Cryptocurrency Compensation: A Primer on Token-Based Awards

On March 19, 2018, Morrison & Foerster LLP attorneys Alfredo B. D. Silva, Ali U. Nardali and Aria Kashefi published a thought piece in Bloomberg Law on legal issues related to use of blockchain tokens as service provider compensation.

In the past year, tokens have nudged their way into mainstream consciousness with the proliferation of “initial coin offerings,” or “ICOs,” and the blockbuster rises – and drops – in the prices of cryptocurrencies. An emerging trend sees companies and virtual organizations leveraging the value of these tokens, not only for non-dilutive capital raising purposes, but also to compensate and incentivize founders, directors, employees, consultants and other service providers. Just as with issuances of founder’s stock, stock options and other traditional equity-based compensation, token-based compensation requires significant consideration from both a tax law and a securities law perspective.

By and large, these token-based awards emulate traditional equity-based awards, including restricted tokens, token options and restricted token units. This is not a coincidence: compensatory award structures generally are largely tax driven, with provisions applicable to token-based awards being the same as those applicable to traditional equity-based awards.  Interestingly, we believe that whereas (i) restricted stock awards have predominantly been awarded at companies’ early stages, (ii) restricted stock units have been more widely used by companies whose stock is publicly traded and more mature private companies and (iii) stock options are heavily used by companies at all stages, in each case, the opposite should be true with the analogous token-based awards.

For example, stock or restricted stock awards can be easily made at or shortly after a company’s formation but can have adverse tax consequences to recipients later in a company’s development. On the other hand, tokens simply cannot be issued prior to a token generation event (“TGE”), whereas, after the TGE, a secondary trading market may exist for a company’s tokens, such that a recipient of a token award can sell tokens as they vest to cover the tax spread.  In contrast, a restricted token unit (“RTU”) can be awarded prior to a TGE, solving this problem, as well as avoiding limitations attendant to token options relating to valuation and exercise provisions under Section 409A of the Internal Revenue Code of 1986, as amended.

Note that, whether or not a token underlying an award is considered a so-called “utility token” and not a security, many practitioners believe that an agreement to acquire a utility token in the future itself constitutes an investment contract and so is a security. Thus, like a SAFT, or Simple Agreement for Future Tokens, an RTU or a token option in any event may be deemed a security, and its issuance should be compliant with the Securities Act – meaning issuers by and large will want to carefully monitor and control issuances to be compliant with the conditions for reliance on Rule 701 under the Securities Act of 1933, as amended, to avoid registration requirements.