Tag Archives: fintech

Non-U.S. Investors and Companies in U.S. Crowdfunding

Non-US Investors and Companies in US Crowdfunding

When I was a kid, back in the 1840s, we referred to people who live outside the United States as “foreigners.” Using the more globalist and clinical term “non-U.S. persons,” I’m going to summarize how people and companies outside the U.S. fit into the U.S. Crowdfunding and Fintech picture.

Can Non-U.S. Investors Participate in U.S. Crowdfunding Offerings?

Yes. No matter where he or she lives, anyone can invest in a U.S. Crowdfunding offering, whether under Title II, Title III, or Title IV.

The Crowdfunding laws don’t distinguish U.S. investors from non-U.S. investors. Thus:

  • To invest in an offering under Title II (SEC Rule 506(c)), a non-U.S. investor must be “accredited.”
  • If a non-U.S. investor invests in an offering under Title III (aka “Regulation CF”), he or she is subject to the same investment limitations as U.S. investors.
  • If a non-U.S. investor who is also non-accredited invests in an offering under Tier 2 of Title IV (aka “Regulation A”), he or she is subject to the same limitations as non-accredited U.S. investors, e., 10% of the greater of income or net worth.

What About Regulation S?

SEC Regulation S provides that an offering limited to non-U.S. investors is exempt from U.S. securities laws. Mysterious on its face, the law makes perfect sense from a national, jurisdictional point of view. The idea is that the U.S. government cares about protecting U.S. citizens, but nobody else.

EXAMPLE:  If a U.S. citizen is abducted in France, the U.S. military sends Delta Force. If a German citizen is abducted in France, Delta Force gets the day off to play volleyball.

Regulation S is relevant to U.S. Crowdfunding because a company raising money using Title II, Title III, or Title may simultaneously raise money from non-U.S. investors using Regulation S. Why would a company do that, given that non-U.S. investors may participate in Title II, Title III, or Title IV? To avoid the limits of U.S. law. Thus:

  • A company raising money using Title II can raise money from non-accredited investors outside the United States using Regulation S.
  • A company raising money using Title III can raise money from investors outside the United States without regard to income levels.
  • A company raising money using Tier 2 of Title IV can raise money from non-accredited investors outside the United States without regard to income or net worth.

Thus, a company raising money in the U.S. using the U.S. Crowdfunding laws can either (1) raise money from non-U.S. investors applying the same rules to everybody, or (2) place non-U.S. investors in a simultaneous offering under Regulation S.

What’s the Catch?

The catch is that the U.S. is not the only country with securities laws. If a company in the U.S. is soliciting investors from Canada, it can satisfy U.S. law by either (1) treating the Canadian investors the same way it treats U.S. investors (for example, accepting investments only from accredited Canadian investors in a Rule 506(c) offering), or (2) bringing in the Canadian investors under Regulation S. But to solicit Canadian investors, the company must comply with Canadian securities laws, too.

Raising Money for Non-U.S. Companies

Whether a non-U.S. company is allowed to raise money using U.S. Crowdfunding laws depends on the kind of Crowdfunding.

Title II Crowdfunding

A non-U.S. company is allowed to raise money using Title II (Rule 506(c)).

Title III Crowdfunding

Only a U.S. entity is allowed to raise money using Title III (aka “Regulation CF”). An entity organized under the laws of Germany may not use Title III.

But that’s not necessarily the end of the story. If a German company wants to raise money in the U.S. using Title III, it has a couple choices:

  • It can create a U.S. subsidiary to raise money using Title III. The key is that the U.S. subsidiary can’t be a shell, raising the money and then passing it up to the parent, because nobody wants to invest in a company with no assets. The U.S. subsidiary should be operating a real business. For example, a German automobile manufacturer might conduct its U.S. operations through a U.S. subsidiary.
  • The stockholders of the German company could transfer their stock to a U.S. entity, making the German company a wholly-owned subsidiary of the U.S. entity. The U.S. entity could then use Title III.

