A Healthy DAO Token Sale: A Legal Guide and Best Practices

DAO token sale, or a DAO Raise — is an event during which a decentralized autonomous organization raises funds for financing by directly selling tokens. Unlike traditional asset-sale models, in a token sale buyers typically transfer funds to the multisig-wallet, and distribution is usually carried out via a smart contract, the deployment of which occurs after the raise closes. About how to conduct a token sale as safely as possible for the DAO and buyers, explains Sergey Ostrovsky — a lawyer, partner AURUM Law Firm.

Legal Aspects: Complexities and Peculiarities

In this article we will talk only about those organisations that lack a legal wrapper, as they are the ones most likely to 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 recognised as a partnership or joint venture. In such a case token holders may bear full joint and several liability, i.e. they are answerable with all their assets for all obligations of the organisation.

For example, in case CFTC against bZx DAO a federal court in California ruled, that the organisation should be treated as a partnership or joint venture. Consequently, all holders of bZx tokens are considered partners and may bear responsibility for users’ financial losses resulting from a protocol hack.

In centralized token sales, legal agreements and other tools are always used to limit liability of the project and the team, as well as to address regulatory and related risks. In the case of a DAO these questions remain unresolved. This increases legal risks for both the organisation itself and for those stakeholders who participate in conducting the token sale and related operations.

Tax Implications

Without a specific legal entity that could act as the seller of tokens and recognise the proceeds from their sale on its balance sheet, a number of difficulties arise as to how to qualify the deals themselves and the income generated from the sale.

For key contributors to the DAO taking part in the token sale, especially the signatories of the multisig wallet to which funds are received, a number of negative tax consequences may arise. Their type and character are determined by the law of their respective jurisdictions, which may imply that the proceeds are recognised as taxable income.

Jurisdictional Complexities

Typically the DAO does not set restrictions on the countries where tokens may be sold. This should be considered, because in many jurisdictions there is already special legislation that in some cases substantially regulates token sales, and in others – prohibits them entirely. In some countries public sale of tokens may contravene traditional financial legislation and the norms regulating securities and investments. Additionally, for a number of jurisdictions sanctions restrictions have been introduced that crypto projects would be well advised not to breach.

To protect the project from possible risks linked to token sales, a list of “prohibited” jurisdictions should be devised, residents of which are not admitted to token sales.

But how can a project ensure real compliance with such restrictions? The answer is to conduct due diligence or KYC-procedures.

Challenges in Carrying Out Due Diligence / KYC

Know Your Customer procedures have already become an integral part of modern token sales. This process allows identifying the purchaser’s identity and the authenticity of their data, and ensuring that they are not subject to sanctions and are not located in a restricted jurisdiction. If KYC is complemented by KYT, one can also verify the source of assets and ensure they were not obtained illegally.

In a token sale, carrying out due diligence or KYC can be challenging, as buyers typically value privacy and try to avoid publicly disclosing personal data. Moreover, at first glance it is unclear who should carry out the procedure for the DAO. A small spoiler: there is a way out.

Token Sale Structuring: A Detailed Guide

Every organisation has its own governance procedures that must be followed when conducting a token sale. Moreover, the tokens being sold usually come from the DAO’s treasury, and using them requires approval by the organisation itself or a dedicated committee.

Therefore, one of the key stages of the token sale will be a DAO resolution authorising its conduct, which should cover the following questions.

1. Sale parameters: total number of tokens offered, their price, and the form of payment accepted (for example, USDC/USDT/ETH).
2. Clear lockup and vesting terms, which apply to the tokens being sold and will be baked into the smart contracts.
3. Applications: minimum cheque, submission procedure, their selection and approval, KYC requirements.
4. Deal mechanics: actions by the buyer upon approval of the application, for example, providing the required information and passing checks, the payment process, and the wallet address to which payment is made.
5. Key timelines and deadlines: for submitting applications and their approval, providing the buyer with the required information, completing KYC, making the payment, etc.

Due Diligence / KYC

Carrying out KYC procedures within a token sale may seem a daunting task, given the complexity of the process itself and buyers’ reluctance to disclose their personal data.

