On-chain Law Series Part 2: Unbundling Existing Legal Systems and Rebundling Them Into On-chain Law

January 19, 2023
TABLE OF CONTENTS

On-chain Law Series Part 2: Unbundling Existing Legal Systems and Rebundling Them Into On-chain Law

January 19, 2023

How legal wrappers help on-chain entities interact with a real (off-chain) world

What do on-chain and off-chain legal systems have in common and what sets them apart? How are on-chain and legal (off-chain) entities formed within the frameworks of those legal systems? What are the principles that determine how they operate? These are the theoretical aspects we explored in part 1 of our On-chain Law series.

We also concluded that the liquidity currently available in the on-chain world is still insufficient for the Web3 industry to work completely autonomously and self-sustainably. Therefore, in order to attract more liquidity from the real (off-chain) world and speed up the mass adoption of blockchain technology, on-chain entities need ‘bridges’ with the off-chain world to attract additional liquidity from the real world. Today, these ‘bridges’ take the form of decentralized legal structures, which are also called ‘legal wrappers for on-chain entities’.

In this article, we will look at the practical aspects of creating legal wrappers for on-chain entities. We will analyze why these legal wrappers have to comply with both the laws of the countries in which they are created and also with the rules of the blockchain networks where they are deployed and launched. We will explore why legal wrappers for on-chain entities must be compliant in the worlds of both off-chain and on-chain law.

Before we dive into the topic, we would like to give a polite reminder that this article is not to be construed or treated as legal advice or legal opinion. Instead, it’s for informational purposes only. Now, let’s begin.

The process of legal structuring of traditional business projects

Comparing the process of creating on-chain entities with the process of creating legal entities in real (off-chain) life is a suitable place to start with the analysis of the practical aspects of legal wrappers for on-chain entities.

It all begins with a group of entrepreneurs planning to launch a business project, developing the concept of a product they will be selling, and finding their first potential customers. In order for them to be able to accept the first payments from their clients, they need to legally formalize their own business project. For this, the founders need to follow this roadmap:

  1. choosing a jurisdiction for company registration (for example, the US, the UK, or Singapore);
  2. finding out how to register a company, issue shares, appoint directors, open a bank account, etc., in a chosen jurisdiction, and understanding how these issues are regulated by the domicile laws of the countries in question; and
  3. choosing a registration agent in the chosen jurisdiction to help with company registration.

Structuring on-chain entities: how is it different from the registration of real-world off-chain legal entities?

At the same time, in the on-chain world, the process of setting-up an on-chain entity is different. To create an on-chain entity, blockchain founders need to do the following:

  1. choose the type of blockchain in the network on which the on-chain entity will be launched (for example, NEAR, Cosmos, Cardano);
  2. find out how tokens are issued in the selected blockchain network, which models of tokenomics work there, what solutions exist for structuring the system of decentralized governance (in other words, how these issues are regulated by the rules that govern the operations of the chosen blockchain network); and 
  3. develop and deploy a token protocol with smart contracts in the chosen blockchain network. Together, the token protocol and the smart contracts make up an on-chain entity.

Thus, by comparing the process of creating legal (off-chain) entities and on-chain entities, one starts to understand that the Web3 founders are now shopping for blockchain networks to launch on-chain projects in the same way that they used to shop for the best jurisdictions for registering legal entities. The rules of operation of these blockchain networks (on-chain law) are viewed by the founders in the same light as the laws of countries (off-chain law), according to which traditional legal entities are formed.

A comparison between on-chain and off-chain entities' stages of development

Corporate and commercial sides to an entity

Now that we have a high-level understanding of how legal (off-chain) and on-chain entities are created, let us go into more detailed aspects of their work. Our goal will be to find out what is regulated in the process of creating and operating both on-chain and legal (off-chain) entities, as well as how it is regulated. To do this, we will conventionally consider two sides to such entities: corporate (stakeholding, treasury, and governance) and commercial (product, goods, or services that the entity sells and around which a business is formed).

For on-chain entities, this division is as follows:

  • the corporate side of the on-chain entity comprises the token protocol with its own economics (tokenomics), which defines stakeholding, as well as the DAO governance, which regulates the treasury management process. 
  • the commercial side of an on-chain entity, which includes a dApp, a set of smart contracts combined into a product that the on-chain entity sells to its end-users for both its own tokens and for cryptocurrency, all to end up in the treasury.
The corporate and commercial sides of an on-chain entity

How are the entities’ corporate and commercial sides regulated? 

