduct more thorough legal due diligence in blockchain companies than they would for traditional high-growth technology startups. For example, investors in blockchain companies usually ask detailed questions about the company’s efforts and plans for regulatory compliance – including in areas of securities regulation, anti-money laundering and money transmitter regulation, and tax. In addition, because many blockchain companies use open-source code, investors typically want comprehensive representations and diligence regarding the company’s compliance with the open-source licenses that underlie the company’s products.
- Negative Covenants: It is not uncommon in traditional venture capital financings to have negative covenants governing matters on which the investors’ consents are required. Blockchain-based companies, however, bring increased focus on these covenants given the typical trajectory of many companies in the space. For example, there may be additional covenants around how the company’s subsidiaries and affiliate entities are governed and what they are permitted to do. Additionally, licensing intellectual property outside the ordinary course of business will likely get additional attention. Lastly, notwithstanding the existence of fiduciary duties typically imposed by state law, it is not uncommon to see negative covenants relating to transactions between the company and its executive officers. While none of these provisions are used solely in blockchain companies, due to the nature of these kinds of companies, investors will have an increased focus on these kinds of provisions.
- Transaction Timing and Costs: In part because of the increased diligence and custom negotiation with respect to governance rights, token rights, and negative covenants, investments in blockchain companies often take longer and cost more than investments in traditional startups. Companies should be prepared for the increase in time and cost as they venture into their fundraising cycles.
Venture capital investors in blockchain companies often require formal rights to receive tokens or other digital assets created by those companies. Typically, these rights are provided through an instrument called a “token warrant.” While token warrants are most frequently issued in priced rounds, they have become increasingly prevalent in connection with SAFE or other convertible rounds. Here are five things that any blockchain company or investor should know when evaluating token warrants:
- Token Warrants Can Confer Broad or Narrow Rights. Companies and investors should pay close attention to the types of tokens that warrants entitle their holders to acquire. Token warrants may provide holders with rights to receive one specific type of token only, such as the first governance token issued by a company. However, token warrants typically provide holders with rights to receive any future tokens created or issued by a company or its affiliates – as well as any future tokens issued by an acquiror of the company’s intellectual property or any entity established by or on behalf of the company to issue tokens or operate a blockchain-based protocol or other technology associated with the tokens. Token warrants may also provide holders with rights to receive tokens created or issued by the company’s founders.
- Exclusions May Apply. Token warrants often outline specific types of tokens that are not acquirable under the terms of the warrant. Often known as Excluded Tokens, they generally include tokens that are generated pursuant to mining, staking, or reward systems. Depending on the applicable company’s business, Excluded Tokens may also include non-fungible tokens, stablecoins, or certain tokens issued in the ordinary course of business. Typically, the company and its investors will negotiate what is considered an Excluded Token based on the company’s business model.
- The Number of Tokens Issuable to Holders Can Be Calculated Several Ways. Token warrants specify the share of tokens holders can acquire under the warrant. This typically depends on three key variables:
- The set of tokens from which the holder’s share is calculated: The holder’s share may be calculated from the number of tokens minted, from the number of tokens minted and issued to the company’s “insiders,” which includes the company’s stockholders and holders of its convertible or exercisable securities, or otherwise. In the “insider” structure, the holder would not be entitled to any share of tokens that are reserved for community members or other non-“insiders.” In addition, token warrants may provide holders with rights to tokens issued in inflationary events or in connection with other increases in the token supply.
- How to calculate the holder’s share: The holder’s share may be a hard-coded percentage, but it is more typically based on the holder’s fully diluted ownership of the company. In the latter structure, the holder’s share will typically equal its fully diluted ownership as a percentage of the total cap table. But investors may negotiate a “super” pro rata share, which is a multiple (e.g. 1.25x, 1.5x) of the investor’s fully diluted ownership.
- When to calculate it: The time at which a holder’s share is calculated can make a difference in how many tokens the holder has a right to acquire. For example, the holder’s share may be calculated as of the date of warrant issuance, the date of the applicable token launch, or the date the warrant is exercised.
- “Lockup” Provisions Govern the Transferability of Tokens. Token warrants typically specify the “lockup” restrictions that will prevent holders from transferring tokens acquired under the warrant for certain periods. Lockup schedules in token warrants may include provisions that prohibit any transfers of tokens for one year after the tokens are acquired, release some tokens from lockup at the one-year mark, and then release the balance over successive monthly increments. For example, a lockup schedule may prohibit 100% of the tokens from being transferred until the one-year anniversary of the exercise date, and then permit the transfer of 50% of the tokens on the one-year anniversary and 1/24th, 1/36th or 1/48th of remaining tokens over the next two to four years. A common provision requires an early release of the lockup provision if certain “insiders” (particularly founders or board members) have a less stringent lockup period. Token warrants may also provide the token issuer with rights to impose additional transfer restrictions on tokens in light of regulatory requirements or in connection with centralized exchange listing requirements.
- Beware of Token Warrants that Compensate Service Providers. Token warrants are not ideal instruments for compensating a company’s service providers (e.g. employees, contractors, advisors). The Internal Revenue Code subjects deferred compensation – including token warrants – to a variety of complex and generally unfavorable tax, vesting and exercise rules. Therefore, companies should generally limit issuing token warrants to investors.