A Utility Token Primer
Over the past 18 months ICOs — or Initial Coin Offerings — have emerged as a leading funding source for technology startups focusing on distributed ledger technologies like the blockchain. What’s more, the traditional uses cases, FINTECH on top of the blockchain, have morphed into technologies focused on IOT, security, the legal profession and healthcare.
Many startups seeking seed capital have taken the ICO route. In 2017 Tezos, a blockchain company, raised approximately 250 million dollars in an ICO round lasting one month. Later in the year FileCoin raised 270 million dollars. Overall, ICOs raised three-quarters of a billion dollars in seed capital.
How did they do it? Did they abide by Securities and Exchange Commission (SEC) regulations?
When raising capital through the ICO market each NEWCO has three choices: abide by SEC regulation related to the Crowd Funding and Jobs act and issue a traditional debt instrument or equity; roll the dice, issue the ICO and hope that the SEC ignores the details; or they can issue an instrument that we’ll call a Utility Token.
The utility token is a new type of software that will revolutionize the distributed, decentralized deployment of computational assets. To read more about tokens I refer you to Balaji Srinivasan’s seminal article on the subject. https://news.earn.com/thoughts-on-tokens-436109aabcbe.
This document offers a framework supporting the sale of a blockchain utility token to the general public. We focus on the creation of utility tokens here for two reasons. First, a utility token, when constructed properly should not be considered a security or a tokenized security and thus should not be subject to US security and exchange laws.
Second, a utility token adds blockchain strength and distributed ledger technology features to the software/service platform through which it is issued. The utility token only has value on that platform and is used to consume products and services that the issuing platform provides.
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We constructed this primer to help you formulate your strategy for structuring a crowd sale for your utility token while providing you with tips on how to inform and protect the buyers of your proposed token. The guidelines in this document are not designed to support every utility token sale but we believe that we’ve provided a framework for the reviewer to pick and choose what fits their blockchain enabled product offering.
Remember to hire and work closely with a legal advisor throughout the utility token life cycle. First and foremost, you must ensure that your utility token distribution scheme is not deemed to be a security AND does not run afoul of your country’s security/exchange legislation. In the case of US companies, we refer you to the Howey Test (http://consumer.findlaw.com/securities-law/what-is-the-howey-test.html) when constructing all token sale documentation.
Throughout this document we refer to the legal entity offering the token as NEWCO and will, at times, refer to the utility token being offered as NWCO — it’s common for a three to four letter abbreviation to refer to a utility token.
So, onto the guidelines. We hope this document helps you decide whether a utility token is right for your NEWCO and if so, how to ensure that the presale preparation supports your successful token launch
White Paper
Publish a detailed white paper that provides the customer or potential token buyer with a deeper understanding of your platform implementation; particularly why distributed ledger technology is an essential part of your platform.
In the White Paper:
· Describe the protocol and the network you will be creating or with which you’ll be integrating
· Define the problem space. Describe how the NEWCO platform satisfies token holder’s needs and map features to need.
· Identify a clear and compelling reason for blockchain integration and why the token is an essential part of that reason.
· Provide a detailed technical description of the proposed implementation highlighting use cases, screen shots etc.,
· Set clear expectations for total token supply and distribution.
· Have one or more independent experts review the white paper
The NEWCO white paper defines the platform, the network and its use cases. It is critical for token buyers to understand the characteristics and functionality of the token they are purchasing, the challenges and risks of development, and the benefits of using the network.
Product Roadmap
During the NEWCO Token Presale, commit to a development roadmap that defines feature/function, value proposition and timeline. The following should be considered when constructing the road map:
· The roadmap should be detailed enough to instill confidence in the NEWCO token.
· Break the roadmap into 1 or more phases. Include estimates of time and investment in each stage of the project.
· Define each stage at a high level only.
· Include a breakdown of estimated expenses/burn rate by stage. Do not make this too detailed.
· Allocate the proceeds from the NEWCO token presale to each product development phase. Consider language that restricts access to funding until the previous stage’s milestones are achieved.
· Consider offering Token holders voting rights to release funds across the 2nd-Last phase of the product plan.
· Identify key team members and advisors. Provide a link to their CVs.
· Clearly explain the token ‘cap table’ and any other compensation paid to key members of the development team and advisory board. Explain any/all vesting requirements of the team.
· Call out early contributions of members of the development team and advisors in order to instill confidence in the NEWCO project.
· Between sale and launch of the network, report back to token holders periodically on progress against the development roadmap. Use social media, webcasts/conferences, blog posts to promote and maintain interest in the NEWCO platform.
·Set aside a block of tokens for:
New development team members and/or advisors
Independent security audits
Affiliates/promoters
Bug bounty programs where early adopters are rewarded for testing
A clear development roadmap provides NEWCO token holders with the confidence that the proceeds of the sale will be properly used for the project and that the platform WILL be launched, which in turn, adds value to the NEWCO token.