Title IV Crowdfunding

Title IV (aka “Regulation A”) may be used only by U.S. or Canadian entities with a “principal place of business” in the U.S. or Canada.

(I have never understood why Canada is included, but whatever.)

If we cut through the legalese, whether a company has its “principal place of business” in the U.S. depends on what the people who run the company see when they wake up in the morning and look out the window. If see the U.S., then the company has it’s “principal place of business” in the U.S. If they see a different country, it doesn’t. (Which country they see when they turn on Skype doesn’t matter.)

Offshore Offerings

Regulation S allows U.S. companies to raise money from non-U.S. investors without worrying about U.S. securities laws. But once those non-U.S. investors own the securities of the U.S. company, they have to think about U.S. tax laws. Often non-U.S. investors, especially wealthy non-U.S. investors, are unenthusiastic about registering with the Internal Revenue Service.

The alternative, especially for larger deals, is for the U.S. entity to form a “feeder” vehicle offshore, typically in the Cayman Islands because of its favorable business and tax climate. Non-U.S. investors invest in the Cayman entity, and the Cayman entity in turn invests in the U.S. entity.

These days, it has become a little fashionable for U.S. token issuers to incorporate in the Cayman Islands and raise money only from non-U.S. investors, to avoid U.S. securities laws. Because the U.S. capital markets are so deep and the cost of complying with U.S. securities laws is so low, this strikes me as foolish. Or viewed from a different angle, if a company turns its back on trillions of dollars of capital to avoid U.S. law, I’d wonder what they’re hiding.

What About the Caravan from Honduras?

Yes, all those people can invest.

Questions? Let me know.

The IRS Regulations on Qualified Opportunity Zone Funds

Qualified Opportunity Zone Funds

The Internal Revenue Service just issued regulations about qualified opportunity zone funds, answering many of the questions raised by the legislation itself. And for the most part, the answers are positive for investors and developers.

Can I Use An LLC?

Yes. Although the legislation provides that a QOZF must be a “corporation or a partnership,” the regulations confirm that a limited liability company treated as a partnership for tax purposes (or any other entity treated as a partnership for tax purposes) qualifies.

How Do I Calculate Rehabilitation Costs?

To qualify as “qualified opportunity zone business property,” either the original use of the property must begin with the QOZF or the QOZF must “substantially improve” the property. The statute says that to “substantially improve” the property, the QOZF must invest as much in improving the property as it paid for the property in the first place.

The regulations carve out an important exception: in calculating how much the QOZF paid for the property, the QOZF may exclude the cost of the land. Thus, a QOZF that buys an apartment building for $2,000,000, of which $1,500,000 was attributable to the cost of the land, is required to spend only $500,000 on renovations, not $2,000,000.

What Kind of Interest Must an Investor Own?

To obtain the tax deferral, an investor must own an equity interest in the QOZF, not a debt instrument. Preferred stock is usually treated as an equity interest.

Are Short-Term Capital Gains Covered?

Yes, all capital gains are covered. Ordinary income — for example, from depreciation recapture — is not.

Do All The Assets of the Business Have to be in the Qualified Opportunity Zone?

A business can qualify as a “qualified opportunity zone business” only if “substantially all” of its tangible assets are located in the qualified opportunity zone. The regulations provide that “substantially all” means at least 70%. That means that 30% of the assets of the qualified opportunity zone business can be outside the qualified opportunity zone.

NOTE:  Don’t get confused. To qualify as a QOZF, the fund itself must have invested 90% of its assets in “qualified opportunity zone property.” One kind of of “qualified opportunity zone property” is a “qualified opportunity zone business.” The 70/30 test applies in determining whether a business is a “qualified opportunity fund business.” So if a QOZF owns assets directly, 90% of those assets must be in the qualified opportunity zone. But if the QOZF invests in a business, then only 70% of the assets of the business must be in the qualified opportunity zone.

NOTE:  Many QOZFs will own property through single-member limited liability companies. When applying the 70% test and the 90% test, bear in mind that a single-member limited liability company is generally not treated as a “partnership” for tax purposes, but rather as a “disregarded entity.” For tax purposes, assets owned by the single-member limited liability company will be treated as owned directly by the QOZF.

