June 5, 2024

How to Build a Legal Strategy for a Token Project

TABLE OF CONTENTS

This article provides a high-level guide that outlines all the criteria required to analyze and strategically plan token releases. The guide will explore the different types of tokens and use cases of tokens, along with various methods of minting and distributing tokens. Based on the criteria that will be covered in this article, founders can use this article to help them do two things:

  1. Identify if their token release can be characterized as a centralized token release or a decentralized token release
  2. Understand what sort of legal strategy they need to take (hint: the legal roadmaps for centralized token releases look very different compared to decentralized token releases)

This article serves as a foundation for exploring token issuance in the context of legal requirements, regional and global compliance requirements (if applicable), and the best legal practices for effective token legal structuring. We will analyze token projects using five key criteria, to help determine if a token issuance legal strategy is centralized or decentralized. Then, we will explore possible token release strategies and the legal work required for the implementation of each identified strategy. 

This guide is brought to you by the team at Legal Nodes, including co-founder Nestor Dubnevych. Legal Nodes is a platform for tech companies operating globally and helps startups establish and maintain legal structures in 20+ countries.

Please note: none of this information should be considered as legal, tax, or investment advice. Whilst we’ve done our best to make sure this information is accurate at the time of publishing, laws and practices may change. For help with the legal structuring of your project, speak to us.

4 legal challenges that Web3 teams face before token issuance

When a Web3 team is approaching the token release stage, two distinctive legal needs arise. These are registering a company to issue tokens and developing documents for the tokens’ distribution.

However, often after starting work on these legal tasks, Web3 teams are faced with the following legal uncertainties:

  1. How can they ascertain if the legal status of the token will be deemed a utility token or a security token?
  2. Which jurisdiction should they choose to register their token issuance company?
  3. Should they register an LLC or a foundation for their token issuance?
  4. What are the requirements for conducting KYC (Know Your Customer) checks when selling tokens?

The importance of legal strategy for token issuance

A founder’s instinctive response is to search for answers to these legal questions. However, finding accurate and helpful answers to these questions is only possible if the founder has a deep and clear understanding of the business practices found in the token project market.

Taking into consideration what utilities (use cases) will be assigned to the tokens, how the token cap table will be structured, and what the methods of token distribution will be (direct vs via intermediaries, paid vs free, private vs public, etc.) will all impact the legal requirements of the project. Ultimately, these factors will dictate which legal strategy of token issuance should be followed: centralized or decentralized. Once these business practices are understood and the legal strategy is determined, founders will find it much easier to find answers to their legal questions.

The legal strategy will outline all the possibilities (both preferential and disadvantageous), for choosing jurisdictions, entity types, documentation and compliance measures that will collectively ensure a successful token issuance.

Centralized vs decentralized token issuance strategies

The legal strategy for issuing tokens is built on the basis of five key features (criteria) for analyzing the token project:

  1. Utilities (use cases) of the token
  2. Technical layers of the Web3 project, within which tokens are issued and operate
  3. Process of initial token minting and distribution
  4. Token cap table
  5. Marketing and promotion of token distribution

We will now analyze each of these five criteria in turn. Additionally, further exploration of each criteria will be published in separate articles. Look for links to these articles in the relevant section.

1. Token utilities (use cases)

Previously, the legal status of a token was determined by analyzing the various rights that a token granted to end users. The list of rights was quite diverse and included:

  • Access to software
  • Gas fee
  • Voting rights
  • Dividends
  • Securitization (tokenization) or real-world assets (RWA)
  • Loyalty program points
  • MEM tokens
  • And more…

Depending on the rights that the token granted, tokens would then be qualified as utility tokens, security tokens (financial instruments), payment tokens (eMoney), and so on.

This approach was relevant between 2017 and 2020, when DLT was still in its early stages, and foresaw a classic centralized release of tokens called an initial coin offering or ICO (learn more about this in our article on the legal status of tokens). During this same period, the first regulatory explorations (and explanations), along with court cases, began to appear, all of which were trying to determine the legal qualification of tokens. Over time, these emerging legal qualifications of token types were applied to ICO campaigns.

However, if we fast forward a few years, decentralized technologies have evolved a lot, and Web3 projects have become a lot more complex in terms of their technical layers. This, in turn, has added additional criteria for the legal qualification of tokens besides just the tokens’ utilities, among which are two key questions:

  • Which technical layer of the Web3 project does this token have utilities in (where/how is it being used?)
  • How exactly was the token initially minted and released? 