Setting aside funding for each stage of the project helps establish structure and permits buyers to assess the probability of a successful launch. Using blockchain features to restrict the development team’s access to funding can deliver more transparency.
Members of the development team and advisors should be paid full and fair value for their services, through a combination of money and tokens, although that can be up to negotiations between NEWCO and the ‘team’.
Quantifying the value of contributions, especially early contributions (pre-crowd-sale) provides transparency. Identifying the development team and advisory board enables potential buyers to assess the credibility of NEWCO and its potential for success.
It reduces the likelihood of fraud, particularly when the NEWCO token sale occurs before the platform is deployed in a production environment and is capable of ‘consuming’ NEWCO tokens.
Consider the Blockchain
Use an open, public blockchain and publish all presale contract source code. This allows the NEWCO token customers to understand the terms and conditions of a presale and provides transparency for auditing the sale throughout the life cycle.
· Consider using an open and transparent blockchain to support the NEWCO token presale. Blockchain implementations like: Ethereum, Waves or Dragonchain would be suitable hosts for a presale.
· Choose open source software to implement the smart contract upon which the tokens will be allocated. For example: Solidity on top of the Ethereum blockchain.
· Use a well-known token contract standard like ERC20. There are several well vetted ERC20 compatible wallets that will support your token.
· Commit to and undertake an independent security audit before launch
Building with open source software and using an open, public blockchain provides transparency, enables real participation from token holders and independent developers, allows for auditing, and helps counter any fraud concerns.
Price the Token
Price the NEWCO token fairly. There are a number of pricing methods: fixed initial price, Dutch auctions, proportional pricing etc. However, it is critical that:
· Define the maximum number of tokens that will ever be offered. This is referred to as a Capped Token Supply.
· You define the maximum number of tokens to be offered to the public during the crowd sale.
· Price fairly and evenly throughout the sale. Don’t offer discounts for early tranches. Ensure that all token holders hold a token with the same value.
· Set a MAX CAP for the total amount (denominated in the currency of choice) you expect to sell
· Set a MIN CAP amount (the minimum you must sell) and provide a method to refund all purchases if the MIN CAP is not met
· Denominate the token in another cryptocurrency like Bitcoin, Ether or Ripple.
The total proceeds from a crowd sale must not exceed the estimated costs of development. A crowd sale should be capped at the number and price of tokens required to raise this amount. Setting the price in a single currency reduces the potential for price confusion and arbitrage.
Allocate Tokens
Determine the percentage of tokens set aside for the development team
Decide on the percentage of the total token supply that will be allocated to each of the key NEWCO stakeholders. Construct a vesting schedule that provides adequate liquidity to the token holder yet, in the case of key personnel, awards them for their continued efforts on the NEWCO project.
· Founders — allocate tokens to the founding team that is commensurate with their contribution based on platform valuation presale.
· Developers — set aside and/or award tokens to the development team, or those contributing to the evolution of the platform.
· Advisors — compensate advisors for any/all work performed.
· Treasury — establish a pool of tokens not awarded to an individual but stored in the Treasury and available for future use.
· General Public — define the number of tokens that will be offered during the crowd sale. The General Public immediately vests — all NEWCO tokens are liquid upon distribution.
Placing too many tokens in the hands of the founders, the development team and other contributors might create the perception of a network/platform controlled by a small group. It’s important to sketch out the ‘token cap table’ that divvies token ownership amongst the NEWCO stakeholders.
Vesting the development team over time aligns their interests with other token holders over a longer period of time. For example: Bob, a NEWCO developer is awarded 1000 tokens of which 25% vest immediately as a reward for work done thus far. The remaining 75% are awarded in equal increments on the 12-month anniversary of the previous reward.
Slowly releasing tokens to the NEWCO development team over time also reduces the supply of ‘useable’ tokens within the market thus preventing a dramatic drop in initial token value.
Prepare the Crowd Sale POS Platform
You’ve probably been thinking about how you’ll take fiat currency or cryptocurrency as payment during the crowd sale. Moreover, we’ll need to track who owns what, how many tokens they’ve purchased, how we’ll contact them in the future and most of all, what to do with the currencies that have been deposited.
We refer to this as the the Token Point of Sale Platform (TPOS). Similar to an ecommerce shopping cart the TPOS provides customer, inventory and ‘cash’ management functionality to support the purchase and distribution of tokens.
While we won’t discuss the mechanics of the POS platform — we do that in our guide to Building a Token Sales Platform — however it is important that we outline a few critical steps in consummating the transaction:
· KYC (Know Your Customer) — It’s essential that you collect as much user information you feel is acceptable to your customer. At the very least you should collect: Full Name, Full Address and a Validated Email Address.
