With the rise of Initial Coin Offierings (ICOs) and Security Token Offerings (STOs) there has been considerable amounts of time spent on the legality of “is it a security or a utility”. That conclusion is becoming more established that token offerings, of whatever kind will likely be securities and require companies to use existing registration or exemption mechanisms to raise money compliantly. That being said, many are suggesting the use of Reg A+, Reg, CF or a 506(c) offering which is logical. However, the legal side of this will likely be the easy part. The hard part that comes after, is how will companies account for and track tokens? Here are the top 5 accounting issues we foresee companies will have post-raise.
1. Integrating a transfer agent – Who owns your security?
Why is it important – Let’s say you build up a great business and it’s time to sell to a larger strategic player in the space. You negotiate a great deal, now your token holders (which is a common stock equivalent or similar) need to be paid out. How does that happen? Do you have the name, address, etc… to facilitate a payout? There will have to be a mechanism for a transfer agent to track who owns the stock at a single point of time and there will have to be some ability for a company to pause the exchange of tokens to facilitate that transaction.
2. The “Reward” security token
Many companies we speak with want to “reward” users or vendors with a token. There are a bevy of issues with this, here are just a few:
Over $600 may trigger a 1099 - This is stock compensation, and you would need to 1099 someone just like if you had given them cash. That means you need their SSN, address, name, and may require a W-9.
Reduction of revenue under US GAAP - Many incentives are not a cost (expense) to a company but actually a reduction of revenue, so a company has to be very careful how to calculate rewards and how rewards are earned or given. Rewards would need to be based on a percentage of value rather than a number of tokens. The tokens change in price and if they become highly valued, their value could exceed the revenue recognized.
Giving away a token may create an obligation for future performance - This one is a rough one. Let’s say you give a reward token to a loyal customer. That specific token can be redeemed at it’s value in the future for product/services. Now let’s contemplate there is a run up in value of the token and the customer wants to cash in. However, it’s not just one customer but thousands of customers. Because the value of that specific token has grown so much, the Company may be obligated to perform on a value that is unsustainable. Think about a pension liability and the big automotive companies or the USPS, it’s not that much different. You provide a promise to fund something in the future at its future value. That value can grow and can bankrupt a company.
3. The Investment Company Issue
If you take Bitcoin, Ether, or your own token, and those items make up a significant portion of your balance sheet, you may subject yourself to the rules and regulations of investment companies. Be careful to and have policies to ensure these are less than 40% of your balance sheet at all times.
To do a regulated token offering, and to use the tokens for utility as well, you have to forget about anonymity. To audit these transactions, an auditor needs to know who the tokens come from and who they go out to. If that isn’t present, it is theoretically possible for one person or a group of people, to create many wallets, to funnel tokens in and out of a company artificially creating revenue or other transactions.
5. Lack of technology ready for compliant offerings
Because this is a newer industry, the products and services provided to the industry are not yet well defined or built out. Any small business can form, start a bank account, setup a QuickBooks Online file, and start accounting for their transactions day one. However, there is no QuickBooks equivalent for token issuers. Current wallet technology may have tax reporting functions, but it certainly won’t have US GAAP reporting functions. Therefore, it is going to make it very difficult for companies that do a compliant ICO/STO, to stay compliant due to the ongoing reporting requirements. This will be a significant hurdle for the industry.
dbbmckennon is a full service CPA firm with offices in Orange County, San Diego and Santa Monica. We specialize in companies filing with the SEC and utilizing equity crowdfunding through Reg A+ and Regulation Crowdfunding. For additional complimentary information regarding this topic or other questions you may have please call one of dbbmckennon‘s offices located in Southern California or contact us here.