My colleague Susan Schalla and I put together the below video chat on IP assignments and confidentiality agreements for Founders Live. If you haven’t checked out Founders Live, check it out at https://founderslive.mn.co/.
If you are interested in how the SEC is thinking about tokens as securities, we recommend you watch William Hinman’s recent speech and read its transcript. We’ve included an embed and a link to the speech below.
We think perhaps the most important and interesting part was this:
But this also points the way to when a digital asset transaction may no longer represent a security offering. If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.
My colleague Danny Neuman and I put together this video about equity crowdfunding for an AMA on Nick Hughes’ Founders Live group.
Equity crowdfunding can proceed along a number of different pathways, including:
- Rule 506(c)
- Title III
- State equity crowdfunding laws
- Regulation A+
If you want to raise money through an equity crowdfunding, we would be happy to talk to you about the various pathways, the amounts you can raise under each approach, the various complications and expected costs of each approach.
Taxation of Stock Options
As of now, the Senate has abandoned the idea of taxing stock options as they vest.
This is the modification to the mark, released late yesterday.
The modification strikes the proposal–Item III.H.1, Nonqualified deferred compensation–from the Chairman’s Mark. A new discussion of Treatment of Qualified Equity Grants begins on p. 69.
The new proposal includes does a complete u-turn from what was originally proposed.
Stock option taxation is a sensitive issue in startup land. Fred Wilson recently sounded the alarm about the Senate’s proposal to tax stock options as they vest. TechCrunch has also written about this.
Right now, what we have to work with is the DESCRIPTION OF THE CHAIRMAN’S MARK OF THE “TAX CUTS AND JOBS ACT”.
The document lays out the proposal as follows:
Under the proposal, any compensation deferred under a nonqualified deferred compensation plan is includible in the gross income of the service provider when there is no substantial risk of forfeiture of the service provider’s rights to such compensation. For this purpose, the rights of a service provider to compensation are treated as subject to a substantial risk of forfeiture only if the rights are conditioned on the future performance of substantial services by any individual. Under the proposal, a condition related to a purpose of the compensation other than the future performance of substantial services (such as a condition based on achieving a specified performance goal or a condition intended in whole or in part to defer taxation) does not create a substantial risk of forfeiture, regardless of whether the possibility of forfeiture is substantial. In addition, a covenant not to compete does not create a substantial risk of forfeiture.
What is interesting about this is it runs completely counter to how the world works today. Today, if you grant stock options at fair market value, there is no tax to the optionee upon receipt. Nor is there tax on vesting. But the new rule proposes taxing on vesting. This is distressing.
Incentive Stock Options Carved Out
There is some good news here. Apparently “statutory options” would not trigger this new rule. See below. Only nonqualified stock options would be problematic.
The proposal applies to all stock options and SARs (and similar arrangements involving noncorporate entities), regardless of how the exercise price compares to the value of the related stock on the date the option or SAR is granted. It is intended that no exceptions are to be provided in regulations or other administrative guidance. However, it is intended that statutory options are not considered nonqualified deferred compensation for purposes of the proposal.
It will be interesting to see what happens here.
A Better Idea
My proposal would be: Congress should make it easier for companies to share equity with workers. I don’t believe service providers should be taxed at all when they receive stock in a private company. The stock can’t be sold, and generally must be held indefinitely.
If the Congress passed a sensible law, which said that service providers would not be taxed on the receipt of equity of their employer if not a registered security that was freely tradeable, equity sharing would flourish, and the wealth created by startup companies would be more widely shared. This would be good for our economy and our politics.
My colleague Susan Schalla and I have been making videos for Nick Hughes’ Founders Live Group, which are followed by AMA chat sessions.
In this video, we talk about tax issues for founders, primarily:
- The 83(b) election — when it applies; when it doesn’t; when it is due; etc.
- Qualified Small Business Stock considerations in choosing what type of business entity to form.
We hope you enjoy the video.
Guest Post By Dan Wright
Federal Research Tax Credits
Is your business involved in creating intellectual property or process and product improvement? If so, you or your business may qualify for federal research tax credits.
First, let’s clear up some myths about what business activity qualifies for the credit. Many people think of white coats and test tubes when they hear the word “research.” However, in this context, the definition is much broader than that.
