What If They ICO? Investors Seek Veto Power Over Future Token Sales

Venture capitalists are grappling with the complexity of initial coin offerings, adding language to their term sheets and hoping for the best.

AccessTimeIconApr 4, 2018 at 4:00 a.m. UTC
Updated Dec 11, 2022 at 2:00 p.m. UTC
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"I think it's fair to say that ICO-related language is making its way into term sheets."

The comment, made by a partner at a major venture capital firm, shines a light on how traditional investors are tweaking their standard paperwork to deal with how a growing number of companies, both blockchain-based and traditional, are pursuing initial coin offerings (ICOs) as a way to raise capital from the sale of crypto tokens.

The partner, who requested to stay anonymous, said investors are requiring companies they back to agree to some kind of arrangement should the company eventually launch an ICO, and to make sure to have a discussion before the launch about "whether or not this is a good move to support the long-term fortunes of the company."

These new term sheet provisions only started showing up in the last six months, according to several investors contacted by CoinDesk.

It may not come as a surprise given that traditional businesses, such as social media platforms Kik and YouNow, are deciding that a crypto token would benefit their business model. But blockchain-based businesses have also diverged from their initial plans to stay away from token sales – one notable example is Blockstack, which allocated a number of crypto tokens to its equity backers when it decided to run an ICO.

Because of the trend, the National Venture Capital Association (NVCA) recently updated the language in its model certificate of incorporation documents, "to provide investors a veto over token, cryptocurrency and blockchain related offerings," a press release on the update explained.

Several VCs CoinDesk spoke with said they'd seen the NVCA language on the term sheets of newer rounds they were participating in, though not all of those documents added language allowing investors to negotiate their terms if the company was to launch an ICO.

According to another venture fund investor that wanted to remain anonymous, those raising money through the simple agreement for future tokens framework got away with launching without investor negotiations.

"The early SAFTs had very few (if any) governance provisions," they said.

All this reflects a bit of a tension between investors and their investments as it relates to the overlap of equity fundraising and crypto token sales.

What to do? 

The venture fund investor said that initially the potential of token sales was addressed through side lettershttps://www.icemiller.com/ice-on-fire-insights/publications/the-use-of-side-letter-agreements-in-private-equit/ – agreements attached to the term sheet after the terms had been agreed on to interpret, supplement or alter those terms – those these tended to require fairly involved negotiations.

But because of the complicated mechanics of today's crypto token sales, the regulatory gray area that surrounds them and the unknown effects they could have on traditional equity, investors are grappling with how to address ICOs in a more sophisticated way.

Stepping back, until recently, tech companies only really had a couple ways to raise money: sell equity or take on debt.

While crypto tokens have been touted as a way to raise money without diluting anyone's ownership stake of the company – primarily since the companies expect enthusiastic backers to increase demand for the token which in turn brings the company a strong return – the crowdfunding mechanism is still so new that it's an unproven strategy to a certain degree.

This then can raise uncomfortable questions for equity investors.

Veteran angel investor Jason Calacanis spoke to this, telling CoinDesk:

"My advice to founders: selling two different securities at the same time, to two different sets of investors, is a quick way to get sued."

Sure, not all crypto tokens will be categorized as securities, but many function similarly, and as such, Calacanis argued, that the value of the crypto token and the value of the equity will move in opposite directions.

And whichever party is on the losing end is likely to feel "screwed" and take action, he said.

Token strategies

That's why investors have come up with several strategies for mitigating their concerns here.

Although VCs generally didn't want to share the specific language they used within their term sheets or other sale documents that addressed ICOs, in speaking about different models being used, it seems three strategies are shaking out.

These include:

  1. Governance. The approach taken by the NVCA, it requires that investors or the board of directors have an opportunity to vote on any sort of issuance of blockchain-based tokens.
  2. Allocation. This approach reflects an investor privilege that already exists in traditional venture funding, whereby an investor in a company's early round can buy into later rounds if they want. Language in this model would just be amended to include future crypto token sales. At least one new, smaller fund CoinDesk spoke to was taking this approach.
  3. Designation. This approach states that if there's a token generation event, then existing investors would automatically receive a certain amount proportionate to the amount of equity they hold. A large, longer-standing seed-focused VC that's still fairly new to blockchain investing advocated for this approach.

Garry Tan, managing partner at early stage VC firm Initialized Capital, for instance, argues for the latter approach, saying, "Roughly speaking, investors are looking to link equity to tokens, and push for something akin to a pro rata share of the company's pre-mine. Otherwise, the equity doesn't mean much and could be worthless if there is no link between equity and tokens."

But with the definitions of tokens – whether they be securities or utility tokens or anything in between – still opaque, it's been challenging for investors to really get a handle on what's happening.

"I think it's important for an investor to get confidence that the founder has a prudent strategy given all that's up in the air with ICOs," Charlie O'Donnell of Brooklyn Bridge Ventures told CoinDesk.

O'Donnell is following blockchain startups, looking for a place to invest, but said he was unlikely to invest in ICOs.

He concluded:

"ICOs might feel like easy money, but the other thing that founders are short on that kills them is time — and legal battles can be just as costly timewise as running out of money."

Startup image via Shutterstock


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