It is clear with the Tezos Greek tragedy, many Initial Coin Offering (ICO) investors are worried about investing in complex and sometimes shady structures. The founders visiting the Swiss city of Zug to set up their foundation may find their days numbered. The idea to create a Malta corporation and benefit from great local rules is probably going to be viewed as sketchy by investors. Add to this Singapore, Cayman Islands and other smaller nations who are trying to attract the best companies while promising amazing tax benefits or whatever they can come up with.
Corporate Structure Counts
Investors do care about corporate structure, the use of proceeds, how the founders are compensated and the company’s plans. Investors need to make an informed investment decision and this means access to the company’s financial, business and ownership disclosures. This may be true in the last few months with the emerging of the ICO as a new way to raise capital directly from the new minted Bitcoin millionaires. But it seems the music is going to stop for a list of reasons including the SEC starting to look into any company selling self anointed utility tokens to U.S. investors.
Truth be told, investors want it all, amazing returns and protection from scammers and people who are not upfront with the investment opportunity. The SEC has three mandates: protect investors, regulate marketplaces and help small companies raise capital. It is interesting to note that the ICO marketplace claims to have taken on these three important responsibilities without any government oversight and this is why they do not want the SEC to interfere.
Corporate governance has as its roots in the requirement of a transparent and fair system for shareholders. You cannot have corporate governance without the board of a company working for the best interest of the shareholders. Investors who purchase utility tokens issued by corporations are not shareholders and therefore they are not represented by the board of directors and they have no say in how the corporation operates.
The majority of today’s ICOs are corporations. Corporations are governed by the board of directors who are elected by the majority of the shareholders. These directors hire a competent CEO who is in charge of the execution of the company’s mission. Investors who purchase tokens in an ICO, it is clear the token holders are not shareholders even if the tokens are given voting rights on how to operate the company’s service their tokens have pre-purchased. It is possible that the best interest of the utility token holders and the shareholders are in direct conflict.
Conflict of Interest
One example of conflict is the idea to issue a limited number of utility tokens for the corporation to sell and issue no more. This puts a limit on the shareholder’s return because the company has pre-sold the revenue to people who in theory are going to use the service at a later date. This in itself is a conflict and if the shareholders vote out the CEO and decide to issue more tokens what happens? The tokens will drop to the level of the price the service is offered and the initial token holders will sue for breach of contract. The token holders have no voting rights on issuing more tokens, the CEO does have this right.
Continuing on the same idea, in an ICO, tokens are freely tradeable in the secondary market on unregulated exchanges but the shares of the company are not. I have seen many ICOs which issue the same utility tokens to the shareholders of the company thus offering them value on top of the shares they own. The reason this is done is because the shareholder’s return is impaired by the permanently fixed token issuance. Therefore, the logical step is to let them participate in the value generated by the utility tokens. In a way, the company has moved the capital table of the company to the utility tokens.
What if the company is sold for billions of dollars, how are the token holders participating ? They do not receive anything in a sale of the company because they do not own equity. The converse is true if the tokens become worth $5,000 each and the shareholders are not getting any of them. The fixed issuance of utility tokens hurts the governance of the company whose board’s role is to protect the interest of the shareholders.
Ethics Count. Strong Corporate Governance is a Must
The CEO is compensated in cash, stocks and tokens. Which one does the CEO want to appreciate most ? Clearly on the long term if should be the stock but what if the CEO cashes out the tokens and become rich while holding on all of the shares ? This is possible and clearly not in the best interest of the shareholders because the CEO got rich before the shareholders got any value. How do you manage a CEO who can leave with cash in hand while the shareholders are still locked with their investment ?
Ethics are one clear and important role in governance. A company’s brand and reputation demands the highest ethics from the board and the CEO who will lead an organization. In an ICO, it is not clear what is going on behind the scenes. Nothing is really disclosed, financials are closely held and it is not clear where the money is going to go. If the utility token holders lose their money, they will sue for securities fraud and probably win. Anytime, a company sells securities to unaccredited investors without registering with the SEC or using an exemption then the company is automatically liable and must refund in full the investors. How does this help the governance of company ? In the case of securities fraud litigation, it most cases the shareholders will lose all of their money and also sue the officers and CEO for fraud and claim monetary damages. This is a battle where the company is right in the middle of two enemies. There is no winning scenario.
ICOs need strong governance to survive on the long term. There are many ideas being floated but ultimately going back to the simple roots will help:
- The company needs to be a corporation with a list of shareholders
- The company needs a board of directors and a CEO
- The company issues shares to the management and sells shares to investors. Those funds are used to finance the growth of the company.
- The shareholders get to vote on the directors elected to the board
- The directors can replace the CEO at anytime as long as they have a majority vote
When a company issues utility tokens as securities, there are several steps that need to happen:
- Shareholders vote on the token issuance and its relationship to the shares they own
- If the tokens are sold to the general public then they may need to be registered with the SEC or use an exemption
- The token holders may have some rights described in the prospectus which in the case of Regulation A+ is qualified by the SEC
Under this structure both shareholders and token investors have clarity of how the economics of the company will affect them. This should be clearly disclosed in the purchase agreements. Allowing investors to make an informed decision is key for the health of the ICO marketplace. It is time now to consider governance as a key factor for investors.
Howard Marks is the CEO at StartEngine Crowdfunding/Capital, the leader in Online Public Offerings. Marks founded StartEngine with the mission to help entrepreneurs achieve their dreams. Marks is the co-founder of Activision Blizzard and Chairman of Activision Studios from 1991 until 1997. As co-founder, former Board Member, and Executive Vice-President of video game giant Activision, he and a partner took control in 1991 and turned the ailing company into the $30B+ market cap video game industry leader. Marks is the 2015 “Treasure of Los Angeles” recipient awarded for his work to transform Los Angeles into a leading technology city. Marks is also named one of the 500 most influential people in Los Angeles by the Los Angeles Business Journal. Marks is a member of Mayor Eric Garcetti’s technology council. Marks has a Bachelor of Science in Computer Engineering from the University of Michigan. He is bilingual and is a triple national of the U.S., United Kingdom, and France.
Marks is launching the StartEngine ICO 2.0 Summit on November 10 in Santa Monica. The goal is to get the industry together and discuss regulation for a fast growing and exciting marketplace.