VC Focus | 10 digital token 'must knows' for international venture capital
Published on 8th Nov 2022
What should VCs know about investing in tokens and what could safeguard the ability to invest in them in the future?
Against a backdrop of rising inflation and market volatility, confidence in the cryptoasset market has wavered in recent months. Nonetheless, venture capital firms (VCs) are still considering investments in crypto and related businesses and there has been an observable increase in interest in investments in digital tokens.
1. Tokens, cryptoassets, virtual currencies: what's the difference?
Tokens, cryptoassets, and virtual currencies are used interchangeably to describe digital assets secured by a cryptographic blockchain. The function of these assets varies greatly but can be broadly categorised:
- Security tokens have the characteristics typical of traditional securities (for example, a tokenised voting share). VCs may be offered security tokens as part of a fundraising round by a prospective portfolio company.
- Utility tokens grant holders access to current or prospective products or services. For example, professional sports teams may issue utility tokens to facilitate fan engagement by offering unique experiences and content.
- Exchange tokens are typically thought of as "mainstream" cryptocurrencies and have a range of applications, including as a means of payment, investment or inflation hedge.
- Stablecoins seek to stabilise the volatility of their value by "pegging" the value of the token to a fiat currency, a valuable commodity, such as gold, or a basket of assets. The stabilisation of stablecoins value means they are less likely to be used for speculative investment.
- Non-fungible tokens (NFTs) are unique tokens that cannot be replicated. The ability to identify NFTs from one another ensures they can be classified as "authentic" or "genuine" by individuals creating (for example) digital artworks and other collectibles.
Irrespective of the type of token, all cryptoassets operate via a blockchain – a distributed ledger supported by a network of computer nodes.
2. Why are tokens getting the attention of VCs?
The use cases for tokens and the underlying blockchain technology continue to grow on a daily basis. With VCs at the forefront of pioneer investments, there are numerous touchpoints with these revolutionary technologies:
- Investments. Some portfolio companies will offer VCs "security tokens" by digitising the rights that investors would otherwise receive through a traditional shareholding. Companies may also offer investors the right to secure additional tokens in the future (Simple Agreement for Future Tokens or SAFTs) based on complex algorithms built into the original tokens.
- Fundraising. VCs continue to monitor the advantages of raising capital for their own funds through the issuance of tokens. Leaders in the space often cite efficiencies from streamlining fund administration and by baking compliance protocols into the token itself. Investors will also potentially reap the benefits of accessible data.
- Web3. Investment in the Web3 space, as well as tech companies supporting the blockchain industry as a whole, are increasingly considered by VCs as part of their investment strategy. Although these acquisitions may not result in direct exposure to tokens, such investments offer more cautious investors the ability to test the waters.
3. What are the main regulations in this area?
Having set out plans to make the UK a global cryptoasset hub, it is clear that the government is looking to support innovation and investment in the cryptoasset space. The judiciary are also keen to accommodate cryptoassets having confirmed their legal status as property several years ago.
Market participants believe that regulation will further support the credibility of the industry, requesting clear, concise, and flexible legislation that can keep up with technological developments. To date, the Financial Conduct Authority (FCA) has tackled the challenge of token regulation in three main areas:
- Categorisation. Continued innovation in the sector means the classification of tokens has become increasingly difficult. Recently, the distinction between "regulated" and "unregulated" tokens has taken centre stage in an attempt to clarify the remit of the FCA and the application of existing securities law.
- Anti-money laundering. Historical concerns regarding tokens largely revolve around the potential abuse of the blockchain to support criminal activities. As a result, all cryptoasset businesses carrying on cryptoasset activity in the UK must be registered with the FCA. Having now processed all those cryptoasset firms on its temporary-permissions list, this is likely to cause a bottleneck while those businesses late to the party seek FCA approval.
- Financial promotion. The FCA has also continued to strengthen its financial promotion rules for high-risk investments (including cryptoassets) following the publication of Policy Statement 22/10 in August 2022. Although the first wave of rules will only take effect from 1 December 2022, the FCA will publish its final rules for cryptoasset promotions once the relevant legislation to bring qualifying cryptoassets within the financial promotion regime has been made.
Naturally, many investors may be precluded from investing in tokens for legal, compliance or internal policy reasons – so not only will VCs will need to consider how these additional regulatory considerations will impact their business but also the investor base from which they seek to raise capital. Moreover, VCs with a European nexus will need to factor in the arrival of the EU's Markets in Cryptoassets Regulation (MiCA) as well as the additional licences that may be required from European regulators to invest in tokens.
4. Are there any tax considerations?
The major tax issue for investors is whether the holding and disposal of tokens is treated as an investment or trading transaction. Not only will this impact the rate of tax that will be payable by UK investors on any gain, but trading transactions may leave non-UK investors exposed to unexpected UK tax liabilities. HMRC has published very helpful guidance that gives some comfort on this issue, particularly where the tokens are treated as "security tokens".
