a16z: How to avoid pitfalls in token issuance? Five guiding principles you must know

Author: a16z Crypto General Counsel & Head of Decentralization; Translation: Jinse Finance xiaozou

To an outside observer, the tension between blockchain builders and the U.S. Securities and Exchange Commission (SEC) seems to have reached a point of tension. The SEC believes that almost all tokens should be registered under U.S. securities laws. Blockchain builders think this regulation is too ridiculous. Despite this difference of opinion, the fundamental goal of the SEC and builders is the same - to create a level playing field.

Such tensions arise from the fact that both sides have very different perspectives on the same challenge. Securities laws attempt to create a level playing field among investors by imposing disclosure requirements on companies with publicly traded securities that are designed to eliminate information asymmetry. Blockchain systems attempt to create a level playing field among a wider range of participants (developers, investors, users, etc.) through decentralization, decentralized use of transparent ledgers, elimination of central control, and reduced reliance on management work. Although builders have a wider audience, they also want to eliminate asymmetric information related to the system and its native assets (tokens).

It’s no surprise, then, that regulators are skeptical of the latter. Such decentralization has no analog in the corporate world; it makes it hard for regulators to identify responsible parties; and, because decentralization is difficult to establish and measure, it can be easily faked.

Either way, the onus is on Web3 builders to prove that the blockchain industry’s approach is valid and worthy of consideration. This task would indeed be easier if the SEC were a constructive partner, but the crypto industry cannot allow the SEC’s failures to fall on its shoulders. Web3 projects must strive to work within existing guidance, whether it’s the Digital Asset Framework released by the SEC in April 2019 or the recent enforcement action ruling against Coinbase.

So, where should projects start? After deciding when and how to launch your token, projects can start by following these five principles for token launches:

(Note: These principles are not intended to guide projects to evade U.S. securities laws, but rather to inform how projects should manage their activities so that the risks associated with holding tokens are clearly separated from the risks associated with investing in securities. All of these guidelines depend on the specifics of your project structure and activities. Please consult with your advisors before implementing these rules in a planned manner.)

Principle 1: Never sell a public token in the United States

In 2017, ICOs (initial coin offerings) boomed as dozens of projects sought to raise funds based on promises that they would achieve important technological breakthroughs. While many projects did so (including Ethereum), many more did not. At the time, the SEC's response was both forceful and reasonable. The Commission sought to apply securities laws to ICOs, which generally met all the conditions of the Howey Test - a contract, plan, or transaction to invest a sum of money in a common cause with a reasonable expectation of profits based on the management or corporate efforts of others.

The Howey test is easiest to apply for significant transactions, where a token issuer sells tokens to investors. In many ICOs, token issuers make clear representations and promises to investors that they will use the proceeds of token sales to fund their operations and provide future returns to investors. These use cases are securities transactions, regardless of whether the instrument sold is a digital asset or stock.

Since 2017, the industry has made significant progress away from U.S. public token sales-based fundraising. We are in a different era. ICOs are nowhere to be found. Instead, tokens allow holders to govern networks, join games, or build communities.

Applying the Howey test to tokens is much more difficult now—airdrops do not involve capital investment, decentralized projects do not rely on management efforts, many secondary token transactions clearly do not meet the Howey test, and, without public marketing, secondary buyers may no longer rely on the efforts of others to make a profit.

Despite some progress over the past seven years, ICOs reappear in new forms with each new cycle and seem to refuse to comply with U.S. securities laws. There are several reasons why this happened:

• Some industry participants believed that U.S. securities laws were ineffective or unfair, and therefore violating them was justified—a convenient ideological position for anyone who wanted to profit from them.

• Some invented new schemes, hoping that slightly changing the facts would produce different results. Ideas such as “protocol-owned liquidity” (indirect sales of tokens by decentralized autonomous organizations, who then control the proceeds through decentralized governance) and “liquidity bootstrapping pools” (indirect sales of tokens through liquidity pools on decentralized exchanges) emerged.

