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CryptoHealth update #10: How to Design a Utility Token in a World Where All Tokens are Securities

With the SEC clear position that token offerings are nearly always securities, companies need to structure their fundraising carefully

The SEC has stated that virtually all tokens are securities and that all applicable securities laws, rules and regulations apply to them and their platforms. Therefore, security tokens are poised to scale in 2018 (read here for an in depth discussion).

So what should healthcare companies and start ups that plan to fund blockchain solutions using a utility token design do next?

1. Understand that rethinking utility tokens (or platform-profit-sharing) is a good thing

Applying a set of compliance activities like Know Your Customer and Anti-Money Laundering (KYC/AML) from prospective buyers and accredited investors to avoid fraud and adding basic investor protections through registration is not in essence bad, nor stifles innovation.

However rethinking utility token design can be worthwhile because most utility token-based solutions DO NOT have a powerful network effect and there is no real advantage to granting early ownership to the platform. There are already many ways to reward and incentivize healthcare and requiring token purchases from motivated users may actually be a barrier to adoption.

Furthermore, some utility tokens confuse where the value is. Are customers using the platform because they like it (and thus are willing to pay for it) or because they hope that everyone else in the network will use it and so their tokens will become valuable? The former is simple and may not require a token design at all, whereas the latter may involve multi-stakeholder adjustments if the model of the utility token doesn’t work.

2. ‘Sequility’ is not a word and new utility token designs are worth considering

Utility tokens may not be allowed to fund companies, but they will create value

In view of the SEC decision, it is very tempting to recategorize utility tokens into sequility tokens, a blanket neologism for both security and utility tokens. Especially since utility tokens are securities in the eyes of the SEC, they do not stop being a security when the platform becomes “operational” and technical distinctions between protocol layer and application layer tokens are generally not relevant.

This means that the token design in healthcare can include security tokens that offer ownership, LP shares, voting rights, dividends, profit shares, (aka investment tokens) but also may have a utility ‘non-investment’ functionality. (One even might argue that improving your health proactively may be considered a financial ‘investment’ too).

New token designs to consider are: (1) work tokens: where increased usage of the network will cause an increase in the price of the token. As demand for service grows (achieving healthy goals, engaging in healthier activities) more revenue will flow to service providers (healthy food vendors, fitness center owners, athletic apparel retailers). Given a fixed supply of tokens, service providers will rationally pay more per token for the right to earn part of a growing cash flow stream.

Moreover, if the use of a utility token is a right to perform work on behalf of the whole network (doctors, payors, employers), the token becomes valued at a multiple of the operating cash flows that the system generates rather than as a fraction of revenues paid to the service providers. As the network grows and matures, it de-risks, decreasing the discount rate and ultimately increasing the end value of the token.

(2): burn-and-mint tokens where using a service does not directly pay a counter-party for the service but rather, burns tokens in the name of the service provider (like less visits to the ER, less hospitalizations, less medication use on behalf of the insurance company). If usage grows and tokens are burned then total supply decreases, creating scarcity and upwards price pressure. This upwards price pressure means fewer tokens need to be burned to purchase the same amount of service from the network increasing the token value (until an optimal state of ‘health’ is achieved).

3. So how to continue and be SEC compliant

(Thank you James Dix)

As I have previously posted, Quadrant Biosciences and MintHealth use a single security or dual token model to offer tokenized equity for their ICO (or more accurately their STO). Both companies registered their token(s) as a security and used Reg D (accredited investors only), Reg S (foreign investors), Reg CF (anyone, including non-accredited investors up to $1 million in a 12-month period), Reg A+ (unaccredited but SEC qualified investors) and Rule 147 (interstate offerings). For more about SEC regulations read here and here.

So if all these ERC-20 utility tokens are securities, what about those who structured them, promoted them and finally sold them to US persons without registering with the SEC or using approved exemptions? What are they supposed to do now?

The short answer is rescind and return your money to your investors. The longer answer is seek legal counsel, work with the SEC and see if other agreements (such as SAFT/E, DATE, RATE) are applicable.

Also note that the Howey test, traditionally used to determine if a legal instrument is a financial security, may be harder to use in a decentralized world.

If patients get healthier using utility tokens and visit less healthcare professionals, is this considered a ‘profit’ that requires a separate provider security token?

Perhaps health tokens by design are always more like a universal commodity rather than a security, transcending borders (think JoinWell), time (think Eterly), governed by the community (think BitMed), a matter the SEC and the CFTC will need to agree upon.

Jay Clayton (SEC) and J. Christopher Giancarlo (CFTC) at Senate Banking Committee hearing discussing cryptocurrencies and ICO’s (February 7th, 2018)

But until the regulatory landscape settles, let us remember that tokens are a not only an interesting non-dilutive alternative to traditional financing, but more importantly a manifestation of the emergence of a new decentralized, self-sovereign reality or as Balaji S. Srinivasan said:

“token buyers will be to investors what bloggers/tweeters are to journalists.”

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