Tokens and Crowdsales: How Startups Are Using Blockchain to Raise Funds

Companies we’ve never heard of are launching IPOs right before our eyes.

But instead of operating for several years before ringing the bell to go public, these companies are going public from day one, and instead of raising money by selling company stock, they are raising money by creating distributed networks and selling tokens.

This new way of building companies is what Coinbase founder Fred Ehrsam describes as a ‘decentralized business model’.

Yet many of the existing rules of business building and investing don’t apply to this new model. So what can we learn from companies that have taken this path?

Tokens

The structure of a token crowdsale is directly related to the type of tokens being issued.

There are three types of tokens we have identified:

1. Debt Tokens

2. Equity Tokens

3. User Tokens

User Tokens

User tokens, or 'appcoins' as Naval Ravikant and Balaji Srinivasan call them, are a form of digital currency required to access services provided by a distributed network.

As Union Square Venture managing partner Albert Wenger explained, you can think of these tokens as the same tokens you buy for a ride at a show.

For example, in Ethereum, you need Ether to build distributed apps on the platform. In the case of distributed storage systems like Sia, you need Siacoin to store files on their network.

User tokens can be earned by providing value to these networks.

Contributors can mine, as is done with Bitcoin, Ethereum, and Sia, or post stories, as is done with the Steemit platform. Because user tokens are on a blockchain, they can be easily redeemed anywhere or using cryptocurrency.

Equity Tokens

Equity tokens are used to fund the development of a network, but are not required to access the services provided by its underlying protocol. As the name suggests, we can think of 'equity tokens' as a cryptographic share of a network.

In exchange for their investment, equity token holders are entitled to receive ‘dividends’ in the form of revenue sharing or network transaction fees. For example, with Sia, 3.9% of successful storage payouts go to holders of their equity token, Siafund.

In many cases, these equity tokens represent shares in a distributed autonomous organization (DAO). The DAO code is responsible for issuing tokens, controlling funds collected from token sales, and contracting a company to develop the network.

In addition to receiving a predetermined reward, holders of equity tokens in the form of DAO shares typically have the right to make recommendations on how the investment funds should be used.

Like Digix, an asset tokenization platform built on Ethereum. DCG token holders:

1. Receive a reward from transaction fees on the Digix Gold Network.

2. Ability to submit and vote on DigixDAO proposals.

Debt Tokens

The third type of token is the 'debt token'.

We can think of these as a sort of “short-term loan” to the network, in exchange for an interest rate on the loan amount. Steemit is one of a handful of networks that have debt tokens, issued in the form of Steem dollars.

Steem dollars are unique to the economics of the Steemit protocol.

By purchasing Steem Dollars, people are able to invest in the network to gain sufficient liquidity without having to commit to the two-year waiting period that Steem Power holders take on.

We see that networks have many combinations.

These include networks with:

1. User and Equity Tokens (Sia, Digix)

2. User tokens (Bitcoin, Ethereum)

3. Equity tokens (Golem, SingularDTV)

4. User, Equity and Debt Tokens (Steemit)

These combinations depend on the unique dynamics and economics of the network.

Crowdsale

The type of token will usually determine the structure of its crowdsale.

User Token Presale

To sell user tokens, companies tend to:

1. Release a white paper that provides a detailed description of the network and defines a roadmap for future development.

2. Announce the token publicly and release the source code before the first token is created.

3. Deploy the network and secure user tokens through mining. In addition, allocate a portion of the pre-sale tokens to the founding team as a reward for the formation and development of the network concept.

4. Promote the network and sell user tokens to everyone, everywhere.

5. Working to increase the number of people using, creating apps on, and maintaining the network.

As the network grows, the demand for tokens increases, which in turn causes the price of user tokens to rise. This is what we call the 'Satoshi business model'. Satoshi's Bitcoin was not obtained through pre-mining rewards, but as the first believer and supporter of the Bitcoin network.

Steemit also follows the Satoshi Nakamoto business model. The company writes the code to power the Steemit distributed network and announces to the public that it will secure approximately 80% of the initial STEEM through mining. The project plans to keep 20%, sell 20% for fundraising, and give away 40% to attract users/referrers.