What Happens in 2028, When the Program Ends?

The qualified opportunity zone program ends in 2028. Nevertheless, the regulations allow investors to continue to claim tax benefits from the program until 2048.

How Long can the QOZF Wait to Invest?

Suppose a QOZF raises $5M today. When does the money have to be invested?

The regulations provide that under some circumstances, you can wait up to 31 months to invest. But this is one area where more guidance is needed.

Questions? Let me know.

Help Wanted

help wantedMy work in the Crowdfunding space has been the most interesting and challenging of my career. Now I’m looking to add to our Crowdfunding team here at Flaster/Greenberg, and I hope you can help find the right person.

The right person would have these qualifications:

  • An attorney with 2-4 years of experience in corporate and securities offerings
  • Crowdfunding-specific experience appreciated but not required
  • A good, fast learner, unafraid to ask questions
  • Someone who pays attention to detail, and takes pride in great legal work
  • A good writer and communicator
  • Good technology skills
  • Lives in the Philadelphia area or is able to work effectively remotely

If you or someone you know has these qualifications, please forward a resume to our Human Resources Director, Karen Roberts, at Karen.Roberts@flastergreenberg.com.

Thank you!

MARK

Questions? Let me know.

Yes, A Parent Company Can Use Title III Crowdfunding

Title III Crowdfunding

We know an “investment company,” as defined in the Investment Company Act of 1940, can’t use Title III Crowdfunding. For that matter, an issuer can’t use Title III even if it’s not an investment company, if the reason it’s not an investment company is one of the exemptions under section 3(b) or section 3(c) of the 1940 Act. By way of example, suppose a a company is engaged in the business of making commercial mortgage loans. Even if the company qualifies for the exemption under section 3(c)(5)(C) of the 1940 Act, it still can’t use Title III.

We also know that, silly as it seems, a company whose only asset is the securities of one company is generally treated as an investment company under the 1940 Act. That’s why we can’t use so-called “special purpose vehicles,” or SPVs, in Title III Crowdfunding, to round up all the investors in one entity and thereby simplify the cap table.

Put those two things together and you might conclude that only an operating company, and not a company that owns stock in the operating company, can use Title III Crowdfunding. But that wouldn’t be quite right.

A company that owns the securities of an operating company – I’ll call that a “parent company” — can’t use Title III if it’s an “investment company” under the 1940 Act. However, while every investment company is a parent company, not every parent company is an investment company. Here’s what I mean.

Section 3(a)(1) of the 1940 Act defines “investment company” as:

  • A company engaged primarily in the business of investing, reinvesting, or trading in securities; or
  • A company engaged in the business of investing, reinvesting, owning, holding, or trading in securities, which owns or proposes to acquire investment securities having a value exceeding 40% of the value of its assets.

Suppose Parent, Inc. owns 100% of Operating Company, LLC, and nothing else. If Parent’s interest in Operating Company is treated as a “security,” then Parent will be an investment company under either definition above and can’t use Title III. However, it should be possible to structure the relationship between Parent and Operating Company so that Parent’s interest is not treated as a security, relying on a long line of cases involving general partnership interests.

These cases arise under the Howey test, made famous by the ICO world. Under Howey, an instrument is a security if and only if:

  • It involves an investment of money or other property in a common enterprise;
  • There is an expectation of profits; and
  • The expectation of profits is based on the efforts of someone else.

Focusing on the third element of the Howey test, courts have held that a general partner’s interest in a limited partnership generally is not a security because (1) by law, the general partner controls the partnership, and (2) the general partner is therefore relying on its own efforts to realize a profit, not the efforts of someone else.

If Operating Company were a partnership and Parent were its general partner, then the arrangement would fall squarely within this line of cases and Parent wouldn’t be treated as an investment company. As a general partner, however, Parent would be fully liable for the liabilities of Operating Company, defeating the main purpose of the parent/subsidiary relationship, i.e., letting the tail wag the dog.