· Accepting Crypto — it’s likely that you’ll want to accept a cryptocurrency for payment and therefore it’s essential to factor in a product like BitPay to allow users to ‘checkout’ and purchase their tokens.
· Auditing & Reporting — you’ll need to maintain impeccable audit controls in order to ensure that tokens are distributed accurately.
· Terms and Conditions — a document must be constructed that details the terms and conditions of the sale. We provide a template of that document in our Building a Token Sales Platform Guide. The user should be asked to accept the terms and conditions before completing the purchase transaction.
· Confirmations — a confirmation document must be sent to the token purchaser that validates what was purchased, in what currency and the amounts of each.
· Build the Smart Contracts — build the smart contract code that supports the Utility Token offering. This can be done on one or more blockchains (e.g., Ethereum)
· Invest in Security and DDOS Protection — insure site security and site uptime by subscribing to SaaS products like Cloudflare.
This is a relatively complicated process and unfortunately not something that can be purchased off-the-shelf, however it is possible to modify a number of standard shopping cart applications to support the transaction.
It is also a good idea to build a relationship with one or more cryptocurrency exchanges in order to handle ‘cash management’ transactions — particularly if you decide to maintain cryptocurrency balances.
Marketing the Crowd Sale
This section isn’t designed to advise you how to market the crowd sale — we’ll provide thoughts on that in our document: Marketing Your Utility Token. However, we will provide some guidelines on what you should avoid in your marketing literature, social media posts and website content.
Avoid using investment vernacular or relating the token sale to traditional investment processes. Do not use the term ‘ICO’ or ‘security’ in any of your marketing content. Remove any language that may lead the token purchaser to believe that they’ll have any equity rights to NEWCO.
Word about your token and crowd sale will inevitably be noticed by media outlets looking for a new story related to the blockchain, ICOs and the next get-rich-quick opportunity. Let them use terms that drive potential token buyers to your sale — however — carefully choose your words when interviewed or corresponding with the news media. Your message must match your content and your words should be measured against what we’ve discussed thus far in this document.
Many organizations choose one member of the founding team to address media related issues. This allows for a continuity of message and eliminate the possibility of misstating crowd sale policy.
Marketing the NEWCO token as a speculative investment, or drawing comparisons to existing investment processes, may mislead or confuse potential buyers. It may also increase the likelihood that the token is perceived as a security.
Create a short disclaimer which accurately describes the risks of the tokens, protocols and network. Long, legalistic disclaimers about the risks of investment are not helpful to buyers and may also provide the impression that the token is an investment. Place this disclaimer in your white paper and on your website.
Provide appropriate disclaimers defining the token as a product, not as an investment. Identify the features that the token enables. Identify why the token adds value.
To summarize — in all content that you or your team writes link the tokens value proposition to it’s use on the platform — ask yourself when constructing each paragraph: ‘am I potentially describing a security?’. If you’re unsure, contact your legal team.
After the Crowd Sale
So you’ve had a successful token crowd sale. Now what?
· Begin the Audit — engage a third party auditing firm to review all transactional logs and create an itemized list of token holders, the number of tokens purchased. The audit should also reconcile all POS transactions with all currency and cryptocurrency deposits.
· Test the Disbursement Platform — You’ll need to construct and test a mechanism to transfer NEWCO tokens to purchasers on top of your chosen blockchain. This can be automated, however in order to keep purchasers updated on progress it’s important to provide transfer transaction status updates to all purchasers either through email or on the web.
· Publish the Audit Results — Document and publish the results of the audit. All purchasers should be disclosed anonymously including only their deposit addresses, token amount and time/date of purchase.
· Withdrawal Instructions — Document clearly the steps required to withdraw NEWCO tokens and store them in a wallet of choice. Commonly suggested wallets are MyEtherWallet and MetaMask — both compatible with ERC-20 tokens. Users will be required to provide you with their wallet address — so you’ll need to collect that information prior to disbursing funds.
· Transfer the Token — Build an automated process that moves your token out of your smart contract into each purchaser’s wallet.
· Support the Effort — Provide customer support dedicated to answering audit and withdrawal related questions.
A Lot to Think About
We hope this document has helped you understand the critical success factors surrounding a blockchain utility token sale. In this document we’ve discussed a number of constraints placed on the offeror of the token as well as some of the key assets needed to adequately promote the sale while protecting NEWCO from any liability.
This document was developed by the team from FYNTEK. FYTECK is a blockchain and FINTECH consultancy located in Camp Hill, Pennsylvania. We provide full life cycle consulting services to companies in the FINTECH space and can help you with your blockchain related development needs, including launching your utility token sale.
This document is intended to supplement, not replace, legal counsel. Best of luck in your endeavors.
Contact us at: FYNTEK, 301 Harmony Lane, Camp Hill, PA 17101. (717) 580.4967