2. Technical layers of the Web3 project where different tokens are issued and function

In previous articles, we analyzed various technical layers of Web3 projects (blockchain layer, protocol layer and dApp layer). These analyses include an examination of the legal status of each layer, and the various approaches to their legal structuring. As tokens on the different technical layers often have different use cases and applications, the different utilities of each token can affect the legal status of the token, too. 

For example, a native token within a blockchain network, which is used by builders to pay the gas fee of the network and support the PoS consensus algorithm, is highly likely to be viewed as a utility token. However, a token at the protocol level that has been launched on top of a blockchain network (in other words, it is a token within the project’s “settlement layer”), then the token utilities are more likely to be recognized as governance. This is because the token is being used to incentivize users to use the protocol more actively (through various staking / yielding mechanisms); for structuring token-based DAO membership; and for launching proposal-based decision-making.

Lastly, a token at the dApp level that is used for hedging the volatility risks of other cryptocurrencies (it has a peg / fiat backing), or is a tokenized RWA (for example, tokenized real estate), then this token is likely to be considered a payment token (eMoney) or securities token, as it is tied to a centralized backing.

3. Process of the initial token minting and distribution

The emergence of decentralized technologies in recent years has served to advance token use cases within the various technical layers of Web3 projects. Additionally, the evolution of these decentralized technologies provided more ways to mint and distribute tokens, instead of simply using an ICO. From 2020 onwards, other types of token distribution methods began to appear on the market, including IDOs, launchpads, fair token launches, etc.

Consequently, The process of the initial token minting and distribution has become an additional criterion when performing an legal analysis of a token. This is because the following questions have emerged, such as:

  • Was the genesis token release planned or not?
  • Who specifically controlled the wallet with pre-minted tokens?
  • Who priced the token?
  • Who will make decisions about the distribution of tokens among different pools?
  • Were tokens distributed directly from pools to end recipients or through intermediaries (DEXs, launchpads, LBP)?

The answers to these questions contain important details required for analyzing who had the technical and market ability to manage the tokens and—as a result—who could be considered as an ‘insider’ of this process, and hold a potential ‘unfair competitive advantage’. This leads to the recognition of these insiders as a ‘common enterprise’, and the tokens themselves as ‘unregistered securities of such enterprise’.

Further analysis of the legal implications of different types of token distribution are explored in our article on Token Distribution Models.

4. Structuring token pools in the token cap table

Project teams should always be wary of any situation where they might be deemed ‘insiders’. Another instance in which this may happen is when the team is structuring token pools via the Token Cap Table, and managing the process of each pool.

The reason why structuring token pools is another important criterion for token qualification, is because it allows us to understand the level of ‘decentralization’ of the management process of the intended tokens. The allocation of tokens among the different pools can indicate if any parties have control over a significant portion of tokens. So, if it is clear that the project team or any other centralized 3rd parties do control a significant part of the tokens, that can contribute towards the qualification of the team as a group of project ‘insiders’. To mitigate any risks, the token pool (the token cap table) should be balanced, so that tokens are proportionally distributed among the different participants (stakeholders) of the ecosystem.

5. Marketing and promoting token distribution

Marketing of tokens and any activities used to promote tokens are another important criterion of token legal analysis.

In particular, the following three areas of token marketing and promotion need to be examined:

  1. How the token is positioned in the project (indicated by how it is marketed/promoted)
  2. Which laws apply to token distribution (indicated by which user market(s) are targeted by the project) 
  3. What consumer protections might be triggered (indicated by user expectations created via marketing/promotional campaigns)

Let’s explore each of these in turn.

Token positioning

How was the token marketed and promoted? What does this tell us about how the token is positioned in the project? Why does the positioning of the token matter?

The positioning of the token affects the expectations of the recipients or buyers. In turn, this affects the legal qualification of the token, which will be based on the regulatory requirements applied to financial promotions, marketing of financial instruments, etc.

Target market

How exactly was the token marketing campaign organized? Which markets were targeted, and across what communities, jurisdictions and user groups? Which market users is the project targeting, and consequently, which law(s) apply to the token distribution process?

If the campaign was targeted, and included local languages, media, and direct advertising, then this will be the basis for applying the law of the country where the campaign was targeted.

If the campaign was not targeted, and could be described as community marketing, then it will be considered a borderless campaign. In this case, the country where the entity that organized the borderless campaign for the distribution of tokens (Token SPV or protoDAO) is registered should be identified, as it is that country’s regulations that must be taken into account.

Consumer protections

Finally, the criterion of the token recipients’ expectations, which were formed following the promotional campaign, must be considered. 