Fortunately, Parent should be able to achieve the same result even though Operating Company is a limited liability company. The key is that Operating Company should be managed by its members, not by a manager. That should place Parent in exactly the same position as the typical general partner:  relying on its own efforts, rather than the efforts of someone else, to realize a profit from the enterprise.

If Parent’s interest in Operating Company isn’t a “security,” then Parent isn’t an “investment company,” and can raise money using Title III.

Questions? Let me know.

Opportunity Zone Funds in Crowdfunding

businessman stack of coins.jpg

Everywhere you look, there’s another opportunity zone fund. What are these things and why are they suddenly so popular?

The Tax Savings

It’s all about taxes, specifically capital gain taxes. Added to the Internal Revenue Code by the 2017 tax act, new section 1400Z-2 allows investors to reduce their capital gain taxes in four increasingly-generous levels:

  • Level One Savings: If you sell property (including property sold through a partnership or limited liability company) and recognize a capital gain, then you don’t have to pay tax right away on the gain to the extent you invest in a “qualified opportunity zone fund,” or QOZF, within 180 days. Instead, the gain is deferred until the earlier of (i) the date you sell your interest in the QOZF, or (ii) December 31, 2026.

EXAMPLE:  You bought stock two years ago for $1,000, and sell it during 2018 for $1,100, recognizing a $100 capital gain. If you invest $75 in a QOZF within 180 days, you pay tax in 2018 only on $25 of the gain. You pay tax on the $75 on the earlier of the date you sell your interest in the QOZF or 12/31/2026.

It gets better.

  • Level Two Savings: If you hold your investment in the QOZF for at least five years, you get to increase your tax basis in the QOZF by 10% of the gain you deferred, further reducing your tax bill.

EXAMPLE:  In the example above, if you hold your investment in the QOZF for at least five years, you get to increase your tax basis by 10% of $75, or $7.50.

And better.

  • Level Three Savings: If you hold your investment in the QOZF for at least seven years, you get to increase your tax basis in the QOZF by another 5% of the gain you deferred.

And better.

  • Level Four Savings: If you hold your investment in the QOZF for 10 years, you pay no capital gain tax on the appreciation in the QOZF.

EXAMPLE:  If, in the original example, you invested $75 in the QOZF and sold it after 10 years for $195 (10% appreciation per year, compounded), you would pay no tax on the $120 of appreciation. 

What if the Value of the QOZF Goes Down?

If you lose money on the QOZF, then your tax on the original capital gain also goes down. 

EXAMPLE:  You sell appreciated stock for a $100 profit, and invest $75 in a QOZF. Three years later, you sell your interest in the QOZF for $50 (I’m assuming your tax basis in the QOZF hasn’t changed). You pay tax on only $50 of capital gain, not the whole $75.

Thus, it’s heads-you-win, tails-the-government-loses. 

What’s A Qualified Opportunity Zone Fund?

A qualified opportunity zone fund means a corporation or partnership that holds 90% of its assets in any mix of the following assets:

  • Stock of a corporation that is a “qualified opportunity zone business.”
  • An interest in a partnership that is a “qualified opportunity zone business.”
  • “Qualified opportunity zone property.”

A “qualified opportunity zone business” is a business substantially all of the assets of which are qualified opportunity zone property.”

”Qualified opportunity zone property” means property that is:

  • Located in a “qualified opportunity zone”;
  • Used by the QOZF in a trade or business; and
  •  Either:
    • The property is brand new (g., ground-up construction); or
    • Within 30 months, the QOZF or the qualified opportunity zone business spends at least as much to renovated the property as it paid to buy it.

Boiled down version:  A qualified opportunity zone fund means a fund that, directly or indirectly, owns new or substantially renovated business assets in a qualified opportunity zone.

Only New Businesses or Assets Count

In figuring out whether a fund is a qualified opportunity zone fund, you take into account only property acquired after 12/31/2017.

Does it Matter Where the Capital Gain Came From?

