31 July 2017

"Know Your Token": A guide to participating in token sales

This article was written by Urszula McCormack, Heidi Machin, Lauren Dray, Jack Nelson, Marina Lauer, Hannah Glass and Henry Wells

Token sales are rapidly gaining momentum as the darling of capital raising in the digital economy. Huge sums have been raised; some tokens have experienced skyrocketing valuations; many believe no regulation applies. This has caused a strong “fear of missing out” effect among those looking to get involved in this rapidly growing space.

But all that glitters is not gold.

Many individuals, hedge funds and businesses are potentially purchasing tokens for projects that may not be technically possible, economically feasible – or, frankly, that may not ever happen. In addition, an increasing number of token sales are attracting adverse regulatory attention, including under securities laws (United States) and anti-Ponzi scheme laws (United States and United Kingdom). Hacking and disputes are also increasingly prevalent.

Does that mean that you shouldn’t participate? Not necessarily.

Digital assets can be extremely useful things and token sales are excellent for certain projects. Many are genuinely not regulated. However, you have to know what you are buying.

This article highlights practical due diligence steps that you can take in order to “Know Your Token”. We provide a brief outline of token sales generally, and then cover the following four key areas:

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First up… what is a token sale?

Generally, a token is an intangible asset utilising blockchain technology. It typically entitles the token holder to a bundle of rights (and possibly liabilities) set out in smart contracts and other relevant documentation, such as an offering document or a whitepaper (or both)

In a token sale, tokens are offered to raise funds for a stated project, within a defined period of time. Underlying projects vary in certainty at token launch and through their evolution over time, with or without the participation of token holders. Once purchased, the token may be able to be traded on exchanges accessible by the public.

Tokens or “coins” can also take many other forms, such as shares in a company or units in a fund. This is important.

We describe token sales, blockchain, smart contracts and other related topics in our Digital 101 database, part of the KWM Digital Intelligence Hub.

A. Know the project: what should you look for?

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Token sales often look good on screen: a promising project, with a slick website, and a well-credentialed development team. But purchasers should look a little deeper before diving in. The following questions are key, and should be asked by all potential purchasers.

1. What is the project?

The project is typically outlined in a conceptual document such as a whitepaper. Some are much more specific than others. Many do not specify the specific outcome of the project, the timeline or the precise way in which you can use your tokens to participate in it and/or to gain value from it.

The key things to consider here are:

  • What is the nature of the project?
  • What are its prospects of success?
  • Is the project a viable solution to a real-world problem - or is it a solution in search of a problem?
  • How much do you know about those problems and solutions?
  • Are others doing this?

We cover how to “know your token” (“KYT”) in Part B below.

2. Who is involved?

Look at the track record of the issuer and the broader development and advisory team. These are usually published on the website and marketing content. Some simple internet sleuthing can provide insights into the team’s experience. LinkedIn, CoinDesk, Medium and Reddit - while not verified information sources - can provide a wealth of background information and commentary.

For institutional purchasers (with larger wallets), you’ll want to do more digging, using your internal due diligence tools and vendor sources, as well as meetings with the issuer.

Many projects will also have early-backers. If public, this can also provide a good insight into the project – although it’s no substitute to doing your own research and getting the professional advice you need.

3. Is there a clear and realistic roadmap?

The project should have clear goals and realistic milestones, wherever possible. Unrealistic timelines with no buffer are a red flag, given the lengthy delays that technology projects can (and often do) experience. Consider if the timeline accords with your own needs.

It is also important to consider how far along the project will be at the time of the token sale. Is there a beta undergoing testing? Has there been a successful use case already established? Or is the project still on the drawing board? These considerations factors into how much capital should be required to complete the project.

4. Is the project lawful?

This almost goes without saying, but it also ties into the regulatory status of the token. Key things to consider are:

  • Where the project will take place.
  • Whether the project itself is legal in that place (or those places).
  • Whether your participation in that project is legal in all relevant jurisdictions and/or requires certain approvals, licences or registrations.
  • Where the law and regulation is heading.

This point is especially relevant for projects involving decentralised autonomous organisations (“DAOs”), as well as those involving cryptocurrencies, given that the legal and regulatory landscape is rapidly evolving.

It may also be worth considering what, if any, structure is in place to issue or offer the tokens, or develop the project (foundation, company, trust, DAO etc.). Even if the tokens are issued by a distributed vehicle, like a DAO, the fact that developers are contracted to a company or that profits are distributed through a trust may be relevant.

B. Know what you are buying

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5. What does the token do?

Surprisingly, this key point can be overlooked by overeager purchasers.

