By Darren Sommers (Principal Solicitor) and Venn King (Special Counsel)
It seems the tech world has gone crazy for Initial Coin Offerings, and why not? A number of businesses have successfully issued Initial Coin Offerings which have generated a substantial return.
Initial Coin Offerings (ICOs) are an issue of tokens by a company which tend to fall under three headings:
- Securities – the ICO is a “security” (eg its terms of issue classify it as a known security, such as a share, option, debenture, warrant, derivative and so on);
- Quasi security – the ICO is not expressly specified to be a security, but has similar rights (looks like duck, quacks like a duck….); and
- Utility tokens – the token is essentially a voucher which allows the purchaser to buy goods and services (usually from the issuer).
While much thought has been given to ICOs, their legal status and the excitement they bring, very little consideration has been given to the impact of an ICO on existing shareholders, including venture capital investors.
Here are some effects which we are seeing:
- Power shift – a successful ICO creates an unexpected power imbalance in favour of founder shareholders vs the typical venture capital investor. Why? Well, the company doesn’t need your money in subsequent rounds so they won’t be as friendly.
- Regulatory uncertainty – regulators are still puzzled by ICOs. Are they shares? securities? financial products? or simply vouchers? Even ASIC is still working that one out. However, regulatory uncertainty creates risk for nominee directors of venture capital investees. The last thing a nominee director wants is ASIC or the SEC knocking on their door.
- Inability to participate in later rounds – some venture capital investors invest small amounts early on to see how a business is progressing, and then reserve the right to have a first go at a later round. However, if the company has a successful ICO, it may not need later rounds of funding. This removes the investor’s ability to increase their investment.
- Anti-dilution triggers – traditionally, venture capital investors seek protection against a later issue of shares at a price which is lower than what they paid. However, these protections may not come into play if an ICO is issued, particularly at a price which indirectly values the company at a lower valuation than what the investor invested at.
- Convertible notes and safe notes – these traditionally convert to equity at the next funding round. However, a funding round may not take place, or may be substantially delayed, if a successful ICO occurs. This may delay conversion or possibly worse (for the investor), allowing the company to repay the convertible note without the investor having the ability to up their percentage of the company.
- No pre-emptive rights – if a company issues shares, then existing shareholders usually have an ability to participate in that issue. However, if a company issues ICOs, then existing shareholders may not have the contractual right under the shareholders agreement to participate – particularly where documentation is already in place and doesn’t cater for cryptocurrencies.
- Liquidation – if an ICO is not a security or share, then it is likely that it is a contractual right, meaning that the holder of the ICO would be a creditor on liquidation/winding up of the company. They would rank ahead of existing shareholders.
So what can you do? Well if you are a venture capital investor then you may need to carefully consider whether you permit your investee company to undertake an ICO. However, the power to block an ICO would assume you have the relevant blocking rights to do so. Most shareholder agreements do not directly deal with ICOs so your power to block them (if that is desirable) may be limited. Now while you can’t change the past, you can change the future. Moving forward you should review your standard investment terms to consider in each case what powers or rights you might want if your investee companies undertake an ICO.
Alternatively, its not all bad, you could participate yourself in the ICO and roll the dice! Who knows, you might make money! But that assumes that your fund documents and your regulatory obligations allow you to do so …. and that’s a whole other discussion.