No. The capital gain you’re deferring could come from the sale of appreciated stock, the sale of real estate, the sale of artwork, or anywhere else.

An Alternative to A Like-Kind Exchange

Under section 1031 of the Internal Revenue Code, the owner of appreciated real estate (only real estate) can defer paying tax on sale by exchanging the real estate for different real estate. In fact, a whole industry has grown up around these so-called “like-kind exchanges.”

For as long as it lasts, the QOZF provides a simpler and possibly better alternative.

What is a Qualified Opportunity Zone?

A “qualified opportunity zone” means a low-income area that has been nominated as such by the Governor of a state and approved by the U.S. Treasury. A list is of current qualified opportunity zones is available here.

No Massage Parlors

In a crippling blow to my own business plans, a “qualified opportunity zone business” does not include massage parlors or hot tub facilities. Nor does it include golf courses, country clubs, suntan facilities, racetracks or other facilities used for gambling, or liquor stores.

Can I Use an LLC?

Section 1400Z-2 itself defines “qualified opportunity zone fund” as a “corporation or partnership.” However, section 7701(a)(2) of the Internal Revenue Code defines “partnership” follows:

The term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term “partner” includes a member in such a syndicate, group, pool, joint venture, or organization.

Based on that definition, a limited liability company should work.

What if I Invest More in a QOZF?

Suppose you sell appreciated stock for a $100 capital gain, and within six months invested $150 in a QOZF. The favorable tax rules apply only to two-thirds of your investment. The other one-third is just a regular investment.

Who Can Form a Qualified Opportunity Zone Fund?

Anyone, literally. If you sell appreciated stock and want to defer or avoid tax on all or part of the gain, you can form your own QOZF.

Conversely, large companies, including large investment managers and large real estate developers, have already formed QOZFs, taking advantage of the tax benefits and the media buzz to raise capital.

Investment Company Act Limits

When Congress enacted the tax benefits for qualified opportunity zone funds, it could have created an exception to the investment company rules at the same time, making the funds even more appealing and effective. But it didn’t.

Consequently, and perhaps paradoxically, larger QOZFs — those with more than 100 investors — will have to own property directly, or take controlling interests in other businesses, to avoid being treated as investment companies. They will not be allowed to hold minority, non-controlling interests in businesses owned by others, such as, say, the residents of the qualified opportunity zone. 

How Can I Raise Capital for My QOZF?

You can raise capital using any method you like, including Title II Crowdfunding (Rule 506(c)), Title III Crowdfunding (Regulation CF), Title IV Crowdfunding (Regulation A), or Rule 506(b).

Qualified opportunity zone funds are about saving taxes, specifically capital gain taxes. They make less sense for non-accredited investors who, by definition, earn less money and pay tax at lower rates. Consequently, we will probably see fewer QOZFs using Title III or Regulation A to raise capital, and many using Rule 506(b).

More Rules to Come

The Internal Revenue Service hasn’t yet issued guidance on the details of this complicated legislation. Expect complicated regulations and at least a few surprises.

Waiting for the Other Shoe to Drop

How long will it take before a QOZF is sold using tokens?

Questions? Let me know.

 

What A Tokenized Security Could Do

What A Tokenized Security Could Do

Here are some things a tokenized security could do:

  • Keep track of the owner (and by extension, the whole cap table)
  • Eliminate paper certificates
  • Facilitate transfers
  • Provide a history of transfers
  • Drastically reduce cost of transfer agent services
  • Provide for distributions with the click of a button
  • Make capital calls with the click of a button
  • Allow conversions (e.g., Convertible Note to equity) with the click of a button
  • Provide reinvestment options
  • Provide the K-1 or 1099
  • Allow digital voting
  • Carry up-to-date and historical information about the company, including financial statements and SEC filings
  • Track the tax basis of the security
  • Carry relevant documents, like an up-to-date Operating Agreement
  • Provide an automatic listing on an exchange
  • Integrate with all of the owner’s other securities, private and public, to provide a personal portfolio
  • Provide a communication channel, including video conference calls and chat rooms, with management and other investors
  • Provide information about the market and/or industry generally
  • Provide instant analytics on standard metrics like ROI, IRR, and P/E ratio, and allow exports to Excel and other tools
  • Compare returns to existing or new indices
  • Provide links to other issuers with similar characteristics, with the opportunity to trade, buy, or sell
  • Provide information about trading in the security by other owners, with alerts about trading by insiders

The way capitalism works, I suspect the first tokenized securities will include just a few features – those with the most sizzle and/or the easiest to implement – with more to come later.