• Some hoped to take advantage of the uncertainty created by the SEC’s insistence on enforcement, which led to a number of inconsistent and irreconcilable rulings.

Projects need to be careful to avoid these schemes. None of these are sufficient excuses to ignore or violate U.S. securities laws.

The only legal way for projects to avoid having securities laws applied to their tokens is to mitigate the risks those laws target (e.g., reliance on management efforts and information asymmetries). Selling public tokens to Americans for fundraising purposes is the antithesis of those efforts, which is why fundraising has been the most focused crypto issue by regulators for years (including some light adjustments and changes to fundraising).

The good news is that it is easy to avoid legal consequences by selling tokens publicly for fundraising purposes in the United States. Of course, if you don’t do this, you can still raise funds in other ways. Public sales of stocks and tokens outside the United States and private sales of stocks and tokens can be conducted in a compliant manner without following the registration requirements of the securities laws.

The bottom line: Public sales in the United States are an own goal. Avoid them at all costs.

Principle 2: Decentralization as the North Star

Builders can use many different token launch strategies. They can decentralize their projects before the token launch, launch outside the United States, or restrict the transferability of their tokens to prevent access to secondary markets in the United States.

In this article, I discuss all of these issues in detail using the DXR (Decentralize, X-clude, Restrict) token launch framework, which points out how each strategy mitigates risk.

Both the X-clude and Restrict strategies can help projects navigate U.S. securities laws when launching tokens if they have not yet achieved “sufficient decentralization.” But crucially, neither is a substitute for decentralization. Decentralization is the only path a project can take to help eliminate the risks that securities laws are designed to address, thereby making their application unnecessary.

So, no matter which strategy a project chooses at the outset, those who intend to use tokens to deliver broad benefits (economic, governance, etc.) should always keep decentralization as their North Star. Other strategies are just stopgap measures.

How does this play out in practice? No matter how a project evolves over time, it should always seek to make progress toward greater decentralization. Here are some examples:

• After mainnet launch, the founding team of an L1 blockchain may want to invest significant development effort into several technical milestones. To reduce the risks associated with "dependency management efforts," they could first exclude the United States from the launch region, and then only launch tokens in the United States once they have made progress toward decentralization. These milestones might include supporting permissionless deployment of validator sets or smart contracts, increasing the total number of independent builders developing on the network, or reducing the concentration of token holdings.

• A Web3 gaming project might want to use restricted tokens in the United States to incentivize economic activity in the game. Over time, as more user-generated content is created, as more gameplay relies on independent third parties, or as more independent servers come online, the project may lift token restrictions.

Planning these steps toward a decentralization plan is arguably the most important work to complete a token launch. The strategy a project chooses will significantly affect how it operates and communicates, both at launch and in the future.

Brief Summary: Decentralization is a big deal. Consider it in all your endeavors.

Principle 3: Communication is everything, manage accordingly

“Communication”, no matter how insignificant or innocuous it may seem, can make or break a project. One misstatement from the CEO can put the entire project in jeopardy.

Projects should have a strict communication policy tailored to the nuances of their token issuance strategy. So let’s break this down using the strategies from the Token Issuance Framework:

(1) Decentralize

This strategy is to ensure that purchasers of a project’s tokens do not have a “reasonable expectation of profits based on the management or entrepreneurial efforts of others” (as described in the Howey Test). In a decentralized project, token holders will not expect profits from the management team because no single group or individual has that power. The founding team may not direct otherwise, or securities laws may be implicated.

So what is a “reasonable expectation”? Much of that depends on what the project or token issuer says about the token (and the tweets, texts, and emails). Courts have repeatedly found that when a project announces that its core team is driving progress and developing economic value, it is reasonable for investors to rely on the efforts of that core team for a return on their investment. This finding can be used to justify the application of securities laws.

