The Empire Strikes Back: Traditional Debt and Equity Capital Providers Get Smart(er) About Token Sales

With thanks to Greg Murphy of Outlier Ventures for his contribution to this article.

Now that 2018 is well underway, traditional debt and equity capital providers would be wise to re-examine many of their familiar forms of contracts to identify new risks – and realize new rewards – that token sales (also called initial coin offerings or ICOs) may create.

New Potential Rewards, New Potential Risks

As has been reported widely, more and more early stage companies, and, increasingly, more established businesses, are taking advantage of a new form of capital raising; namely, developing and selling digital tokens.

Token sales enable entities to raise money without having to sell equity (which often requires founders to cede aspects of control and economic rights) or incur debt (which typically would restrict the company’s activities and require repayment).

Token sales enable entities to raise money without having to sell equity #ICOClick To Tweet

The very nature of digital tokens provides token sellers with tremendous flexibility in terms of structuring the bundle of rights that holders of a particular token may or may not have.  For instance, token sellers may create tokens that have attributes typically associated with debt or equity, some that look more like software licenses, as well as many other token types.

Given their frequently international nature, many token sales are likely to implicate a broad (and sometimes nearly global) scope of regulatory frameworks, including, among others, securities, tax, financial services and money transmitter, sanctions, investment company and investment advisor and broker-dealer laws and regulations. 

Token sales also generally are subject to anti-fraud, good faith and fair dealing requirements. While many of these legal and regulatory considerations exist in the context of traditional debt or equity issuances, token sales typically do not correspond one-to-one with those familiar capital raising structures and may raise unique questions for which the answers are unclear.

While token sales may provide certain companies with an innovative avenue by which to distribute their products and services, as well as raise capital, they also may raise token sellers’ risk profiles in ways that some debt and equity investors may not have anticipated or priced-in.

In 2018, many existing and would-be token sellers, as well as their investors and other capital providers, would be wise to take a close look at the terms of their equity and debt agreements in light of the token sale market.  Hopefully, before any disputes or potential liabilities have arisen.

many existing & would-be token sellers would be wise to take a look at the terms of their equity & debt agreementsClick To Tweet

Equity Investors Think It Through

Some shareholders and venture investors, who historically may have relied upon more typical pre-emptive rights and other anti-dilution provisions or covenants to restrict or limit a company’s ability to issue additional equity, may have been dismayed to discover that they did not have specific consent or veto rights that would restrict, police or otherwise govern the company’s ability to launch a token sale.  Similarly, many negotiated restrictions on the company’s ability to incur debt or undergo fundamental changes may not have contemplated or prevented the company from consummating a token sale. 

Why might an equity investor care? 

In addition to the much-discussed risk that a given token sale may be a sale of securities, a given token could be structured to provide the token holders with rights commonly associated with equity or debt, including certain voting and economic rights. 

In addition, the post-token sale company may be subject to unforeseen risks and liabilities as a result of the token sale itself.  For example, a token seller may fail to carry out proper know-your-customer and anti-money laundering checks during the token sale; may fail to comply with sanctions and terrorist financing laws; or may fail to register as a money transmitter if required by law to do so.  In addition, certain token sales may cause a heightened litigation risk or may result in unexpected adverse tax consequences.    

Just as importantly, some investors that may have entered into SAFEs (Simple Agreements for Future Equity) or received warrants may have been surprised to discover that certain token sales may not have constituted liquidation or liquidity events or investments under certain of those SAFEs or warrants.  Complications also may arise in the context of convertible debt issuances.

Now that investors with bargaining power know better, token sale-specific provisions are likely to be front-of-mind and are beginning to appear in term sheets.

Customary Debt Provisions Are Re-Examined

Much debate has occurred over whether a given digital token is a security, but implications go beyond securities law analyses.  The nature of the tokens and the sales are relevant under many credit facilities, as well.

For instance, many traditional secured lenders typically restrict or limit, through covenants, representations and events of default, the ability of a borrower to incur additional debt, issue equity or undergo fundamental changes (such as changes of control, mergers, sale of all or substantially all of the company’s assets, etc.). Many of those same debt documents also require mandatory prepayments in the event that the borrower receives proceeds, for example, of equity or debt issuances or certain asset sales.

Is the sale of a given token (which is software) like a sale of inventory under the relevant debt documents, or is it more like a pre-sale of services or goods? Alternatively, is it more like a sale of equity, or a debt incurrence? Lenders and noteholders are likely this year to re-examine their forms of debt agreements, to make sure that proceeds of token sales, and, perhaps more importantly, permission for token sales, are addressed in a manner that protects the credit providers.

Similarly, token sellers that also may be borrowers under credit facilities or issuers of notes need to be mindful of the restrictions under their debt documents.  For example, does a token seller need to prepay its outstanding loan with the proceeds of its token sale?  Does the token seller need to request consent in order to launch a token sale?  For a company that may have an outstanding loan secured by all assets of the company, does that mean the secured lender will have a security interest in any tokens developed or sold by the company? Could a token seller unwittingly breach its ’40 Act (i.e., Investment Company Act of 1940, as amended) representation by selling tokens that are securities?

Some Traditional Players Look to Expand Their Horizons

In addition to identifying risks, however, many traditional debt and equity capital providers are likely to recognize and welcome the potential new benefits that token sales can create.  For example, beyond merely raising money, the sale and distribution of a given company’s digital tokens may lead to faster and more widespread adoption of that company’s products or services.  Token sellers may be motivated to develop certain projects more quickly in order to launch token sales and benefit from those potential blockchain network effects.

many traditional debt & equity capital providers are likely to recognize the potential token sales can create #ICOClick To Tweet

Indeed, debt and equity providers appear to be discovering new opportunities for themselves in the token sale space.  For instance, we are starting to see some of the more traditional capital markets players (such as underwriters and bookrunners), many of which were somewhat or entirely disintermediated from last year’s token sale process, begin to contemplate providing marketing and sales services in connection with certain token sales, particularly in the case of self-described security tokens.

This year, we are likely to see the development of new contractual provisions that contemplate the ability (and negotiated rights) of certain capital markets actors to play lead arranger and other similar roles not just in debt, equity and hybrid (debt/equity) financings, but also in token sales.   Many familiar concepts are likely to be reimagined.  For instance,  some “alternative transaction fee,” “right of first refusal” and exclusivity provisions may be expanded to refer also to digital token sales, and certain “change of control” definitions also may be modified.  Perhaps one day “flex” language, common in leveraged financing fee letters, will begin to include the ability to flex all or a portion of a given facility to a sale of tokens.

While no one knows for sure what 2018 will bring, wise market participants and their lawyers will be re-examining their contracts.

This article is not legal advice or investment advice and should not be relied on as such.  In addition, the views expressed in this article are the author’s own and may not necessarily reflect the views of her employer.


Joshua Ashley Klayman, chairs the Wall Street Blockchain Alliance’s Legal Working Groupand frequently speaks and publishes about blockchain technology, smart contracts, cryptocurrency and tokens sales (initial coin offerings), among other topics.  Klayman’s clients have included investment banks, other financial institutions and issuers (including token sale issuers); private equity, venture and hedge funds and their portfolio companies; major publicly traded organizations and emerging companies. Klayman regularly represents lenders and borrowers in leveraged finance transactions involving senior, mezzanine and subordinated debt and equity offerings and co-investments, as well as in general lending matters. In her corporate practice, Klayman represents public and private organizations in a broad array of commercial transactions (including mergers and acquisitions, as well as royalty purchase and licensing transactions) and corporate governance matters.

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