Unsolved Issues Moving from Equity to Tokens

Shifting from equity-financing to token issuances has created issues between investors, entrepreneurs, and early stage employees that don’t have any precedent on how to move forward. Here are two issues that we’ve seen arise and how different stakeholders are collaborating on a positive outcome.

Conversion at Qualified Financing: ICO Series-A after a SAFE round

ICOs are a relatively new avenue for project financing. Blockchain companies started before 2016 likely raised traditional equity rounds to fund early development. If a company raised using a SAFE note, a simple instrument for debt financing popularized by YC, then that note does not convert into equity until there is a qualified financing. If the company goes out of business before that, the investor does not have interest or an expectation they will get their money back.

Enter ICOs. If a company raised a SAFE for their initial capital but decides to raise their next (and possibly final) round of financing using a token sale or an ICO, it is not legally binding that this counts as a qualified financing. Additionally, many companies raise money in a foundation, not the original equity entity. How those two legal entities bridge ownership is often up to the entrepreneur.

Going forward, early stage investors and entrepreneurs should agree on terms of how they want to bridge equity and tokens if they choose that option down the road. Board members could otherwise block an ICO if they don’t view it as a good path for the company shareholders. Put an explicit clause in your SAFE or convertible debt documents about what happens if there is a token sale down the road. It will safe negotiation later.

Taxes and Timing Matter: Employee Equity vs. Token Compensation

Silicon Valley has pioneered the standard that early stage companies compensate employees with a mix of equity and cash compensation. The success of the PayPal mafia is largely attributed to early employees ability to cash out after a big success. Today, companies issue equity, options, or RSUs to compensate early employees to help build the business even if they take a payout to join them.

To incentivize employee loyalty, equity grants include a vesting period and an opportunity to take advantage of long-term capitals gains when they are exercised or when a company exits at a later date. The tax burden for receiving RSUs and options are paid when exercised, so it is in the employees control and does not affect current income. In the tokenized world, many companies are granting tokens in lieu of equity, options, or RSUs. These tokens are likely to be liquid sooner, but may be taxed as income upon issuance to the employee (even if there is a lock up on how long to wait before you sell). This creates a tax burden for the employee, including being taxed at a higher rate than long term capital gains, and does not provide liquidity to cover the tax burden.

Early employees who expect equity compensation and upside when joining an early stage blockchain company should discuss the tax implications of tokens with their tax advisor. The token grants may be more attractive for their short liquidity horizon, but they may not provide as much tax advantage as equity. Employers should also be aware of these tradeoffs to help educate new employees about the opportunities and risks of taking tokens.

[Update 4/22: There may be a better alternative to employee token grants.]

Bespoke Before Best Practices

The new frontier of ICOs and token financings are here to stay. Taking time to figure out what can be translated vs. what should be treated differently from an equity company is key to make entrepreneurs, employees, and investors happy. Until there are best practices, we’ll continue to see bespoke solutions.

We’re learning out loud, so please leave thoughts, questions or feedback in the comments. If you want to discuss more about bridging equity to tokens, join us at our next Lattice Ventures : BlockTalk on March 26th.

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Disclaimer: I am not a lawyer or financial advisor, please consult proper counsel and do not take this as legal or financial advice.

Originally published at likesandlaunch.com.

Image credit: BankRate