Ethereum’s situation was different. Its presale consisted of distributing private keys to buyers as a software access token for use in the future network. Ethereum raised more than $18 million worth of Bitcoin in the form of 60 million ETH tokens, of which 12 million ETH (20%) were retained by the development team.

When Ethereum was launched, buyers received their ether as the first blocks were mined.

Equity Token Crowdsale

For equity tokens, companies tend to:

1. Release a white paper that provides a detailed description of the network and defines a roadmap for future development.

2. A smart contract is written for a DAO, and a predetermined number of equity tokens are allocated to the company founders.

3. Allow companies to become suppliers to the DAO, responsible for developing the network in exchange for payment fees.

4. Promote the DAO crowdsale and sell equity tokens to everyone, everywhere. Use the money to pay for development work on the company.

5. Work hard to grow the network to increase the value of equity tokens and collect rewards based on increased network usage.

Digix raised $5.5 million in 12 hours by following the steps above.

Because DigixGlobal was the company that conceptualized the network, published the white paper, wrote the DAO Ethereum smart contract, and holds a significant number of equity tokens, they became the default service provider for DigixDao.

Regulation of Token Crowdsales

The laws governing the issuance and sale of crypto tokens depend on the jurisdiction in which these events take place.

In countries like Singapore and Switzerland, virtual currencies are not considered securities and are not legal.

In the United States, the Howey test is used to evaluate the sale of securities.

Under the Howey test, an investment vehicle is considered profitable if it A) involves the investment of money or other tangible or definable thought in B) a common enterprise and has C) a reasonable expectation of profits derived primarily from the entrepreneurial or managerial efforts of others.

The public sale of securities to U.S. citizens is regulated by the SEC, and it is illegal to perform such an act without permission.

Industry thought leaders such as nonprofit advocacy group Coin Center and Harvard University’s Berkman Institute’s Primavera de Filippi have suggested that the issuance of user and equity tokens could be included in the Howey test for securities sales. But the fact is that the power of these tokens goes beyond our understanding of traditional securities.

We also know that the SEC is exploring ways to regulate blockchains as transfer agents. The actual impact of this regulation on token issuance remains unknown.

Connecting tokens to the traditional world

We see four different approaches that can be used to conduct legal and compliant token crowdsales.

GmbH and foundations in Switzerland

Ethereum’s token presale was conducted by the Ethereum Foundation, a Swiss-based non-profit organization whose sole purpose is to manage the funds raised from the sale of ether to best serve the Ethereum ecosystem.

To allow U.S. citizens to purchase Ether without SEC regulation, they structured the user token presale as a sale of crypto fuel — ether (ETH) — which is used to run distributed applications on the Ethereum open source platform.

The initial development of the software was performed by Ethereum Switzerland GmbH.

Singapore Companies and DAOs

In the case of Digix, the smart contracts for DigixDAO were written by DigixGlobal, a Singapore-based company. The company was then hired by DigixDAO to develop the Digix network. The equity tokens sold represent shares in DigixDAO.

Although the Monetary Authority of Singapore (MAS) does not consider the tokens to be securities, their legal sale to U.S. citizens depends on the SEC’s interpretation of the tokens under the Howey test.

'CODE'

The third type of experiment is what Singular-DTV – a blockchain entertainment studio – is using as a ‘centrally organised distributed entity’.

‘CODE’ is a combination of a centrally managed organization (CO) in the form of a Swiss GmbH and a decentralized entity (DE) in the form of a tokenized ecosystem built on Ethereum.

In this case, the GmbH is responsible for spending the ether collected through the decentralized entity token sale to create the media project and collect the generated revenue. 'CODE' should be regulated and taxable, protecting token holders from potential liability.

Independent company

The final approach is to keep the network and token issuance independent of its creator.

Tokens are distributed through a computer algorithm that does not specify any specific public key to receive funds. According to the Satoshi business model, the network creator secures its share of tokens by becoming the first miner of this public network. Steemit achieves this by operating as a Delaware C Corp.

The formation of these entities was one of the first attempts to legally connect the new model of company creation to the traditional world.

Overall, we have seen over 40 companies using the token-based model for financial protocol development. We believe it can also be expanded to other types of companies.