The foundation model came about as a response to the US securities enforcement actions early on. In 2014, FeedZeBirds was one of the first projects to face an SEC enforcement action for crowdfunding online; prior to this, blockchains were layer one blockchains were launched in a Bitcoin-like manner. This meant that there was no centralized issuer, the mining was decentralized and the token emissions were not centrally controlled as a result. Well, this can be inconvenient, so instead of selling miners, the industry gravitated towards traditional fundraising ahead of a cryptocurrency launch, like a normal startup.
The Life Cycle of a Token Launch
A token launch can be segmented into two separate activities. If you’re familiar with how the Securities Act of ’33 and ’34 are structured, they segment the issuance of a security from the steady state management of a security. A token is first issued, and at point of issuance or upon entering circulation, the token needs to either be decentralized with no central authority like Bitcoin or it needs to fall into a securities regime (the treatment of airdrops can be disputed here although there are many loopholes that industry has not explored sufficiently). After the token is distributed, we now have a different set of rules for management, this is where the financial assets (the funds that were raised) of the issuer are offloaded to a foundation for ongoing management. At the end of the day, all this does, is shift the securities implications or potential obligations away from the centralized team that could be considered the issuer of the asset.
In summary, regulatory frameworks treat fundraising and issuance of the asset as a distinct from the ongoing management.
A Quick Note on Startups
Startups are meant to bring new technological innovations into the world with a competitive business model to the status quo, if one exists. This means that the startup requires sufficient capital to enter the market and to achieve the requisite business traction it needs to generate an outsized outcome for its shareholders. Launching a startup is already a high-risk endeavor due to the nature of markets, any additional risk should be calculated as an exponential to the base risk model of a startup. For example, interpersonal strife between the team. If the company does not have sufficient inertia, any strife can very easily result in a failure of the business.
A Quick Note on Foundation and Operating Company Dynamics
A startup, by design, has the ability to provide the founders with outsized returns in exchange for their efforts for bringing a product or in this case an asset to market. This is in the form of equity. When fundraising for a cryptocurrency or token, the same dynamics and incentives are applied, just like the equity, an outsized portion of the supply is allocated to the founders.
The foundation, if run properly, needs to operate with financial prudence and needs to operate with a fiduciary obligation to all holders of the underlying, managed asset. This creates an environment where the foundation naturally operates at odds with the incentives of the operating company.
The operating company wants more capital to fuel innovation, meanwhile the foundation directors have an obligation to place restraint upon the disbursement of funds. This can be at odds with the dynamics of a startup which needs to move at a fast-pace to achieve product-market fit.
Where it Can Go Wrong
Apart from the regulatory obligation that the Foundation meets, we have the practical obligations of the Foundation. These include management of the capital and the governance structure around the management of capital. In the past this has led to significant strife. We can use the Tezos Foundation as an example.
In 2017, Tezos raised $232 Million in a token sale. All users of which were later processed through the requisite compliance requirements by Tokensoft Inc. The foundation was setup in Zug and amongst its directors had Johann Gevers, the operating company being run by Arthur and Kathleen Breitman. Now let’s contrast the motivations of an operating company with a those of a foundation. A startup and its associated operating company are designed to move fast an break things. A Swiss foundation is more likely to be run like a Swiss watch, methodical, precise, every movement being performed with great prior and active consideration.
This resulted in a back and forth which captured a majority of the attention in the space at the time due to the amount of capital raised and the profile of the company and its investors. In order to best convey the situation, I’ll just place some sourced quotes for review:
“An attorney for the Breitmans sent a 46-page letter on Sunday to the two other members of the foundation’s three-person board, calling for Gevers’ prompt removal and seeking to give the couple a “substantial role” in a new structure that would limit the foundation’s responsibilities. The document accuses Gevers of “self-dealing, self-promotion and conflicts of interest.” - Reuters
“The Breitmans have been trying to control the foundation as if it were their own private entity, Gevers said, by bypassing the foundation’s legal structure and interfering with management and operations. This has resulted in costly delays in developing and launching the Tezos network and new currency, he said.” - Reuters
We need not see more.