When it comes to decentralization, a strict communication policy is not a sleazy strategy to evade U.S. securities laws—it is a legitimate way to reduce the likelihood that token purchasers will rely on management or corporate efforts to make a profit, which helps protect web3 projects and their users. The fact is that by refusing to develop constructive rules and weaponizing the communication dialogue with builders, the SEC has created incentives that are diametrically opposed to its own mission. Web3 builders are effectively incentivized to disclose as little as possible about their projects and activities to the public.

So what does this policy look like in practice?

First, projects should not discuss or mention their tokens, including potential airdrops, token distributions, or token economics, before they launch. The consequences of doing so can be severe — the SEC has successfully stopped many companies from issuing tokens, and they may do so again. Don’t give them the chance.

Second, after the token is issued, projects should avoid discussing the price or potential value of the token or presenting it as an investment opportunity, including any mention of any mechanism that could cause the token to appreciate in value, and any commitment to use private capital to continue to fund the project’s development and success. All of these actions will increase the likelihood that token holders will have a reasonable expectation of profit.

How members of the project’s ecosystem — including founders, development companies, foundations, and DAOs — talk about their roles after the project is decentralized is critical. It’s easy for the founding team to speak in a centralized manner even if the project is very decentralized, especially if they are accustomed to talking about achievements, milestones, and other items in the first person.

Here are a few ways to avoid falling into this trap:

• Don’t refer to yourself in a way that vaguely implies ownership or control over the protocol or DAO (e.g., “As CEO of Xyz protocol…”, “Today, we turned on Xyz feature of the protocol…”).

• Avoid forward-looking statements whenever possible, especially regarding mechanisms such as planned “burning” of tokens to achieve pricing targets or stability.

• Avoid making promises or providing guarantees about work in progress, and avoid describing work in progress as outsized in importance to the project’s ecosystem (e.g., use “initial development team” instead of “core development team” or “primary development team” where appropriate, and don’t refer to individual contributors as “directors”).

• Highlight efforts that have contributed or will contribute to greater decentralization, such as contributions from third-party developers or app operators.

• Let the project’s DAO or foundation speak for itself to avoid confusion with the DevCo or founders who launched the project. A better approach is to avoid confusing third parties and rename or re-promote the original DevCo so that it is not the same as the protocol name.

Ultimately, all communications should reflect the principles of decentralization, especially in public. Communication must be public, and the purpose is to prevent any individual or group from obtaining significant asymmetric information.

Summary: Once decentralized, no one person or company is the spokesperson for the project. The project's ecosystem has its own operating system, which is independent and unique. Just one mistake can be catastrophic.

(2) X-clude

To issue tokens outside the United States, projects can take inspiration from the traditional financial sector and adopt a strict communication policy that follows the requirements of Regulation S, which specifically requires that stocks issued outside the United States are not subject to certain registration requirements under the U.S. securities laws.

The goal of this strategy is to prevent the flow of tokens into the United States, so communications should avoid "directed sales efforts" to promote or advertise tokens in the United States, risking "regulating the U.S. market" (i.e. creating demand for tokens in the United States). Ultimately, the stringency of these policies will depend on whether there is “Substantial U.S. Market Interest” (SUSMI) in these tokens (i.e., significant U.S. market demand for the tokens).

Bottom line: If you don’t offer tokens in the U.S., don’t act as if you do. Any social media comments you make about your project’s tokens should specifically emphasize that these tokens are not available in the U.S.

(3)Restrict

Limiting the issuance of tokens to transfers of restricted tokens or “off-chain” credits allows for a more flexible communication strategy. Well-thought-out projects will be insulated from legal risk because individuals cannot make a “funding investment” to earn tokens under the Howey test.

Nevertheless, this insulation can quickly fall apart if the project encourages participants to treat the transfer of restricted tokens or credits as an investment product. Such comments could seriously undermine the legal basis of restricted tokens.