Usually, the token will grant access to a platform or service that the purchaser wants to use (or will want to use once complete). However some tokens do not have any utility at all.

So here, you need to ask yourself: do I want what the token offers?

6. What is its regulatory status?

Most token sales are not authorised in any jurisdiction and are operated by unlicensed persons. That does not mean it is unlawful. However, if it is unlawful, is that really your problem?

Well, it depends. The issuer is generally primarily liable for compliance with securities, anti-Ponzi scheme, consumer protection and other laws. However, you should care about how your tokens are regulated. The following table outlines some reasons why (there are many others).

Scenario

What can happen

Why you should care

Token sale should have been approved / registered

  • Token sale may be suspended
  • Secondary trading may be prohibited

Any token you have bought may become worthless.

Issuer should have had a licence

Issuer is investigated, subject to a large penalty, shut down and/or even imprisoned.

There may be no one to deliver the project.

Token is classed as something different to what you expected

  • Token sale and trading may be difficult or event impossible
  • Tax treatment is different

You might be subject to a range of additional obligations.

 

In all cases, it is very unlikely that you will get back your initial contribution to participate in the token sale.

The key steps you can take to protect yourself here include:

  • reading the offering documentation and making sure it makes sense to you;
  • checking to see if the issuer has obtained legal advice in relevant jurisdictions, and has not just received advice from a consultant;
  • obtaining your own legal, taxation and other professional advice; and
  • be especially cautious if the primary function of the token is to enable the holder to claim payments of any sort, as the token may in fact be a financial product.

7. Capped or uncapped?

Debate abounds about the merits of capped or uncapped token sales.

In a capped token sale, once a certain figure is reached the token sale will cease. They are often capped by reference to the amount needed to develop the project which may have greater perceived legitimacy.

In an uncapped token sale, tokens are generated as they are purchased, with the only limit being the purchase period. This (theoretically) makes it less likely that the tokens will end up concentrated in the hands of a few purchasers.

Even where the number of tokens is capped, the full number of tokens may not be released through the token sale. Additional tokens may be released over time in further token offerings or through mining. In most instances the issuer will retain a percentage of tokens. You should consider:

  • how, when and by whom tokens will be released; and
  • what percentage of tokens are being made available for sale and what percentage are being retained by the issuer.

8. What representations and warranties are contained in offering documentation?

You must read the documentation. It is a legal contract, even if the issuer claims that the token and the project exist only “in cyberspace” (a potential red flag in itself).

Offering documentation often contains a series of representations and warranties that the purchaser agrees to by participating in the token sale. These typically include representations that the purchaser:

  1. has read all the relevant material relating to the token sale;
  2. has the technical ability and understanding required to participate in the token sale; and
  3. is permitted to buy and hold cryptocurrencies and cryptographic tokens under the laws of their home jurisdiction.

You should carefully consider the list of representations and warranties to ensure that they can be truthfully made. Agreeing to representations or warranties that are not true may make it impossible to seek redress from the issuer.

9. Is it in your preferred language?

Pay particular attention to language. Make sure that any translations you rely on are authorised by the issuer. Many translations are generated under bounty programs, which can be valuable for prospective buyers and cost-effective for the issuer. However, they are sometimes of poor quality. Further, keeping all translations updated can be problematic and time consuming.

10. Will there be a secondary market?

If there is no secondary market, then it will be difficult for purchasers to trade their tokens or otherwise exit the project. And if the token is not popular, there may also be low trading volumes.

Both factors should be considered before purchase, if you wish to have the ability to sell your tokens.

As the law and regulations are still in a state of flux, before selling a token on a secondary market it is important to consider whether the token is still subject to the same legal and regulatory status as it was when it was issued. Take care also that the terms and conditions of the exchange itself (including any legal or regulatory requirements) do not impose any obligations on you buying or selling the tokens. If it does, consider whether you can comply with those requirements.

11. Does it look like a Ponzi scheme?

As in any industry, there are malicious entities operating token sales of dubious value. Watch out for projects that:

  1. promise high returns with little or no risk;
  2. rely on existing token holders to promote and sell tokens; or
  3. have no identifiable revenue streams other than the sale of tokens.

C. Know the process

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12. Am I eligible?

Issuers often restrict individuals from certain jurisdictions from participating in a token sale. This is due to concerns about the legal treatment of tokens and cryptocurrencies in those jurisdictions. Professional investor status also varies between jurisdictions.

13. Embrace AML/KYC…it’s a good sign

The more reputable issuers conduct anti-money laundering and know your customer (“AML/KYC”) checks. Embrace them. They are the sign of a mature issuer.

