How a sensible ICO regulation could boost the next wave of DLT innovation — Part II
In the second part of the topic regarding the ICO and how credible regulations could affect it in a positive way, we try to give a deeper and better understanding of the main issues related to it.
As a matter of fact, the current degree of trust in initial coin offerings is close to zero, and it will remain at this level until clear rules are in place. In 2017 and 2018, the team of VCLAW encountered the chaos surrounding the early-stage blockchain-based projects. This required us to analyse the innovative funding models in the context of the existing laws having no exact definition for most of the created digital assets. Back then, the token buyers didn’t ask many questions as the hype was in its prime. Now the time for introducing certainty for all parties has come. In the previous Part I, we described the core pillars of an efficient and credible regulation that would be suitable to address most of the issues that we identified so far in the crypto industry. Every regulatory body shall conduct a thorough but preliminarily established and transparent due diligence process to achieve this. Everyone needs to know what is expected to be covered as a requirement to ‘tick the boxes’. Accordingly, this article aims to make a short overview of the initial part of this due diligence and the analysis of the project’s structure from a legal standpoint.
WHAT IS THE LEGAL STRUCTURE OF A PROJECT?
For the purposes of this article, we shall assume that the project is started by an enthusiastic team that is gathered around the vision to create something new and not by an established company. In this way, we are not getting into the details of classic due diligence going through the legal and financial history of the respective entity. However, it is crucial that the relations between all parties involved in the creation and execution of the undertaking are evidently structured consistently with the core necessities of the entire concept. To avoid the vagueness of the “Legal Structure” notion, we need to list the following most essential points to be reviewed:
- Corporate and shareholding structure;
- Agreements between the co-founders and employment agreements;
- Contracts with Investors;
- Existing or future agreements governing the intellectual property aspects;
- Preliminary or existing agreements with other counterparties (services providers, suppliers, rental and other contracts).
The significance of the above points is clear when it comes to equity investment. Of course, one may argue that this approach does not apply to ICOs. Still, the history of multiple projects crashing showed that the lack of transparency affected the ability of token buyers for a proper assessment of the project’s viability. The trough is that we were ‘throwing our money from the terrace’ without even knowing if there is a company behind the ICO. Furthermore, legal relations matter when it comes to the engagement of everyone involved in making all that has been promised come true. On the other hand, the transparency ensures that the use of proceeds gathered in the ICO process will be as planned, and there are no arrangements that affect the stability of the project and the interests of the token holders.
HOW THESE DIFFERENT POINTS AFFECT THE TOKEN HOLDERS?
As mentioned in the previous publication, we are against a lengthy and unnecessarily heavy regulatory assessment process for each project. However, there shall be a unified framework of agreements and corporate documents to be reviewed by the regulator for the sake of transparency. It is crucial that all team members have a long-term dedication throughout the execution phase. There are precise motivational vesting models based on achieving the agreed milestones corresponding to the project’s purposes. It is also essential to consider any bonus or dividend-related systems and policies that shouldn’t contradict the common goals and general token distribution and value preservation. This applies especially to tokenomics game plan where the increase of the value of tokens is expected to be driven by business activities which is the case of payment tokens for services and use of platforms. If some of the founders or their counterparties are ‘draining’ the system while taking dividends or high salaries (in tokens or fiat), it may endanger the project’s integrity.
It is commonly known that every project needs initial boosting from various source of funding to reach the point of conducting an ICO. In case that we have an established and appropriate regulation enacted, the venture capital and other investors will most probably immediately back enterprises aiming to accomplish creative tokenomic models driven by the value generation processes. The tricky part here is that the contracts signed between investors and founders often have multiple limitations to the abilities of the latter to operate the business as they deem appropriate. Such restrictions may nullify some of the arrangements displayed in a whitepaper or agreed to with the token purchasers. It is worth pointing out that sometimes the excellent tokenomics models are contrary to the conventional profit generation and distribution systems. A comprehensive regulatory review of these relations has to establish that everything stipulated with equity investors is in line with the entire tokenisation concept, and no harm to token holders is or may be done.
In most DLT based projects, intellectual property is the main asset as they primarily consist of online-based platforms (even in alpha or beta version) and anticipate developing complex technology solutions. Sometimes the IT infrastructure is created under the conditions of partnerships and other forms of collaborations. Moreover, the involvement of third-parties service and software providers may endanger the independence of the undertaking unless suitable legal measures for the prevention of such a blockage are in place. In this regard, infringement of third-parties’ rights may also occur when any software is used without proper authorisations and licensing. Therefore, preservation of the core asset is also necessary for securing that it will stay in the company, and the venture will be able to continuously operate without the interference of IP-related claims.
Legal structures may not be as exciting as the well-presented tokenomics models and technological innovations. Still, they are the means to make these two essential aspects work most securely for everyone involved in tokenised undertakings. Nobody should be willing to bear the risk of buying tokens if there is not a solid contractual and corporate framework to ensure that the assets of the company behind the venture and its relations with third-parties are protected accordingly. We often hear that the prices of virtual currencies are based on “thin air” and market speculation. Nevertheless, when the initial legal framework of the project is formed legitimately, this enhances its credibility and ability to achieve its goals. Nothing can indeed prevent the occurrence of events that will hinder the projects as all commercial risks are always there. However, every token holder needs the certainty created by the knowledge that all rights and obligations surrounding the undertaking are in line with his/her interest, and there are no hidden pitfalls on the way to the bright future.