Bottom line:Restrict Restrictive strategies do not exempt builders from legal concerns. Careless statements can cause trouble for projects for years to come, preventing them from changing their launch strategy or even achieving decentralization.

Principle 4: Be Careful with Secondary Market Listings and Liquidity

Secondary market listings and liquidity are another area where the SEC has shown that enforcement creates incentives that run counter to its mission.

Projects often seek to list on secondary trading platforms so that more people can access their tokens and use them to obtain blockchain products (e.g., you need to own ETH to use the Ethereum blockchain). This is often required to ensure sufficient liquidity on trading platforms, and a lack of liquidity can lead to price volatility and increase risk for the project and its users. Why? In the early days of a token offering, large purchases or sales on a particular platform can greatly affect the price of a token. When the price falls, everyone can lose money. When the price rises, FOMO-driven investors may drive the price to unsustainable levels - and when the price stabilizes, they may lose more.

For Web3 users, increasing access and ensuring sufficient liquidity (usually through market makers) is a better option. It also helps make the market more fair, orderly, and efficient. Despite this being the SEC’s stated mission, it has used project announcements regarding the availability of their tokens on secondary trading platforms against these projects. It has also attempted to treat the provision of liquidity in the secondary market as if it were an ordinary token sale.

Projects that do not initially adopt a decentralized token launch strategy have more flexibility with secondary market listings and liquidity, as both strategies delay the availability of fully transferable tokens within the U.S. This can buy projects time to address liquidity issues by increasing the public float (number of tokens in circulation) of their tokens before the tokens become widely available in the U.S., and therefore, token issuers are less likely to have to deal with secondary market listings and liquidity issues in the U.S.

Bottom line: Projects need to approach these listings and liquidity with extreme caution. The risk/benefit analysis is generally not worth it. At the very least, projects that are unsure whether they have achieved “sufficient decentralization” should not announce the listing of their tokens on exchanges, nor should they engage in any market making activities within the U.S.

Principle 5: Always Make Token Lockups Last for At Least One Year After Token Issuance

This is critical. Projects should implement transfer restrictions on all tokens issued to insiders (employees, investors, advisors, partners, etc.), affiliates, and anyone who may participate in the token distribution. These restrictions should apply for at least one year after the token is issued.

The SEC has successfully used the lack of a one-year lockup period to prevent token issuers from issuing tokens. It may do so again. Worse, the SEC precedent gives plaintiffs’ lawyers a roadmap to bring class-action lawsuits against companies that fail in this regard. That’s free money for them and a huge pain in the ass for the project.

Ideally, token lockups and other appropriate transfer restrictions should only be unlocked after the one-year period ends, starting with the token launch, and then distributed linearly over the next three years from then on, for a total lockup period of four years. This approach can help mitigate the legal risks mentioned above. It can also position a project for long-term success by reducing downward price pressure on the token and demonstrating confidence in its long-term development.

It’s a win-win situation.

Given these clear benefits, projects should also be wary of investors who attempt to demand shorter lock-up periods. Such demands could indicate that these investors will not comply with securities laws and may sell the tokens in the first place.

For projects that issue tokens outside the U.S., any tokens issued to U.S. employees, investors, and other insiders should follow this guidance. Teams should discuss with their counsel whether a broader application of lock-up strategies is necessary to preserve the Regulation S exemption.

Finally, any project that uses transfer-restricted tokens or points as part of its token issuance strategy should adjust this approach to release transfer restrictions one year after the project's tokens become transferable within the U.S.

Conclusion:

As we've covered in this article, every token launch is different. But there are some guiding principles that apply to most projects, such as avoiding public fundraising, developing a decentralization plan, implementing strict communication guidelines, carefully considering secondary markets, and waiting at least one year before unlocking token locks, which can help projects avoid the most common pitfalls of token issuance. Not only that, adhering to these general guidelines can help builders strengthen their legitimacy, innovate safely, and move the industry forward.