Practical Issues with Foundations
Many foundations operate grants programs. The goal of the grants programs are to increase the demand of the cryptocurrency or token by delegating funds for the purpose of marketing or additional software development on the underlying software. The issue with the grants is moreso that they operate like NGOs in the United States that disperse funds in ways that fail to match their target deployment goals. With typical software, by the time a payment has been made the software already exists for consumption or it is delivered upon a specific date. With grants programs, there is no feedback loop to ensure that the economic result has been delivered back to the cryptocurrency or token.
This has led to billions of dollars in grants with no accountability, and in most cases, zero evidence that any economic value has accrued back to the token. This exists largely to the decoupling of the foundation with the operational company, there is no overlap in incentives, process nor expedient timelines. Foundations do not have an incentive for increasing cash reserves.
This has also led to a cottage industry of foundation directors that are managing these foundations without an urgency to grow the economic value of the token. They become ghost foundations where a small group perpetually collects a paycheck with no oversight or accountability.
Foundations and Taxes
The sole reason foundations today are kept outside of the United States is for tax reasons. Tokens can be issued under applicable securities laws in the US, however there has not been a well-trodden tax solution in place. I’d argue that if the teams that were incentivized to run the blockchain, generated a profit in the first-place, this would be more of a concern. It is also the case, that a lot of the profits can be offset by incentives in the United States tax code. This has likely been under-explored as tax-advisors have generally concerned themselves with the issuance process and the ongoing operations have been less-trodden.
A Practical Alternative to a Foundation
We’ve seen a rise in digital asset treasuries, essentially publicly reporting companies that hold a particular digital asset. While the economic model is questionable, the governance implications have been tested over a hundred years through the United States court system as well as the general economic engine. Let’s first evaluate a public reporting entity in theUnited States based on its fundamental pieces. You have a company where shareholders own shares and have an interest in its positive-yielding economic outcome. The leadership of the company is obligated by regulation to provide historical evidence of the companies performance. The leadership of the company also have a fiduciary responsibility to the company, meaning all their actions should be in accordance with the interests of shareholders. They are also required to provide forward looking guidance on the performance of the shares.
While it doesn’t make sense to replace equity with a token, it can make sense to add a token or cryptocurrency onto the balance sheet of the publicly reporting company. Let’s evaluate what this accomplishes. The first being alignment. Although it is a startup, you know have direct responsibility of the founders with the performance of the token. You also have a legal obligation for every dollar spent in the company to be attributable to a positive shareholder outcome.
With founders that do not hold the token natively, we can also have better decentralization and better alignment with securities laws. Securities laws natively promote decentralization and checks and balances whereas Money Transmission Laws and Bank Secrecy Act laws natively promote centralization.
Most importantly the diligence for every dollar spent undergoes strict and continuous review by the leadership of the company, ensuring the fast course correction that a startup needs to find product market fit.
Now is this practical? To layer the operational burdens of a public company onto startups? Absolutely not. It’s a distraction. However if the economic upside justifies it, it could be worth the effort or risk. Alternatively, a shared services entity can be setup by the venture capital community to offload the compliance burden away from startups.
Perhaps the entity holding the cryptocurrency is structured as a ’40 Act Fund which is managed by the operating company so as to segment away the direct burdens of being a publicly reporting company at small scale. Others have recommended structuring these entities as Public Benefit Corporations which can attempt to reach similar goals.
A Path Forward
As the industry strives to create more tokenholder value, it’s always worth revisiting the constructs at play. Are they actually better, are they worse? How can we place additional pressure on creating value. Ensuring founders are working hard everyday, hyper-focused on the one goal of increasing the economic value of their enterprise.
Originally published on The Masonic. Subscribe for occasional writing on tokenization, compliance, and what’s actually happening at the frontier of financial technology.