A DAO token sale, or DAO Raise, is an event in which a decentralized autonomous organization raises funds through the direct sale of tokens. Unlike traditional asset sales models, during a token sale, buyers usually transfer funds to a multi-sig wallet, and distribution is usually carried out using a smart contract, the deployment of which occurs after the raise is closed. Sergey Ostrovsky, lawyer, partner of AURUM Law Firm, talks about how to conduct a token sale as safely as possible for DAOs and buyers.
Legal aspects: difficulties and features
In this article we will only talk about those organizations that do not have a legal shell, since they are the ones who primarily face problems when structuring a token sale.
In various jurisdictions, a DAO as an association of people, efforts or capital to achieve common goals may be recognized as a partnership or partnership. In this case, token holders potentially bear full joint liability, that is, they are liable with all their property for all obligations of the organization.
For example, in the case CFTC v. bZx DAO, a California federal court ruled that the organization should be treated as a partnership or partnership. Consequently, all bZx token holders are considered partners and may be held responsible for financial losses of users as a result of a protocol hack.
Centralized token sales always use legal agreements and other tools that limit the liability of the project and team, as well as address regulatory and related risks. In the case of DAO, these issues remain unresolved. This increases legal risks both for the organization itself and for those stakeholders who participate in the token sale and related transactions.
Tax consequences
Without a specific legal entity that could act as a seller of tokens and receive income from their sale on its balance sheet, a number of difficulties arise with how to qualify both the transactions themselves and the income received from the sale.
For key DAO contributors taking part in the token sale, especially signatories of the multisig wallet into which the funds are received, a number of negative tax consequences may arise. Their type and nature is determined by the law of their own jurisdictions, which may imply that the funds received are treated as taxable income.
Jurisdictional complications
Typically, DAOs do not place restrictions on the countries where tokens can be sold. This should be taken into account, since many jurisdictions have already introduced special legislation that in some cases significantly regulates, and in others completely prohibits the sale of tokens. In some countries, the public sale of tokens may violate classical financial laws and regulations governing transactions with securities and investments. In addition, sanctions restrictions have been introduced in relation to a number of jurisdictions, which it is better for crypto projects not to violate.
In order to protect the project from possible risks associated with the sale of tokens, it is necessary to develop a list of “prohibited” jurisdictions whose residents are not allowed to participate in the token sale.
But how can a project ensure that such restrictions are actually respected? The answer is by conducting due diligence or KYC-procedures.
Difficulties in conducting due diligence / KYC
Client identity verification procedures have already become an integral part of modern token sales. This process allows us to verify the buyer’s identity and authenticity, and ensure that they are not sanctioned or located in a prohibited jurisdiction. If KYC is supplemented KYTyou can also check the source of origin of assets and make sure that they were not obtained illegally.
In the case of a token sale, performing due diligence or KYC procedures can be difficult, since buyers usually prefer confidentiality and try to avoid public disclosure of personal data. In addition, at first glance, it is unclear who and how should carry out the procedure for the DAO. Small spoiler: there is a way out.
Structuring a Token Sale: A Detailed Guide
Each organization has its own governance procedures that must be followed when conducting a token sale. Moreover, the tokens sold typically come from the DAO’s treasury and require the approval of the organization itself or a special committee for their use.
Therefore, one of the key stages of the token sale will be the adoption of a DAO resolution on its holding, which should cover the following issues.
- Sale parameters: total number of tokens offered, their price and type of payment accepted (for example, USDC/USDT/ETH).
- Clear conditions lockapa And vestingwhich apply to the tokens being sold and will be embedded in smart contracts.
- Submission of applications: minimum check, procedure for submitting applications, their selection and approval, requirements for passing KYC.
- The mechanics of the transaction: the buyer’s actions if the application is approved, for example, providing the necessary information and passing checks, the payment procedure and the address of the wallet to which it is deposited.
- Key deadlines: for submitting applications and their approval, providing the buyer with the necessary information, completing KYC, making payments, etc.
Due diligence / KYC
Carrying out KYC procedures as part of a token sale seems like an impossible task, given the complexity of the process itself and the reluctance of buyers to disclose their personal data.
