What are the considerations when issuing tokens? How to avoid legal risks and potential SEC enforcement actions?

a16z provides a legal perspective on how project teams can issue tokens to minimize the risk of being sanctioned by U.S. laws. They offer clear guidelines on token sales, when they can be circulated in the U.S., token lock-up periods, and team communication considerations. Here is a summary.

How to Issue Tokens to Reduce Legal Risks?

One of the most common questions for project founders is how to issue tokens. However, there are many details to consider when issuing tokens. This article outlines five key principles to pay attention to from a U.S. legal perspective, including:

• Avoid public token sales in the U.S. for fundraising purposes
• Decentralize the project
• Exercise caution in statements made by stakeholders
• Handle token listing and liquidity in secondary markets carefully
• Impose a minimum one-year lock-up period for tokens

Of course, these discussions may have other imperfections and are provided for reference only.

Avoid Public Token Sales in the U.S. for Fundraising Purposes

In 2017, ICOs flourished, with dozens of projects promising to achieve significant technological breakthroughs to raise funds. The SEC's response at the time was robust and reasonable, attempting to apply securities laws to ICOs as they often met all the conditions of the Howey Test.

Nothing is easier to apply the Howey Test to than the primary market. In many ICOs, token issuers made explicit promises to investors, using the proceeds from token sales to fund their operations and provide future returns to investors.

As the industry evolves, more diverse fundraising methods emerge, making it increasingly challenging to determine whether tokens issued, including airdrops, decentralized projects, or secondary market token trading, meet the conditions of the Howey Test.

However, ICOs reappear in each new cycle in new forms, with some developers changing their approaches in hopes of avoiding trouble with the SEC. For example, conducting indirect token sales through DAOs, controlling the revenue and liquidity generated through decentralized governance. Or some developers may feel that the SEC is unreasonable and simply do not care about it.

Projects need to be cautious to avoid these schemes. There is no reason significant enough to ignore or violate U.S. securities laws.

The good news is that it is easy to avoid legal consequences by not raising funds through public token sales. Teams can choose not to do so but can still raise funds through other means, such as compliantly offering equity and tokens for sale outside the U.S., without having to comply with securities law registration requirements.

Decentralize the Project

Developers can use various token issuance strategies to avoid being classified as securities by the SEC. The three main strategies currently used to avoid being deemed securities are:

• Decentralize the project
• Launch the project outside the U.S.
• Restrict token transferability to prevent entry into U.S. secondary markets

If the project has not fully achieved decentralization, launching the project outside the U.S. and restricting the transferability of its tokens can help the project comply with U.S. securities laws upon launch. But remember, decentralization is the only way for the project to eliminate the risks of securities laws.

Regardless of the strategy chosen initially, projects intending to convey broad rights through tokens, such as assets or governance rights, should always consider decentralization as the guiding principle; all other strategies are just temporary measures.

Practically, how should this be implemented? Regardless of how the project evolves over time, it should always seek to make progress towards greater decentralization. For example:

• If it's a Layer1 project, setting technical milestones may include making the validator set more decentralized, increasing the number of independent builders on the network, or reducing token concentration before launching services in the U.S.
• If it's a Web3 gaming project, encouraging more user-generated content, making more gameplay dependent on independent third parties rather than the team, or more independent servers going live before allowing token transfers.

Planning a decentralization roadmap for tokens can be one of the most critical tasks before token issuance. The strategy chosen by the project will have a significant impact on its current and future operations and communications.

Exercise Caution in Statements Made by Stakeholders

Communication is crucial and can make or break a project. A single misstatement by a CEO can put the whole project at risk. Project teams should establish strict communication policies based on the subtle differences in their token issuance strategies.

Decentralization Strategy

The purpose of this strategy is to ensure that token buyers do not have "reasonable profit expectations based on the efforts of others." In decentralized projects, token holders do not expect the management team to bring profits because no group or individual has that power. The project team should not provide any additional explanations on this issue, as it may involve securities laws.