Tricky issues can nonetheless arise where the fund is involved in staking tokens. Even if the holding or staking of tokens is not treated as trading activity, HMRC's guidance indicates that returns from staking tokens (see 8 below) would be taxed as miscellaneous income. Non-UK resident investors are generally liable to UK tax (and subject to tax filings) on UK source miscellaneous income, unless exempt under an applicable double tax treaty.
Given the uncertainty around tokens as an evolving asset class, and the potentially serious consequences for investors if VCs are deemed to be trading (or returning miscellaneous income to investors), there are additional structuring questions for VCs from the outset including considering the use of "blocker" entities.
5. Digital assets need digital custodians
Not all custodians and fund service providers have the expertise and capabilities to handle tokenised investments. From 10 January 2021, all existing cryptoasset businesses carrying on cryptoasset activity in the UK must have been registered with the FCA following the closure of the temporary registration regime. Until existing service providers obtain the FCA permissions necessary to expand their custody services to tokens, we expect partnerships with new market participants to be a particular trend in the coming months to bridge any regulatory gaps.
Therefore, VCs should involve their administrators and service providers as early as possible in any plans to explore tokenised investments. If this cannot be accommodated, VCs investing in a mix of asset classes may require different custodians for different assets.
6. Who holds the keys?
As well as the regulatory obligations under the Client Asset Sourcebook, Markets in Financial Instruments Directive and the FCA's Investment Funds sourcebook, managers will need to consider the expectations of the market when safeguarding digital assets.
VCs will need to carefully consider the robustness of their service providers and counterparties to survive sophisticated hacking attacks and illiquidity. The range and quality of services offered by token businesses varies greatly but it is increasingly common for custodians and exchanges to possess high-quality security specifications (for example, Service Organization Control 2 or SOC2) as well as A-rated insurance policies to mitigate against asset loss.
Hot and cold custody is another consideration for VCs. "Hot" custody is where evidence of ownership is based on a system that is accessible via the internet, with "cold" custody referring to a system that is air gapped from the internet, making it more difficult to hack. The likelihood is that VCs will leverage "hot" systems, which are more easily accessed online, but this is a key consideration as tokenised product offerings become more valuable.
7. Double down on due diligence
Despite the growth of institutional interest in tokens, market participants remain conscious of the risks of investing in new assets. When evaluating tokenised investments, VCs should expand the scope of their typical due diligence processes, including the regulatory position of the digital custodian, the conditionality associated with future token issuances and the security protocols protecting these assets.
Additional complexity arises if tokens are involved in the consideration for any investment – including the value of the digital consideration at the time of the transaction and the way in which payment is documented. We have previously considered these challenges in an overview of tokens and blockchain in an M&A context.
8. Liquidity and 'staking'
Exchanges help with liquidity, making markets and offering the opportunity for bilateral trading between participants. The tokens acquired by a VC may also open up potential exit opportunities through the potential for listing on an exchange.
However, VCs should be cautious when investing in niche tokens that have a limited secondary sale market. The transfer of privately issued security tokens – akin to the transfer of shares in privately owned companies, remains in its infancy and VCs should determine with the portfolio company how such obstacles will be overcome should a sale be required.
The potential to generate a return by "staking" tokens (that is, a way for token holders to earn passive income on their digital assets without needing to sell them) also present an attractive opportunity for VCs but should be treated with caution, with the recent "merge" on the Ethereum blockchain still unable to support the redemption of staked assets until the implementation of the Shanghai upgrade.
9. The future of fund raising?
VCs are beginning to see tokenisation as an opportunity to attract new sources of capital to their own funds. A tokenised fund, which is essentially a digitised fund through which units are exchanged on a blockchain, allows traditional limited-partner interests to be stored, swapped and traded on a distributed ledger. Service providers are also exploring how time-consuming know your customer, anti-money laundering and on-boarding processes can be streamlined to support the shift to the complete digitalisation of VC fund investments. As such, the benefits for VCs are clear and could offer a valuable way to reduce the costs of investor registers and secondary trading whilst opening the door for new sources of capital by utilising tokens to pool the commitments of smaller investors.
10. Futureproof your fund documents and structure
VCs should ensure they have the flexibility to invest in tokens in the future. Without express provisions in their fund documents, or clarifications that digital tokens may be held in addition to traditional securities, VCs may be precluded from investing in lucrative token rounds later down the line. Equally, alternative investment structures may be required to segregate tokenised investments from the main investment vehicle.
VCs should ensure they have the right to set up "blocker" entities to participate in any token issues to protect investors from unexpected tax risks and filings.
VCs should also ensure that their investment guidelines permit investments in tokenised investments and that the additional expenses associated with specialised custodians and service providers are appropriately covered.
This is the first in our VC Focus series focusing on legal, regulatory and tax issues facing the venture capital industry in the UK and internationally.
Osborne Clarke has a market leading venture and growth capital practice across Europe, supporting investors across sectors including financial services, media and communications, life sciences and healthcare, and real estate and infrastructure. If you have queries on any of the issues covered in this note please connect with one of our experts.