The commercial side of on-chain entities, decentralized apps and their business model that fills the treasury, can be very different, limited only by the imagination of entrepreneurs developing and selling them. Examples include products for decentralized data storage and value exchange such as decentralized media and social networks, decentralized financial services (DeFi), decentralized games (play-to-earn), etc.

Most of the services we’ve just described are blockchain-agnostic, as their commercial products can be launched on smart contracts in the environment of almost any blockchain network. Often, the commercial sides of on-chain entities are ‘cross-chain’, or in other words, they work within different blockchain networks simultaneously. It works in a similar way to legal (off-chain) entities, as a company can be registered in one country but then sells its products or services in different countries of the world at the same time.

As for the corporate side of on-chain entities, token protocols and tokenomics and the DAO that manages the protocol and treasury, here, the founders' "imagination" is limited by the framework of the blockchain network. Each token protocol and tokenomics are initially deployed and subsequently work within a selected layer 1 blockchain network, which has its own rules of operation. By analogy, each jurisdiction in which a legal (off-chain) entity is registered has its own legal system and its own laws that regulate the process of creating and operating a legal entity there.

What is the difference between creating legal (off-chain) entities and issuing shares in different jurisdictions?

When entrepreneurs set up a legal (off-chain) entity, it is important for them to understand exactly how they will handle issuing, distribution, and dilution of shares, as well as making additional issues of shares and dividing the shares into different classes. This will influence how and when the founders will be able to sell their own shares, what stock incentive schemes they will be able to create for their own team, and how they will be able to attract investments, amongst other things.

Let us use the US and the UK as examples since they are one of the most popular jurisdictions for registering legal entities. In the US, at the time of company formation, you can authorize shares and issue them gradually: for example, by issuing the first part immediately and leaving the other half for the future for options and attracting investments. In contrast, when forming a company in the UK, all the shares are immediately issued and, as a result, must be immediately distributed to shareholders. In other words, in the UK, corporate law does not allow to leave a pool of authorized but unissued shares with the purpose of distributing them later.

The above-described difference between issuing shares in the US and the UK is also reflected in the formation of option pools for advisors and teams in these jurisdictions. For example, in the US, you can reserve a pool of authorized shares in the company's share treasury and leave them unissued until the team members' options begin to convert. In the UK, however, option pools are structured only with the issue of additional shares, as it is not possible for companies to keep authorized but unissued shares in treasury.

What is the difference between creating on-chain entities and issuing tokens in various blockchain networks?

Just as we compared the US and the UK in terms of issuing equity, we can now compare the Ethereum and Cosmos networks for issuing tokens.

In the case of Ethereum, most on-chain entities have a token cap, the maximum fixed emission, which is pre-minted from the very beginning. They are subsequently distributed in a centralized or a decentralized way, depending on the tokenomics and governance model of the on-chain entity. This is very similar to how in the US, companies can have an authorized pool and non-distributed shares.

In contrast to Ethereum, during the Genesis release, an initial pool of tokens is released, which is automatically distributed according to the token captable. All future issues of tokens are structured as additional issues, where additional tokens are automatically exchanged through the network at the same time with the beginning of each new stage (epoch) in the blockchain network’s development. This is somewhat similar to how in UK companies, the primary pool of shares must be distributed at the time the company is formed and all future issues are structured as additional admissions.

On-chain entities must comply with the rules of operation of the blockchain networks in which they are created (on-chain law), while their legal wrappers must comply with the laws of the countries where the legal entities that make up those legal wrappers are registered.

Legal wrappers for on-chain entities: what are they and what do they consist of?

To summarize, the creation of on-chain entities has to comply with the rules of operation of the blockchain network in which they are deployed. This is similar to how the creation of a legal (off-chain) entity has to comply with the laws of the jurisdiction where the legal entity is registered. However, fulfilling this requirement alone may not be enough, as on-chain entities also need legal wrappers to interact with the real (off-chain) world.

These legal wrappers are created in the form of a group of companies, where each company is responsible for its own function. 

  • a DevCo is charged with hiring a team and developing the protocol
  • a TokenCo handles everything related to issuing and distributing tokens, 
  • a DAOCo is responsible for the legal registration and protection of its decentralized community.

Because today there is no jurisdiction in which the legislation would be equally favorable to issuing tokens, launching a DAO, hiring people for the team, and accommodating the founders’ globally-oriented lifestyle, legal wrappers are created as a system of legal entities and each legal entity has its own purpose and goal. The legal entities themselves within this structure are often registered in different jurisdictions and, as a result, must comply with the laws and legislation of multiple jurisdictions.