What constitutes "reasonable expectations"? This largely depends on how the token issuer discusses the token, including in tweets, texts, and emails. According to past cases, when a project announces that its core team is driving progress and value, investors may consider the information reasonable for investment returns, potentially leading to the token being deemed a security.

In practice, it is advisable for teams to disclose as little information as possible. It is recommended that teams refrain from discussing related issues before the token is launched, including potential airdrops, token distribution, or token economics. Furthermore, after token issuance, teams should also avoid discussing the token's price or potential value, not treat it as an investment opportunity, make no commitments, and reduce the likelihood of token holders having reasonable profit expectations.

Applied to every role, how members of the project ecosystem, including founders, development companies, foundations, and DAOs, communicate is also crucial. Teams are prone to falling into centralized language traps because they are accustomed to discussing achievements and milestones in the first person. Avoiding these pitfalls can be achieved through several methods:

• Avoid implying ownership or control of the protocol or DAO, such as "As the CEO of the protocol..." or "Today, we launched the xxx feature of the protocol..."
• Avoid forward-looking statements, especially regarding mechanisms like "burning" tokens to achieve price targets or stability.
• Avoid overemphasizing the importance of the team or contributors' work to the project ecosystem; use "initial development team" instead of "core development team" or "primary development team" when appropriate.
• Emphasize decentralized milestones, such as contributions from third-party developers or application development teams.
• Provide speaking rights for the project's DAO or foundation to avoid confusion with the project's founders who initiated it.

Launch the Project Outside the U.S.

Projects launched outside the U.S. can be exempt from certain registration requirements under U.S. securities laws. The goal of this strategy is to prevent tokens from flowing back into the U.S., so communication should avoid promotion in the U.S., and the presence of "significant market demand for tokens in the U.S." can also influence this.

In summary, if tokens are not offered in the U.S., do not communicate as if tokens are being offered. Any statements about tokens made by the team on social media should explicitly state that these tokens are not available in the U.S.

Restrict Token Transferability

Strategies that restrict token transfers or impose limitations off-chain can mitigate legal risks, as individuals cannot invest funds to obtain tokens based on the Howey Test, thus not constituting a security. However, if the project's statements encourage participants to view restricted tokens or points as investment products, the protection of token transferability can quickly erode. Such statements may seriously undermine the legal basis for restricting tokens and should be avoided.

Handle Token Listing and Liquidity in Secondary Markets with Caution

The listing of tokens on secondary markets and ensuring sufficient liquidity is one of the risks the SEC is concerned about.

Project teams typically seek to list tokens on secondary markets such as Binance or Uniswap to allow more people to purchase tokens. This usually involves ensuring there is enough liquidity on the trading platform, as a lack of liquidity can lead to price fluctuations and increase risks for the project and its users, which is why the SEC is concerned.

Project teams need to handle the listing and liquidity of these markets extremely carefully. Projects that are unsure if they have achieved full decentralization should not release information about their token listing on exchanges and may not engage in market-making activities within the U.S.

Impose a Minimum One-Year Lock-Up Period for Tokens

Projects should establish a minimum one-year lock-up period for tokens issued to the internal team, as the SEC has successfully used the absence of a one-year lock-up period to literally block token issuance, suggesting that the SEC may do so again.

Ideally, token lock-up restrictions should begin to release after one year and linearly release over three years from that point, making the total lock-up period four years. This approach can help teams mitigate the legal risks mentioned above and reduce the pressure of token price declines.

Projects should also be wary of investors attempting to shorten the lock-up period, as such demands may indicate that investors are not complying with securities laws and may sell tokens in a short period.

Recommended Reading: Diamond Hands Will Not Make Money? VC: Prices of Recently Issued Tokens Will Inevitably Fall Reason for Recommendation: This article discusses problems with recent large coin issuance models from a macro perspective, which can be read in conjunction with this article's legal perspective to provide a more comprehensive assessment of project token design for the future.