To solve this problem, the DAO may engage a contractor, ideally a law firm, to carry out all the necessary procedures for the benefit of the organization. We at AURUM, for example, provide similar services. In simplified form, the whole process looks like this:
- If the DAO is interested, we make an offer, usually through a forum post or Discord message. It includes our recommendations for verification procedures, a proposed list of prohibited jurisdictions and other terms.
- The DAO (or an authorized committee) approves our proposal and performs a “conclusive action” – it makes a payment to our wallet, after which we receive a list of potential buyers for whom we need to conduct checks.
- Our employees contact each buyer directly, explain the essence and procedure of the verification, and also collect all the necessary information and documents.
- A comprehensive check of each buyer is carried out, including in order to verify his solvency and the source of funds.
- Based on the results of the verification, we publish an official report in which we indicate the wallet addresses of those buyers who passed the verification and the amount of their purchase. Other data is not disclosed.
- With our report, DAO completes the token sale, allowing only verified buyers to participate.
The good thing about the described procedure is that participants disclose their personal data only to the law firm. This information is not published anywhere, which allows you to maintain a sufficient level of anonymity.
The DAO sells tokens only to those buyers who are considered “safe”, have passed checks and meet approved criteria. Buyers, on the other hand, get the opportunity to participate in the token sale without disclosing their personal information publicly.
This balance provides sufficient security for all parties involved in the transaction.
Token Sale Tool
I am certainly aware of the concept of “code is law” and recognize its impact on the industry. However, it is important to understand that the code itself cannot address all the legal issues, nuances and consequences that arise during a token sale. At least for now. Not to mention that for some types of buyers, such as funds and institutional investors, the lack of a contract can be a significant problem.
For these reasons, we use legal instruments (contracts) to formalize the transaction and formalize key terms. If the DAO does not have a legal structure, one-sided written agreements that are signed by the buyer can be used, or Terms of Salewith which the buyer must agree.
Although these agreements are accepted only by the buyer, with the right legal structures they can be extended to include DAO members and contributors participating in the token sale. Thus, they will all receive legal protection, including limitation and exclusion of liability.
This approach promotes decentralization and makes it possible to introduce certainty into the transaction itself, formalize some of its conditions, and also ensure the security of the DAO and key stakeholders.
Closing the token sale
After completion of preparation, all checks and registration of instruments, buyers make payment for tokens to the wallet address specified in the DAO resolution.
When funds are raised, the organization deploys a smart contract to distribute the sold tokens to buyers. Participants in the token sale will be able to withdraw their tokens from this smart contract in accordance with the vesting schedule that was approved by the DAO.
Taxation
Receiving funds from the sale of tokens leads to ambiguous tax consequences. This is especially true for those individuals who are signatories of multisig wallets or manage funds of the organization.
If not used for token sale structuring SPV, the possibilities of tax planning and tax risk management will be severely limited. The issue is so complex that there is no point in raising it in this article; separate material is needed here.
For those considering an SPV, I would suggest using a trust to wrap the multisig wallet involved in the token sale. More information about this structure can be found in the rather detailed material dYdX.
In other cases, I recommend contacting tax advisors to understand the potential risks, assess the possible consequences and explore strategies for effective tax planning. It is essential that all parties to a transaction understand both the individual and collective obligations and potential consequences.
What is the result: token sale of a healthy person
The described model combines the key elements of decentralization, security and legal compliance. But what does this mean for all token sale participants in practice? Let’s figure it out.
For DAOs, complete decentralization is maintained. At the same time, members of the organization receive adequate legal protection and an additional level of financial security. Without changing the principles of decentralization, we carry out compliance and significantly reduce possible risks and potential liability for the DAO and its participants.
Buyers, in turn, have long been accustomed to undergoing KYC checks, and this will not be news to them. Moreover, since the procedure is carried out by professional lawyers, buyers are guaranteed the confidentiality and security of personal data. Moreover, a clear and understandable token sale procedure allows them to understand exactly what they are getting into.
Key stakeholders, such as signatories of multisig wallets, promoters and persons directly involved in the token sale on the side of the DAO, receive legal protection and the opportunity to rely on legal instruments that significantly limit their possible liability and risks.