How legal entities of a legal wrapper are structured

Therefore, on-chain entities must comply with the rules of operation of the blockchain networks in which they are created (on-chain law), while their legal wrappers must comply with the laws of the countries where the legal entities that make up those legal wrappers are registered.

How are the legal wrappers for on-chain entities regulated?

Each legal entity included in the legal wrapper has its own functional purpose, the reason for which it was created. Based on this criterion, all legal entities included in the legal wrapper for an on-chain entity can be categorized into one of the following types:

  • DevCo / DevLab companies, responsible for hiring people to develop a decentralized protocol and solving other operational tasks;
  • Token Distribution companies, which take care of the token protocol deployment. After pre-minting/Genesis release, it distributes one part of the tokens to the DevLab for early investors (investors with Token Rights or Warrants) and core contributors (core members) with token options or incentives, and the second part to the community, which will be partially distributed in a decentralized way (staking, validators' rewards, etc.) and partially in a centralized way (through a foundation);
  • Token Foundations, the purpose of which is to handle the centralized distribution of token treasury in the form of grants for the development and support of the ecosystem;
  • DAO Associations, set up to create a legal representation for DAO members, which will work as a liability and governance wrapper for DAO members; and
  • dApps Distribution companies, which launch and maintain centralized interfaces, such as websites, mobile applications, etc. of decentralized applications, e.g. DeFi, GameFi, etc.

Based on the purpose for which each company is created, it is possible to determine the type of activity that the company will be engaged in and, as a result, the list of laws and regulations that this activity and each company as a whole, will have to comply with.

The compliance checklist for each company type for a legal wrapper

How blockchain networks (on-chain law) and their tokenomics affect legal wrappers

Previously, we discerned the structure of legal wrappers for on-chain entities, the types of legal entities included in them, and the laws of the countries with which the latter have to comply. The final stage of creating the legal wrapper is synching it with the features of the blockchain network where it is launched. In other words, the final to-do is the synchronization of the legal wrapper with the on-chain law.

In general, the way most blockchain networks work is based on the same decentralization principles, consensus algorithms, etc. At the same time, however, each blockchain network has its own distinctive features of how it works token-wise and how the network’s tokenomics works, namely:

  • specifics of the initial token issue of tokens, e.g. the Token Generation Event in the Ethereum network VS Genesis Token Supply in the Cosmos network;
  • special features of issuing tokens, as well as their inflation models. For example, in hard-cap tokenomics, such as Ethereum, token issuance is centrally controlled. In contrast, decentralized token issuance involves the minting of new tokens at the end of each epoch of the blockchain network, such as in Cosmos; and
  • peculiarities of the distribution of the strategic (community) token pool. Depending on whether all tokens were pre-minted at the time of the token protocol launch or whether they will be issued during the network operation, the distribution of the token treasury can be centralized (from the Foundation), decentralized (staking), or combined.

In addition to successfully setting up the legal wrapper, it is vital to consider the distribution of tokens for core contributors and investors, namely to decide on the following:

  • how vesting and a lock-up of tokens for core contributors is going to work within the framework of the token incentive scheme; and
  • how the formulas for converting Token Warrants and SAFTs into tokens for investors are going to work, under what conditions will the Treasury Round (private token sale) take place, and what the public distribution of tokens will look like, e.g. paid (like a Liquidity Bootstrapping Pool in Cosmos) or Initial Stake Pool Offering (like in Cardano).

How do different tokenomics components influence the legal wrapper?

Let's look at how different tokenomics' components influence the legal wrapper based on how the tokenomics' rules function in a blockchain network. 

Launching a token protocol

Case 1: Centralized deployment by core contributors who are also responsible for token pre-minting and the initial token distribution.

In this case, a DevCo is required to develop the protocol and to launch protocol tokens. Then, a separate Token SPV (Token Distribution Co) is registered, the sole purpose of which will be deployment of protocol tokens to the blockchain network, token pre-minting, and initial token distribution.

Case 2: Core contributors develop the token protocol and publish it as an open-source code. The protocol itself is deployed in a decentralized way by the node holders and validators who deploy the code’s data.

In this case, only the DevCo is required to develop the token protocol.

Types of token emission

Type 1: Emission with a hard cap, where all of the tokens are pre-minted, which is then divided into tokens for investors and the core contributors, as well as a strategic reserve for the community, the distribution of which is controlled by the core contributors or the DAO.