Another common misconception is that the research, or resulting products, must be completely original to qualify. However, that is not generally the case. Instead, qualifying research very often involves research that results in a product or process that is only new to the business performing the research. That fact that similar products or research may already exist is not relevant to qualifying your business activity.
What is the Credit Based On?
The credit is a wage-based program, which you can calculate by identifying the wages paid to employees who perform qualified research activities. Amounts paid to outside consultants are also included in the credit at 65% of each qualifying dollar spent. In some cases, supplies that are consumed in the research process can also be included in the calculation.
Multiple methods of calculating the credit may be available. But in short, the credit available to the qualifying business activity equates to 6%-20% percent of the incremental research expenses. The exact percentage is determined by the elected applicable method.
Who Qualifies for the Credit?
Any business performing qualifying research can qualify for the benefit. Since the incentive is in the form of a tax “credit,” the business must have a tax liability to get a current cash benefit. It is not a refundable credit, but the portion of a credit that is not used in the year it is generated can be carried forward.
Since regular corporations are subject to federal tax, they can claim the credit. Businesses that are considered “pass-through” entities for federal income tax purposes, such as LLCs that have elected partnership status and corporations (or LLCs) that have elected S corporation status, pass the credit through to the owners of the entity.
What Qualifies as Research Activity?
Only business activity conducted in the U.S. qualifies. Further, the research activity must be “technological in nature.” This means that it must involve a hard science, such as computer software; engineering; medical, biological, or physical research; or other similar science disciplines.
Additionally, “funded research” does not typically qualify. This means that if research activity is funded by an outside source, such as grants or customers, the arrangement must be carefully evaluated to determine if it qualifies. That said, the fact that the research is partially or wholly funded by third parties does not automatically disqualify the activity.
What Activities do not Qualify?
The rules specify which business activities are disqualified. These activities include:
- Costs incurred once production of the component begins;
- Adaptation of an existing component to a particular customer’s requirement or need;
- Efficiency surveys;
- Activity related to management function/technique;
- Marketing research;
- Advertising or promotions;
- Routine data collection/testing to evaluate quality control;
- Activity related to style, taste, cosmetic or seasonal design factors.
New Opportunities that Apply to 2016 and Beyond
Alternative Minimum Tax (“AMT”) Offset
Until 2016, the credit could only be used to reduce a regular tax liability. Beginning in 2016, however, it can also be used to offset AMT liabilities. The AMT offset is only available to businesses with under $50 million in gross receipts. However, credits passing through from qualifying businesses can still apply to individual tax liabilities.
Payroll Tax Election
Beginning in 2016, qualified startup businesses can generate research credits. Qualified startup businesses include those that have not had “gross receipts” for more than 5 years (meaning, the five year test starts with the first year in which business had gross receipts), and have had gross receipts of less than $5 million in the claim year. Research credits can then be used to offset the employer’s portion of the FICA tax in the following year. It’s worth noting, however, that startups should consider the related party rules when applying the gross receipts tests.
Since many startup businesses don’t generate taxable income in the early years after formation, the credit program historically provided little, if any, immediate benefit. Now that the credit can be used to offset payroll taxes, the credit has real value for qualifying startups.
If you would like help determining if your business activity qualifies for the research credit incentives, and/or determining an estimate of the benefit, please contact Dan Wright at email@example.com.
By Evan Jensen and Joe Wallin and Jordan Rood
If you are considering token sales and selling blockchain tokens in the U.S., you not only have to worry about the U.S. federal securities laws (see the latest from the SEC here), but also the laws of each state within the U.S. in which you sell the tokens.
Worrying about both federal and state law is something that happens whenever you offer to issue a security unless the federal law specifically preempts the state securities laws. Specific federal exemption occurs in very limited circumstances.
For example, if you are selling tokens to California and Washington residents, you have to worry about California and Washington state securities laws.
An example of federal preemption occurs under Rule 506(b). If you sell securities to only accredited investors under Rule 506(b), state law is preempted except for the requirement to file a Form D and pay the filing fees in states in which you have investors that require the filing.
In general though, the state securities laws exist side by side with the federal law and you have to comply with both. For example, if you issue stock options you have to comply with both federal and state law.
It is possible a token will not be a security under the federal securities law, but will be a security under a particular state’s laws. This could make your coin offering, if you are considering one in which you sell coins to US residents, more difficult than you might expect.