If in the future, expectations differ from what the token actually represents, then this will have legal consequences for the organizer who distributed the token, as they will be viewed as ‘deceiving buyers’. For example, if a team promised users the possibility of using the token in the protocol immediately after receiving the token, but the protocol or product simply isn’t ready yet, then this could be qualified as violation of the users’ consumer rights.

Additionally, if there are calls to action (CTAs) and any other types of promises and calls to buy or calls to invest in tokens on the project's website, then this be evidence that the project team had the specific intention of using the tokens as a financial / fundraising tool, rather than as a tool for building and incentivizing the network (a community building tool). Based on this, the token can be reclassified from a utility token to a security token.

Centralized and decentralized token release strategies

Based on the five criteria that we have just analyzed above, we can now clearly differentiate centralized token release strategies and decentralized token release strategies.

In a centralized token strategy:

  • The token has service-financial utilities, as: it provides access to the use of software or gameplay / is used for in-app or in-game purchases; has real-world asset security / fiat peg / gives dividends and investment increase; and (usually) the token is issued within the framework of the dApp layer of the Web3 project
  • The team releases tokens and controls the wallet of minted tokens
  • The team prices tokens, in other words, they determine the token sale price
  • The team controls a significant portion of the tokens in the treasury
  • The team markets tokens by targeting specific markets for the purpose of attracting investment for product development

In a decentralized token strategy:

  • The token has protocol-management utilities, as: it is used as a gas fee to incentivize stakeholders who support the consensus protocol of the decentralized network; used for staking / yielding mechanisms; and used for structuring DAO membership and proposal-based decision making)
  • Tokens are issued autonomously or deployed by the proto-DAO with subsequent autonomous distribution to token pools
  • Token Price Discovery occurs through decentralized market mechanisms such as a liquidity bootstrapping pool (LBP) and an automated market maker (AMM), etc.
  • Token pools are distributed proportionally among stakeholders of the decentralized ecosystem
  • Token promotion campaigns are organized through the community and are borderless, as they lack any targeting of specific jurisdictions

👉Learn more: Progressive Decentralization: a Legal Playbook for Web3 Builders

What are the legal tasks required for each token distribution strategy?

In the final section of this article, we will now determine the list of legal work that needs to be done for a project to implement their chosen token distribution strategy.

As a general rule, should a team choose a centralized strategy for their project, it is worth considering the issue of regulated tokens, which necessitates the following legal tasks:

  1. Registering a Token SPV in a token-friendly jurisdiction
  2. Obtaining Token Regulatory Approval to obtain the right to issue a certain type of token
  3. Obtaining VASP or CASP authorization to obtain the right to sell the issued token
  4. Implementing financial compliance measures (including KYC, AML) for all token sales

Should a team choose a decentralized strategy for their project, then decentralized token issuance is possible, and will involves the following legal tasks:

  1. Registering a legal wrapper for a proto-DAO, which will deploy tokens and affect their subsequent autonomous distribution
  2. Public disclosure of token-related activities, including the token cap table, token pools, and distribution plan
  3. Preparing T&Cs for the token distribution campaign (whether that is an LBP, Airdrop, or launchpad) and also preparing legal disclaimers for the website
  4. Setting up restrictions and geoblocking jurisdictions that have degrees of regulatory uncertainty over decentralized token launches
  5. Registering a Foundation for holding the token treasury on behalf of the community (DAO)

Build your token legal strategy with help from Legal Nodes

Any Web3 project team that has plans to issue tokens, or is simply exploring different options for possible future token releases, needs to think carefully about the legal implications that their token strategy could trigger.

By having a clear understanding of the five criteria that influence the legal status of your tokens and token utilities, you can:

  1. Identify if your token issuance will be centralized or decentralized
  2. Identify any areas of risk, such as where a team might be considered an ‘insider’ or where consumer protections or certain jurisdictional laws mighty apply
  3. Take proactive steps to create a robust legal structure that will support you through a compliant token issuance process

The legal works needed to ensure a compliant token issuance journey are vastly different for centralized models and decentralized models of issuance. Within both roadmaps are a set of steps that can materialize into very different actions for different projects, depending on which jurisdictions entities are registered in, which authorisations / restrictions need to be put in place for jurisdictions, and which documentation is best for each step.

At Legal Nodes, we help Web3 project teams get an international perspective on all their legal options for their token issuance. From drawing up the right documents, to consulting with the right industry experts, we help teams discover their options, identify risks and obligations, and fulfill all their tasks. We do all of this via a single platform that integrates service providers working around the globe to help you build with confidence. Speak to us today to get started.

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