To address this, a DAO may engage a contractor, ideally a law firm, to perform all necessary procedures on behalf of the organisation. We at AURUM, for example, provide such services. In simplified form the process looks as follows:

1. In case of interest from the DAO we make an offer, usually via a forum post or a Discord message. It includes our recommendations on verification procedures, the proposed list of prohibited jurisdictions and other terms.
2. The DAO (or an authorised committee) approves our proposal and performs a “conclusive action” — transferring payment to our wallet, after which we obtain a list of potential buyers to be checked.
3. Our staff contact each buyer directly, explain the essence and procedure of the checks, and collect all necessary information and documents.
4. A comprehensive check of each buyer is conducted, including checks on their solvency and source of funds.
5. As a result of the checks we publish an official report indicating the wallet addresses of buyers who passed the checks and the amount of their purchase. Other data is not disclosed.
6. With our report the DAO completes the token sale, admitting only vetted buyers to participate.

The described procedure is advantageous in that participants disclose their personal data only to the law firm. This information is not published anywhere, which helps preserve a sufficient level of anonymity.

The DAO sells tokens only to buyers who are deemed “safe”, have passed checks and meet the approved criteria. Buyers, on the other hand, gain the opportunity to participate in the token sale without publicly disclosing their personal data.

This balance provides adequate safety for all parties involved in the transaction.

Token Sale Instrument

Of course I know the concept “code is law” and recognise its influence on the industry. However it is important to understand that code alone cannot address all legal issues, nuances and consequences arising from conducting a token sale. At least not yet. Not to mention that for some categories of buyers, such as funds and institutional investors, the absence of a contract can become a significant problem.

For these reasons we use legal instruments (contracts) to document the deal and formalise key terms. If the DAO does not have a legal structure, unilateral written agreements signed by the buyer, or Terms of Sale, with which the buyer must agree, can be used.

Although these agreements are entered into only by the buyer, with the right legal constructions their scope can be extended to DAO members and contributors involved in the token sale. In this way all of them receive legal protection, including limitation and exclusion of liability.

This approach supports decentralisation and brings certainty to the transaction itself, formalising some of its terms, and ensuring the safety of the DAO and key stakeholders.

Closing the Token Sale

After the preparation is complete, all checks and instruments have been completed, buyers transfer payment for tokens to the wallet address specified in the DAO’s resolution.

When funds are gathered, the organisation deploys the smart contract to distribute the sold tokens among buyers. Token sale participants will be able to withdraw their tokens from this smart contract in accordance with the vesting schedule approved by the DAO.

Taxation

Raising funds from token sales leads to ambiguous tax consequences. This is especially pertinent for those who are signatories of multisig wallets or manage the organisation’s funds.

If no SPV is used for structuring the token sale, the scope for tax planning and management will be severely limited. The issue is so complex that there is no point in addressing it in this article; a separate piece is required.

For those considering an SPV route, I would suggest using a targeted trust to wrap the multisig wallet involved in the token sale. More on this structure can be found in the fairly detailed material from dYdX.

In other cases I would advise turning to tax advisers to understand potential risks, assess possible consequences and study strategies for effective tax planning. It is essential that all participants understand both individual and collective obligations and potential consequences.

What It All Adds Up To: A Healthy DAO Token Sale

The described model combines decentralisation, security and legal compliance. But what does it mean for all participants in practice? Let us unpack.

The DAO remains fully decentralised. At the same time, members of the organisation gain adequate legal protection and an additional layer of financial security. Without compromising decentralisation, we perform compliance and significantly reduce potential risks and liabilities for the DAO and its participants.

Buyers, for their part, have long been accustomed to undergoing KYC checks, and this is not news to them. At the same time, because the procedure is carried out by professional lawyers, buyers are guaranteed confidentiality and the security of their personal data. Moreover, a clear and transparent token sale procedure allows them to understand precisely what they are getting into.

Key stakeholders such as multisig signatories, promoters and those directly involved in the token sale on the DAO side gain legal protection and a basis to rely on legal instruments that substantially limit their potential liability and risks.