Questions? Let me know.

Section 17(b) of the Securities Act in Crowdfunding and Token Sales

Among the tricks of Wall Street bad guys is the fake financial analysis, prepared (and paid for) to promote a particular stock but presented as an objective review. Section 17(b) of the Securities Act of 1933 was written to stop that:

It shall be unlawful for any person. . . . to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof [italics added].

It’s no joke. For example, in April 2017 the SEC brought an enforcement action charging 28 businesses and individuals for participating in a scheme to generate bullish articles on investment websites like SeekingAlpha.com, Benzinga.com, and SmallCapNetwork.com while concealing the compensation.  See Press Release, SEC: Payments for Bullish Articles on Stocks Must Be Disclosed to Investors, Rel. No. 2017-79 (Apr. 10, 2017).

Hypothetical examples in the Crowdfunding and token world:

  • NewCo pays an industry periodical to publish an article written by NewCo that purports to objectively rate the “Top 10 ICOs of 2018” and happens to list NewCo’s ICO as #1. Section 17(b) doesn’t make the article illegal, it just says the periodical has to disclose both the fact that it’s being paid and the amount of the payment.
  • If NewCo paid me to highlight its ICO on this blog, I’d have to report the compensation.
  • A real estate Crowdfunding platform sends an email promoting an offering, or a group of offerings, on its platform. That email is not covered by section 17(b) because of the italicized language above, i.e., it’s clear that the email is an offer of securities (which raises its own issues, separate from section 17(b)).
  • An investor relations firm places favorable articles about NewCo in trade publications while NewCo’s ICO is live. Those articles are covered by section 17(b).
  • A live event called “ICO Summit World” purports to highlight “The Most Promising ICOs of 2018,” but presents only companies that pay to play. Definitely covered by section 17(b).

My sense is that in the Crowdfunding world, and especially in the token world, there’s a lot of paid promotional activity going on without the disclosure required by section 17(b). The securities laws don’t apply to tokens, right?

Questions? Let me know.

The Per-Investor Limits of Title III Require Concurrent Offerings

Since the JOBS Act was signed by President Obama in 2012, advocates have been urging Congress to increase the overall limit of $1 million (now $1.07 million, after adjustment for inflation) to $5 million. But for many issuers, the overall limit is less important than the per-investor limits.

The maximum an investor can invest in all Title III offerings during any period of 12 months is:

  • If the investor’s annual income or net worth is less than $107,000, she may invest the greater of:
    • $2,200; or
    • 5% of the lesser of her annual income or net worth.
  • If the investor’s annual income and net worth are both at least $107,000, she can invest the lesser of:
    • $107,000; or
    • 10% of the lesser of her annual income or net worth.

These limits apply to everyone, including “accredited investors.” They’re adjusted periodically by the SEC based on inflation.

These limits make Title III much less attractive than it should be relative to Title II. Consider the typical small issuer, NewCo, LLC, deciding whether to use Title II or Title III to raise $1 million or less. On one hand, the CEO of NewCo might like the idea of raising money from non-accredited investors, whether because investors might also become customers (e.g., a restaurant or brewery), because the CEO is ideologically committed to making a good investment available to ordinary people, or otherwise. Yet by using Title III, NewCo is hurting its chances of raising capital.

Suppose a typical accredited investor has income of $300,000 and a net worth of $750,000. During any 12-month period she can invest only $30,000 in all Title III offerings. How much of that will she invest in NewCo? Half? A third? A quarter? In a Title II offering she could invest any amount.