If you are concerned about…

  • completing these online, ask if you can visit in person;
  • the issuer’s data protection measures and cybersecurity controls, ask about them (the issuer should be able to describe them, and there are often bug reviews as part of bounty programs) – but if you’re still not happy, then that’s a sign to not participate at all; or
  • preserving your anonymity, move on.

14. Are there any other restrictions on you buying?

Some jurisdictions have stringent capital controls that may apply to cryptocurrencies. Tax issues may also arise, particularly in respect of any capital gains arising from the tokens, as well as any applicable value-added taxes.

Getting professional advice on your situation is essential before participating in a token sale. Be aware, however, that capital controls and tax positions can change quickly and often without notice.

15. Are there any vesting or lock-up periods?

Most token sales feature vesting schedules and lock-up periods for the issuer and pre-sale purchasers (if any). These should be compared with the project’s road map to determine whether they provide the correct incentives, at the correct times, for these insiders.

Purchasers’ tokens may also be subject to a lock-up pending completion of AML/KYC requirements. These requirements should be clearly stated in the offering documentation.

16. What security measures are in place?

Token sales have been the target of distributed denial of service attacks (“DDoS”) and other attacks. Thefts of token sale proceeds have occurred. Accordingly, it is important that purchasers consider what security precautions the issuer has taken to protect the integrity of the token sale (including any associated personal data), the proceeds of the token sale, as well as the tokens themselves.

17. Protect yourself against hacks, fraud and other issues

A number of token sales have suffered hacks, fraud and scams, such as ethereum addresses being changed on issuer’s websites. Less sophisticated attackers will simply post their personal wallet address on social media forums, and falsely state that this is the contribution address, in an attempt to divert contributions to themselves.

You must therefore also take steps to protect yourself. This includes:

  • straight to the source – only referring to official sources of information about the token sale – not just social media threads;
  • social media – using social media wisely. Social media contains some great information about token sales, but do not rely on it. This is especially important for obtaining information about how to send your money – do not use any smart contract address posted on social media;
  • official announcements – regularly checking for official announcements on verifiable channels; and
  • your own due diligence – as described above, satisfying yourself about the security arrangements of the token issuer and (as a general rule) only using reputable wallets and exchanges.

These steps are not fireproof. However they will take you a long way toward avoiding most scams.

18. Where will the proceeds go?

Different token sales offer different levels of detail regarding the use of proceeds. Some will present a simple pie chart allocating funds to “development”, “legal”, “marketing”, and so on.

Others will offer precise figures required for particular elements, and will offer ongoing auditing of the use of funds.

Either way, the distribution of proceeds should coincide with costs arising under the roadmap. Ideally, it will be possible for purchasers to monitor the proceeds by reference to the issuer’s cryptocurrency addresses.

19. What happens if the project is abandoned?

Offering documents will often set out a variety of termination events. These typically give the issuer a great degree of flexibility in assessing whether to terminate the token sale and/or project if a termination event occurs.

Purchasers should consider what they will get back in the event of termination. If refunds are offered, consideration should be given to whether they get back the full amount that they contributed, or whether fees are deducted.

Given the volatility in cryptocurrency markets, a purchaser should also note that their contribution may be worth substantially more or substantially less at the time of refund.

D. Know the consequences

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20. What should I do if I am not happy?

First and foremost, you should know what you are signing up to and obtain any professional advice that you need. Your legal options may be constrained both by terms set out in the offering documents and by the novelty of token sales themselves.

However, if you are unhappy, speak to the issuer. Ask if you can raise a formal complaint if needed. Still unhappy? Speak to a lawyer well-versed in digital assets.

21. What law governs the token sale?

Legal protections for token sales are largely untested. Nonetheless, it is worthwhile looking at where the issuer is based or incorporated, and the project’s target markets. How do these jurisdictions treat cryptocurrencies? Have any relevant regulators issued any guidance, or have any court cases taken place?

For example, if the issuer is located in a jurisdiction that has strong consumer protection laws, then this may represent one particular legal avenue. Importantly, claims that the token sale is “jurisdiction-less” should be taken with a grain of salt. Courts and governments typically decide the extent of their own jurisdiction, and cannot be easily ousted by language in an offering document.

How do I participate?

If you have considered the above questions and decide to participate, the next steps are practical ones: setting up and securing your wallet, obtaining the cryptocurrency necessary to purchase, and locating the correct contribution address.

Last word

Token sales can potentially make capital raising easier – but they do not make it easier to complete a project and operate a successful organisation. Purchasers should consider the above questions, as well as the business fundamentals of the project, before participating in a token sale.

The information in this alert is by no means exhaustive, given the plethora of tokens out there. It is not legal advice.

Contact us if you have any questions.

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