What is the Risk Capital Test?
The risk capital test is a test some jurisdictions apply to determine whether in a particular transaction the instrument offered is a security. This test is different, and arguably more expansive, than the Howey test used by the SEC in its analysis finding that the DAO tokens qualified as securities. Further, each of the approximately 16 states that apply a risk capital analysis characterize it a bit differently, but there are common elements among them.
In Washington State, for example, the statutory definition of “security” includes this concept:
“investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture”
The Full Statutory Definition of Security in Washington State
Below is the full statutory definition of a security in Washington State, RCW 21.20.005(17)(a):
(17)(a) “Security” means any note; stock; treasury stock; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral-trust certificate; preorganization certificate or subscription; transferable share; investment contract; investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture; voting-trust certificate; certificate of deposit for a security; fractional undivided interest in an oil, gas, or mineral lease or in payments out of production under a lease, right, or royalty; charitable gift annuity; any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, including any interest therein or based on the value thereof; or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any security under this subsection. This subsection applies whether or not the security is evidenced by a written document.
Practical Application of the Risk Capital Test
If you are buying a blockchain token, you are investing money or other consideration into something. Are you investing it in the “risk capital” of a “venture with the expectation of some valuable benefit where you do not receive the right to exercise practical and actual control over the managerial decisions of the venture”?
It all depends on what the the terms of the token offering.
If the offering white paper tells you that you might expect some benefit from the increase in the value of the token being sold, does that mean the token is by definition a security under Washington law?
If you are buying a token for access to a computer network or software that doesn’t yet exist, or exists but only in an early state, and your capital is “at risk” because it is going to be used to further develop the software, then there is a risk that you are selling a security under state law, even if the token is not a security under federal law.
One of the most famous cases in this area involved a country club to be built with membership funds.
[As an aside: we thing it is interesting and illuminating from a socialogical point of view that 30 years ago we were talking about whether memberships to clubs were securities and now we are taking about whether blockchain tokens are securities]
In the old, somewhat famous case re golf club memberships, the promoters hadn’t built the club, but were selling memberships to build the club. The California Supreme Court held that this was a security under at risk test, even though the memberships only entitled the purchasers to use the club once it was built. They weren’t entitled to a share of the profits of the club.
The case is worth reading when thinking about what is a security under states law for states who have adopted the risk capital test.
The analogy with a blockchain token sale is quite clear- even if the token is a software access token, a utility token, etc., if it is being offered far in advance of the service, and the funds raised from the sale of the token are usedto build the service (the “club”) then the purchaser’s capital is in a sense being put at risk. And no matter how promising the project, arguably the person purchasing the token is in danger of never receiving the promised service. The valuable benefit, in such a case, would be the future service being provided, likely coupled with an increase in the value of the token as it changes from a future value to an immediate value. An access token being sold to raise money to build a software platform may be fine under the federal Howey test, but nevertheless certain states may consider it to be a security.
Contrast this with a token being offered where the service is immediately available. A software service might restrict usage using a permission/license token rather than a serial number, as is common with software products like Microsoft Office. Or perhaps a usage currency could provide a limited amount of access which is consumed when the user performs actions or acquires content.
Probably the easiest example of a type of token that could be sold that would not be a security would be a token that entitles you to play a video game that is already built. It is hard to see how that would be a security. It is no different than selling the rights to play a video game for cash. The service being provided is an entertainment software product, handed over immediately when the user purchases the token. This could take one of several different forms, such as the popular free-to-play model using a cryptocurrency instead of a platform-specific virtual currency (i.e. Riot Points, World of Tanks gold). It could be a token representing ownership of a digital game product, or DLC content within a game. Or, it could take the form of a token credit inserted to play a specific game once, in the fashion of an old-school arcade machine.
The important detail here is that in each of these cases the connection between the token and actually playing the game is immediate- the user is purchasing and receiving the product immediately, rather than an expectation of a future value as a consequence of a contribution of risk capital.
Still, what if a token features a mixture of characteristics? What if there are two or more types of tokens which are connected to one another or related to one another in some way- even if one of the tokens does not have an expectation of profit, perhaps a combination of tokens and/or smart contracts could create an expectation in the purchaser that a token will eventually return a profit. And how far in advance of the service being available is too far?