With this type of emission, a Token Foundation and a DAO Association are needed. The former handles the management of the token treasury ecosystem, and the latter is responsible for the decentralized process of managing the token protocol and the strategic reserve of tokens.

Type 2: Genesis token supply (an initial basic number of tokens), which is distributed in a central way, and a strategic pool formed via automatic initial issues during the functioning of the token protocol.

With this type of emission, only the DAO Association is needed, which, if necessary, will be making a decision on changing the rules of the autonomous (decentralized) distribution of the strategic reserve.

Token incentives for core contributors

Scenario 1: tokens are distributed in a centralized way. In this scenario, the DevLab receives this pool of tokens from the Token SPV and then distributes it amongst the core contributors. This requires an agreement between the Token SPV and the DevLab, as well as a Token Incentive Scheme and Token Warrants for the core contributors. In addition, depending on the DevCo’s national law, token valuations and tax structuring may be required.

Scenario 2: tokens are distributed during the TGE in an autonomous way via smart contracts with vesting and cliff rules woven into it.

This scenario does not require legal structuring, but does need it for legally fixing the origin of these tokens: this pool can be added to the Token Foundation treasury, and, in the future, the Token Foundation will distribute token incentives for core contributors.

Conversion of investor’s token rights / warrants / SAFTs

Scenario 1: the DevCo also signs Token Rights or Token Warrants with investors, in addition to SAFE, at the equity fundraising stage.

In this scenario, the DevCo receives a part of tokens from the investor pool from the Token SPV at the time of the initial minting in order to further redistribute these tokens amongst the early investors based on the results of converting Token Rights and Warrants into tokens.

Scenario 2: the company only engages in token-based fundraising using the Token SPV, only signing SAFTs on its behalf.

In this scenario, the Token SPV converts SAFTs into tokens with their subsequent transfer of SAFTs to investors at the time of deployment of protocol tokens and pre-minting tokens.

📚 Read more: Token Warrant, SAFT or Token Sale Agreement: a Guide to Choosing a Web3 Fundraising Document

Public token distribution

Case 1: the distribution is paid and centralized, e.g. via an Initial DEX Offering or a launchpad.

In this case, the Token SPV goes through an onboarding procedure on a DEX and lists the token, becoming the holder of the liquidity raised by conducting the IDO.

Case 2: the distribution is decentralized and paid, e.g. via a Liquidity Bootstrapping Pool or an Initial Staking Pool Offering.

In this case, if part of the liquidity pool or the staking pool will be sent to a strategic reserve, a Token Foundation is required to hold the reserve.

Case 3: the distribution is decentralized and non-paid, such as airdrops, token bounty campaigns, etc.

In this case, no legal structure is needed.

💡 Worth checking: Models of Token Distribution and How to Legally Structure Them

Additional token issuance or minting of additional tokens

Scenario 1: tokens are issued/minted in a centralized way, handled by the project’s team.

In this scenario, the Token SPV turns into a permanent company in the legal wrapper’s structure and controls the token protocol, including additional issues and token burning.

Scenario 2: tokens are issued/minted in a centralized way via voting within the DAO.

In this scenario, the DAO Association is needed to serve as a liability and governance wrapper for the DAO members who will vote on the new token issuances.

Scenario 3: tokens are issued/minted by the network in an autonomous way: when a new block is formed or at the end of the network’s epoch and the onset of a new one.

As a general rule, a legal structure is not required in this scenario, but if part of the newly-minted tokens will fall into the strategic reserve, then a Token Foundation is required to manage it.

Decentralized governance

Case 1: delegating (staking) tokens.

In this case, a governance wrapper for the DAO with governing bodies is needed: it allows the appointment of community delegates for decentralized voting and decision-making. Foundations and Non-profit LLCs are the most suitable types of legal entities for these types of cases.

Case 2: voting with tokens without delegating.

All DAO members vote: in this case, an Association is the most suitable type of legal entity.

📚 Read more: Designing a Governance System for a DAO: a Checklist for Web3 Founders

Why do legal wrappers need to comply with both real world (off-chain) law and on-chain law?

To summarize, the corporate side of on-chain entities has to comply with the rules of the blockchain network on which the on-chain entity is launched. At the same time, to successfully develop today, the on-chain entity needs a legal wrapper and its legal entities need to comply with the laws of the countries where they are registered.

