Effects of an ICO on Equity Shareholder Rights

This is a transcript of The Blockchain Report entitled, “Don’t Bogart My Rights, Dude”: Possible Threats to Equity Shareholder Rights from ICO’s.

This podcast transcript occasionally refers to investor rights as [ equity shareholder rights ] for purposes of search engine optimization. Other edits have been made as well.

Ian: [00:00:05] Welcome to The Blockchain Report sponsored by Sun Fund. I’m Ian McGrady, Director of Communications at Sun Fund and your host. We’re here today with Scott Licamele the co-founder of Sun Fund.

Scott: [00:00:13] Hi there.

Ian: [00:00:13] Here at the Blockchain Report we focus on sharing our opinions about business and blockchain. Sometimes that will cross over into renewable energy because that’s our core business as well. Today we’re talking about Initial Coin Offers and the rights of existing equity shareholders when the business wants to do an Initial Coin Offer as a follow-on to their initial capital raise.

Ian: [00:00:36] So first I want to point you to this article in CoinDesk by Brady Dale. And it’s called “What if They ICO? Investors Seek Veto Power Over Future Token Sales” and this article will be in the show notes. Basically, the article looks at the impact of an ICO on the businesses’ existing shareholders — not so much for the debt owners — but it does look at the rights of the existing shareholders. So the question I have for you Scott is: why should either of these groups, either debt holders or equity holders, be concerned about any future or imminent plans for a company to hold an Initial Coin Offer?

Scott: [00:01:15] I think this is probably less relevant for debt holders because usually their rights are very clearly defined. In other words: debt is first in line in terms of payments, cash flows, liquidation rights. All these things are ahead of equity and frankly, they’re ahead of tokens –especially unregistered, non-security, utility tokens which have no rights or definition really of any kind because they’re not equity and they’re legally unenforceable. So debt is less an issue because if you issue debt you’re getting a coupon you have value. You have liquidation rights. However, for common and preferred equity investors like say, a VC investing in an early stage blockchain startup what have you, like many ICOs we’ve seen, the issue is very serious and I think there are two key things to consider. Number one is are the rights in any way being diluted? Are the rights of equity holders in any way being diluted by the potential or future planned ICO? Obviously, that varies from deal-to-deal based on terms agreements and conditions and covenants with respect to the VC and the founders. So it’s kind of hard to speak to specific cases. But at sort of a very broad level or high level that’s the first issue: are my rights being diluted should the company engage in an ICO? And you know that means, is capital in some way flowing more to the token holders than to the equity holders. That’s kind of the way basically to look at it. So the second issue would be the legal risks and the costs associated with legal risks of conducting an ICO. And by that I specifically mean conducting an ICO, for example: in the U.S. market, not as a security token but just doing it the, call it the “traditional way” as a utility token, meaning it’s not registered as a security. It’s just being sold without any regulation at all.

Scott: [00:03:01] If that’s the case then the risk to the equity investor is that the company itself will be under legal pressure and incur costs potentially should the SEC or another entity come after them. So that’s a serious issue to consider, probably for an early stage company [it’s] as important as the potential dilution of rights that might occur.

Ian: [00:03:23] Now Scott,there are other [equity shareholder rights]. Those [ equity shareholder rights ] can range from cash flow rights, liquidation rights, the right to elect directors, and the right to sell shares. Investors may want to know about those  [ equity shareholder rights ] in this new context of an ICO. Now can an ICO be issued with similar types of rights?

Scott: [00:03:40] So that’s very good question and the answer is if it’s issued as a security token like in the U.S. market then essentially what’s happening is, let’s say I’m a VC. Again the same example — I put in 10 million bucks in your company. They do an ICO than they then that the founders decide “Oh, we need to do it as a security token”. Well okay: “Well, what are they issuing? Are they selling more equity or are they selling the same equity? Because they’re probably registering it as a security, right? Obviously, if you’re doing a security token, it’s either going to be common or preferred equity. So then, suddenly they’re creating another share class potentially, for example, and that could create issues. So that’s very serious problem.

[00:04:21] So a very specific example would be: a VC invests in a stake of common equity shares and then let’s say the company leader decides to do an ICO registered … as securities and let’s say for example that they issue them as preferred shares. Well, the liquidation rights of the preferred shareholders are usually ahead of the common shareholders.

Scott: [00:04:43] So suddenly people are … depending on how it’s done, and obviously, there are many different iterations of this whether it’s common or preferred equity in all the different provisions for each of those categories… But, essentially there could be a situation where the ICO issued as security, [that could] could and somewhat contravene, contradict or get in front of the rights of the initial common shareholder.

Ian: [00:05:08] If I’m an equity shareholderof either kind and I hear the company that I’m invested in is going to issue an ICO: What kinds of questions should I …I should expect them to sort of bring these concerns to me. They should say okay here’s what we’re planning here’s what we’re here’s here’s how this ICO is going to affect you. Is that basically how it works.

Scott: [00:05:31] If I were an equity investor or a VC investor in a company that’s how I want to you know we want to do and I say you know I think the first question would be is if for the U.S. market just because we are based here so we can speak to that. The first question I have is OK “well how are you issuing that?” And if they if the answer is “Well, we’re going to do it as a utility token and, you know, I guess we’ll just figure it out with respect to that whole SEC ‘thing’ at some point in the future –” that would be a red flag for me. I would say “No, that’s that’s not okay. You need to consult with an attorney and determine whether or not your token is a security. And if it is to register as such.” [Because of questions around my equity shareholder rights.]

Scott: [00:06:07] Then if that’s the conclusion, the next question would be “Okay, well are you diluting me? Are you are you issuing new shares and diluting my equity position if it’s the same class of stock? Or is it a different class of stock? And then the question is if it’s a different class of stock that’s not diluting the directly, is it in some way diluting my [ equity shareholder rights ], my interest in the company?” That’s how I would look at that.

Ian: [00:06:30] Right. Or maybe the company will just give you some tokens so that you know your [ equity shareholder rights ] are somehow remediated or repaired by being a token holder at that point.

Scott: [00:06:39] Yeah… in other words yes there could be a scenario where where the founders say “Hey, we want to do an ICO and we’re gonna give you proportionally based on your initial investment share and tokens” but obviously that is dilutive by definition in most cases. So: bottom line is, there are legal and economic rights issues that I would want to make sure I fully understood as an investor before getting involved with a company that’s planning on doing an ICO in addition to a traditional VC seed raise.

Ian: [00:07:15] Well, Scott thanks for sharing your opinions here at the Sun Fund Blockchain Report.

Scott: [00:07:18] Thank you so much.

Ian: [00:07:19] And everyone remember: this is not investment advice. It’s opinion. Please use a professional qualified financial adviser. This is Ian McGrady signing off for this edition of The Blockchain Report. Check us out at SunFund.io. Thanks. And we’ll see you next time.