Again, the larger point to token issuers is—and this is somewhat of an understatement–issuing a token is not the easiest thing in the world to do, from a legal and regulatory compliance point of view. As a general takeaway, a simple tactic to avoid this “risk capital” issue is to just avoid issuing tokens to residents of those particular states applying the rule, but otherwise, structuring the tokens to reflect a (relatively) immediate consumable benefit, rather than a speculative future one, is a way to reduce the likelihood that tokens would be deemed securities under the risk capital test.
Disclaimer: This blog post is for information purposes only. It doesn’t constitute legal advice or the establishment of an attorney-client relationship. Always consult with counsel before attempting to sell anything that might be a security.
By Evan Jensen and Joe Wallin
One thing the SEC didn’t say anything about in its analysis of The DAO token offering last week was the place in the ecosystem for “utility tokens.”
This was bemoaned by at least one other legal commentator. As Trent Dykes’ said, it “seems unlikely that the SEC was unaware of the concept of utility tokens, yet it chose not to discuss that topic. We wished they had.”
As opposed to a currency token, which is a token intended to serve as a store of value, or an application token, which is intended to serve as a tool for the monetization of a specific service or platform (perhaps as an app-specific currency), a utility token is something different altogether.
Utility tokens are tokens intended to serve a very particular function, such as
- tracking a particular piece of information, or representing the movement of an object as it passes through a supply chain, or
- conferring a user a right or permission to perform a specific action on a platform or service.
And even a quite mundane and simple utility token can acquire a growing wealth of functionality due to being decentralized, as many different people develop on top of it.
Let us give you an example. Suppose a library wanted to use blockchain tokens to keep track of its books.
The library could create a category of token for its books. Its users would be given a “library card” which would essentially be an address, if they didn’t already have one. When a patron of the library checked out a book, the library would transfer the token to that person. And when they returned the book, they could return the token as well. Assuming everyone transfers the tokens when called upon this system would work just fine, effectively replacing the library’s private database. And, if done properly this would replace not just one library, but potentially create a single global database for any libraries which choose to participate.
But what if a user doesn’t return the token when their book is due to be returned? Or what if a user returned the token but not the book? How do would we handle this?
There are a number of different solutions.
To actually implement most blockchain applications, some degree of application-specific work is required to hammer out the practical problems for each use case. Developers have to make it work in practice using the set of tools available on the blockchain- chiefly by writing smart contracts.
A blockchain smart contract can be written to hold a token, rather than sending it to the user’s address directly where they will have exclusive control. So our scrappy developers could implement a “borrow” smart contract for holding library book tokens — when a user checks out a book, instead of going to the patron’s address, the token is temporarily held within a smart contract.
This smart contract *could* be written to automatically return the token when the book is returned. And there are many use cases that would make sense to have this sort of function, such as an access credential token that should expire after a certain period of time. But the problem with this use case is that the physical book is still out there. In this case, returning the token alone does not help.
Suppose instead the patron must supply an amount in escrow to the borrow smart contract, perhaps approximately equal to the price of one or two books, which when the user accrues late fees for failing to return the book, the smart contract will automatically draw down from. This would be synonymous with the fees many libraries currently charge to obtain a library card, and when depleted the user would be unable to borrow more books before replenishing it.
If the person returns the book on time they will be able to borrow another one for free. But if they never return the book, then eventually the user will essentially have purchased the book, and the library is effectively forced to assume there is a possibility a book will never actually be returned. And they should structure their application and smart contract accordingly.
At this early stage the library book token may not seem very useful. After all, existing library databases track who has which book all the time.
But blockchains have interesting features.
First is decentralization, which in this instance represents the collapsing of the distinction between a provider and a consumer. In other words, each user of this blockchain system for library books could be *either a patron or a library at the same time. *This could be set up to allow me as a user to transfer a book to someone else without it having to go back to the library.* *
Second, don’t forget, blockchains are public databases. This means that the information about which addresses have which tokens (books) is public information that anyone can view (the public information would just be the address; no one would know which books you had checked out unless they knew your address). In some use cases, this is a serious drawback, such as if privacy is important, but it can also be very useful. Perhaps you would like to check and see if a certain library has a copy of a certain book available before you go down and check it out. Or perhaps you would like to browse a list of all the books a library has on a website. Or maybe you’re a data aggregator interested in searching for macro trends in global book movement or reading patterns. Third parties can devise all manner of inventive applications for these systems.