From here, we can conclude that the legal wrapper for the on-chain entity must indirectly, through the on-chain entity itself, also be synchronized with the rules of the blockchain network in which it is launched, as illustrated in the table above.

Why legal wrappers must comply with both on-chain and off-chain laws

In other words, today, legal wrappers for on-chain entities must comply not only with the laws of the countries where the legal wrappers are created (in off-chain law), but also be synchronized with the rules governing the operation of blockchain networks where the on-chain entities are launched. Simply put, legal wrappers for on-chain entities today must be compliant with both off-chain law and on-chain law.

How to create a legal wrapper compliant with both real-world (off-chain) law and on-chain law

In order to create a legal wrapper for an on-chain entity that complies with both real-world (off-chain) and on-chain law, the roadmap will look something like this:

  1. choosing a blockchain network to launch an on-chain entity: Ethereum, NEAR, Cardano, etc.).
  2. analyzing the rules that govern the tokenomics of the selected blockchain network: launching the token protocol, organizing the primary emission, determining the methods of token distribution, and the rules of additional issues, etc.
  3. based on the tokenomics, determining the list of legal entities that will make up the legal wrapper: DevCo, Token SPV, Foundation, DAO Association, etc.
  4. after determining the types of companies that will comprise the legal wrapper, choosing the most favorable jurisdictions for their registration.
  5. after the registration of the companies within the legal wrapper, fulfilling the requirements of companies’ national laws in order to legalize all the activities of each company as well as to analyze and fulfill the regulatory compliance in the countries where such companies will operate.

Following this roadmap will allow the creation of a legal wrapper for the on-chain entity that will comply with both on-chain law (the rules of the blockchain network) and off-chain law (the laws of the countries where the companies from the wrapper are registered).

A checklist of on-chain and off-chain compliance for Web3 projects

Additionally, the legal wrapper created following the checklist above, will help the on-chain entity interact with the real (off-chain) world, attract investments and additional liquidity, and also help protect the participants of the on-chain entity — such as core contributors, investors, DAO members etc. — from the risks of regulatory uncertainties found today in the Web3 industry.

How will the transformation of real (off-chain) law into on-chain law look like and how is Legal Nodes a part of it?

In the first part of our series on on-chain law, we established that once there is enough liquidity in the on-chain market for this industry to become self-sufficient and self-sustainable, many legal wrappers will lose their relevance, as on-chain entities will no longer need to build bridges to connect with the real (off-chain) world. At this moment, it is likely that the existing (traditional) legal systems will also lose their applied meaning in their entirety and there will be only one legal system for those entities to comply with: on-chain law.

However, before completely abandoning real (off-chain) law and switching to on-chain law, the Web3 industry will need to do a lot of work to figure out the rules of on-chain law, as well as adopt all the best practices from the existing traditional legal systems, and evolve them to work with the innovative and transparent nature of blockchain technologies. For that, this process will need to go through two stages: unbundling and rebundling. First, the law will be fragmented into separate components and then it will be reassembled into an updated form with the help of innovative blockchain technologies.

All innovations have gone through this process. Remember how traditional workplaces with folders, papers, pens, and a trash can were first unbundled by the first developers of operating systems for personal computers and then rebundled into the Windows or MacOS desktops that we are so used to seeing on our screens today? That same process is taking place in the legal systems as we speak— they are being unbundled into separate rules of corporate governance, such as vestings, lock-ups, share classes, voting procedures, etc., and assembled (rebundled) into a new on-chain structure: systems of smart contracts, which take in the corporate governance rules into its code.

Here at Legal Nodes, we believe that the role of the new generation of lawyers is to transfer those best practices of corporate governance from the outdated system of off-chain law into the innovative system of on-chain law. Once the process of creating and launching smart contracts becomes as simple as launching a landing page on the web, lawyers will need to put aside their hard-copies of their documents which encode the traditional (off-chain) law practices and make the switch to on-chain law.

In this process of switching, Legal Nodes will transform from a multi-jurisdictional platform that today helps founders set-up cross-border business structures, into a multi-chain platform that allows a new generation of entrepreneurs to create on-chain entities using various blockchain networks.

Disclaimer: the information in this guide is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice. Any mention of any of assets or third party services or products in this article is not an endorsement to purchase them.

Nestor is a Co-founder & Head of Web3 Legal at Legal Nodes. Having over seven years of legal consulting experience, Nestor loves working with innovative startups and Web3 projects, helping them navigate the regulations and scale on global markets.

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