Because of the per-investor limits, a Title III issuer has to attract a lot more investors than a Title II issuer. That drives up investor-acquisition costs and makes Title III more expensive than Title II, even before you get to the disclosures.

The solution, of course, is that Congress should make the Title III rule the same as the Tier 2 rule in Regulation A:  namely, that non-accredited investors are limited, but accredited investors are not. I can’t see any policy argument against that rule.

In the meantime, almost every Title III issuer should conduct a concurrent Title II offering, and every Title III funding portal should build concurrent offerings into its functionality.

Questions? Let me know.

Cryptocurrencies: There’s Nothing New Under The Sun

Blockchain technology is revolutionary, promising to disrupt many of today’s industries. In contrast, the cryptocurrencies that live on the blockchain – to avoid confusion, I’m going to refer to cryptocurrencies as “tokens” – are really just high-tech manifestations of traditional ideas.

Broadly speaking, there are three kinds of tokens today:

  • Tokens like Bitcoin that are intended to function as currencies
  • Tokens that represent economic interests in businesses, e., securities
  • Tokens that give the holder some kind of contract right in the business conducted by the issuer, g., a distributed storage network

Tokens that are intended to function as currencies are like, well, they’re like currencies. They’re secure, they’re anonymous (maybe), they’re decentralized, but fundamentally they’re like paper money. The idea of paper money was revolutionary, rendering the barter economy obsolete. A digital representation of paper money is incrementally better, but not revolutionary.

Tokens that are securities – digital stock certificates – are helpful and better than paper or Excel spreadsheets but obviously not revolutionary.

The most interesting kind of tokens are the third:  tokens that give the holder the right to participate in a business.

Imagine you’re Henry Ford designing an automobile. You need a lot of capital. Your investment banker suggests you sell stock on Wall Street, but someone else suggests a different approach. You publish design specifications for your new automobile in something you happen to call a “Whitepaper,” and you sell to the public a limited number of licenses giving the holder the right to manufacture tires (or oil filters, or whatever) based on those specifications.

You just sold tokens, even though the blockchain doesn’t exist and you keep track of the sales in a red leather book.

Financially, you’ve pre-sold licensing rights. Some pros and cons versus selling stock:

  • On the plus side, you still own 100% of your company.
  • On the minus side, you have reduced or eliminated a future revenue stream for the company, e., licensing revenue.
  • On the plus side, because the tokens weren’t a security, you didn’t incur all that time and cost.
  • On the minus side, you really, really care about the quality of your cars – the whole future of your business depends on it – but the tokens might not end up in the hands of the highest-quality suppliers. That’s especially true in a market frenzy that reminds you of Tulip Mania in 1637, where many buyers are low-information speculators.
  • On the plus side, if raising money by pre-selling licensing rights happens to be a super-cool thing, the token sale might raise a lot more money than the licensing rights are actually worth.
  • On the minus side, you didn’t get to deal with securities lawyers.

What about the pros and cons to token buyers?

  • On the minus side, you have far less legal protection, as a buyer and owner of the token, than you would as the buyer and owner of securities in a public company.
  • On the plus side, your specialized expertise as a parts designer or manufacturer might give you a unique ability to increase the value of Ford, and therefore the value of your token.
  • On the minus side, while you know a lot about your own abilities, and might know a lot about Henry Ford and his team, you know nothing at all about the other token buyers. If they turn out to be lousy parts designers and manufacturers, you lose.
  • On the plus side, if you think Ford Motor Company is going to be hugely successful and tokens are the only thing they’re selling, you have no choice.
  • On the minus side, the token probably gives you the right to benefit from only one aspect of the company’s business, g., parts for the the Model T. If the company pivots or expands, you might find yourself left behind.
  • On the plus side, if you’re in a Tulip Mania market, maybe you’ll buy the token today and next week you can double your money selling it to someone else.
  • On the minus side, if we look hard at Ford’s Whitepaper we realize it’s very ambiguous. Do I or Ford really know what I’m getting? Or is this going to end up in litigation?