Third, smart contracts can be added which expand functionality, perhaps in ways that a system’s original creators never envisioned. Perhaps book publishers will see this large database of book possession and write their own smart contracts which offer their books for sale. They don’t need anyone’s permission to do this, but would need to convince users that their code is worthwhile for them to use. But if they are useful enough to be used, then those new developments become building blocks for still further development, becoming incorporated into other, larger or more sophisticated functions.
In summary, utility tokens represent unique opportunities. Although there is clearly a need for greater supervision of investment-oriented activities regarding ICO’s, it is important not to overly generalize to all tokens, many of which may be primarily concerned with users and software in a service rather than raising money.
By Evan Jensen and Joe Wallin
On July 25, 2017, the SEC issued a number of important pronouncements with respect to initial coin offerings and blockchain tokens.
The SEC issued: (1) a press release; (2) an investigative report into The DAO coin offering; (3) a Statement by the Divisions of Corporation Finance and Enforcement on the Report of Investigation on The DAO; and (4) an Investor Bulletin on Coin Offerings.
These materials are important and good reading if you are curious about this area.
The take away for many casual observers has been that the SEC declared that blockchain tokens are securities.
But that is not what the SEC said.
The SEC said that a Blockchain token “may” be a security. But a Blockchain token is not necessarily a security. It depends on what the token does, and what the offeror of the token promises.
The SEC’s investigative report said:
“Accordingly, the Commissioner deems it appropriate and in the public interest to issue this Report in order to stress that the U.S. federal securities laws may apply to various activities, including distributed ledger technology, depending on particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.”
Clearly, if a token grants a right to share in the profits of the business — then the offeror of the token is selling a security under the U.S. securities laws.
In the Investor Bulletin, the SEC said:
“Depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offering or sold may be securities.”
The DAO token fell within the definition of a security for a number of reasons. For one, the SEC’s investigative report indicated that the intention of the offering was to “distribute the DAO’s anticipated earnings from the projects it funded.”
"the various promotional materials disseminated .... informed investors that the DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment."
The Definition of a Security Under US law
The SEC’s analysis of the DAO token or coin as a security is quoted below.
“Under Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act, a security includes “an investment contract.” See 15 U.S.C. §§ 77b-77c. An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. See SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); see also United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) (The “touchstone” of an investment contract “is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”). This definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Howey, 328 U.S. at 299 (emphasis added). The test “permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of ‘the many types of instruments that in our commercial world fall within the ordinary concept of a security.’” Id. In analyzing whether something is a security, “form should be disregarded for substance,” Tcherepnin v. Knight, 389 U.S. 332, 336 (1967), “and the emphasis should be on economic realities underlying a transaction, and not on the name appended thereto.” United Housing Found., 421 U.S. at 849.”
Using this definition, many types of blockchain projects and their respective tokens likely are not securities. For example, a token which confers a license with language to the effect of “the bearer of this token has my [the author’s] permission to copy a specific creative work” most likely is not a security, but rather is more analogous to a content license, similar to one which might be purchased from iTunes. By contrast, a token which promises a share of the profits of a company would clearly be classified as a security, since the purchaser of the token expects a profit from the efforts of the company selling the token.
Blockchains and tokens are capable of an incredibly broad, creative, and flexible range of functionality, far above and beyond solely investment vehicles. Blockchains can be used to store practically any form of data or record, and tokens used to track anything that is transferable, not just securities such as stock or other interests in business enterprises. For example, a venue such as a theater could use a smart contract to automate the sale of tickets, automatically generating a unique token for each seat in the venue for each showing, and sell tokens representing show tickets using an online platform. A ticket is a good example of a function that requires a token that is transferable, but should not be characterized as a security.
In short, although some crypto tokens are securities, not necessarily all crypto tokens are securities, requiring a careful analysis of the token, its function, and the promotional materials and representations made by its creator(s). And that is what is really the heart and crux of the matter.
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You can find a list of cryptocurrency whitepapers here.
This blog is for informational purposes only, and is not legal advice. Always consult counsel if you are thinking about doing anything in this area.