Who knows where the pros and cons come out. Someday economists will explain whether and in what circumstances a token is more economically efficient than a traditional security.

I feel quite sure that tokens that are currencies and tokens that are digital stock certificates are here to stay, because while not revolutionary, each represents an undeniable, if incremental, improvement over today’s technology. I’m not so sure about tokens that represent prepaid products or services. Until we hear from the economists, the jury is still out.

Questions? Let me know.

Options Or Profits Interests For Key Employees of LLCs?

Co-Authored By: Steve Poulathas & Mark Roderick

You own an LLC and want to compensate key contributors with some kind of equity. Do you give them an equity interest in the Company today or an option acquire an equity interest in the future?

Before we get to that question:

  • Make sure that equity is the right answer for this particular employee. It’s great for key contributors to have a stake in the company, but if this particular employee is your CMO, a cash commission on sales might make more sense because it provides a more targeted incentive.
  • Make sure you’re giving the employee equity in the right business unit. If you operate a Crowdfunding platform, for example, and want to incentivize an IT guy, maybe the IT should be held in a separate entity and licensed to the operating company.
  • To dispel some confusion, a limited liability company can issue options. In fact, here’s a Stock Incentive Plan drafted for a limited liability company. The only thing a limited liability company can’t do is offer “incentive stock options,” otherwise known as ISOs, which provide special tax benefits to employees but are also subject to lots of rules.

Okay, equity is the right answer for this particular employee and you’re giving her equity in the right company. Now, what kind of equity?

There are lots of flavors of equity. These are the three you’re most likely to consider:

  • Outright Grant of Equity: Your employee will become a full owner right away, sharing in the current value of the business, possibly subject to a vesting period.
  • Profits Interest: Your employee will become a full owner right away, but economically will share only in the future appreciation of the Company, not the current value.
  • Option: Your employee won’t become an owner right away, but will have the right to buy an interest in the future based on today’s value – again allowing her to share in future appreciation but not current value.

In making your choice, there are three primary factors:

  • Economics: How much value are you trying to transfer to your employee, and when?
  • Messiness of Ownership Interests: If your employee becomes an owner of the business, even an owner subject to vesting and/or an owner whose economic rights are limited to future appreciation, you have to treat her as an owner. You have to give her information, you have to return her email when she asks (as an owner) why your salary is so high and why your husband is on the payroll, you have to send her a K-1 every year, and so forth.
  • Taxes: For better or worse (mostly worse), tax considerations are the principal driver behind many executive compensation decisions, a great example of the tail wagging the dog. If you thought the JOBS Act was hard to follow, take a look at section 409A of the Internal Revenue Code!

So here’s where we come out.

An outright grant of equity might be a good choice for a real startup assembling a team to get off the ground, as long as there is little or no value. By definition the founder isn’t giving up much economically, and the outright grant achieves a great tax result for the employee, namely capital gain rates on exit. The main downside is that the employee is a real owner, entitled to information, etc. But that’s not the end of the world, especially if the employee is in the nature of a co-founder.

(If your company already has value, then you’re giving something away, by definition, and your employee has to pay tax.)

A profits interest is just like an outright grant except for the economics:  there is no immediate transfer of value. But the tax treatment is the same (no deduction for the company, capital gain at exit for the employee) and the employee is a full owner right away.

An option is economically very similar to a profits interest, because the employee shares only in future appreciation, not current value (for tax reasons, the option exercise price can’t be lower than the current value). But otherwise they’re the opposite. The employee isn’t treated as an owner until she exercises the option. And upon exercise, she recognizes ordinary income, not capital gain, while the company gets a deduction.

For a company with just a few key contributors a profits interest isn’t bad. You give your employees a great tax result and what the heck, what are a few more owners among close friends? But for a company with more than a few key contributors the option is better only because it’s so much easier to keep a tighter cap table. And while the tax treatment of the employee isn’t as favorable, I’ve never seen an employee refuse an option for that reason.

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