Over the past several years, Teknos has valued hundreds of types of cryptocurrencies and tokens (utility, security, stable, etc.) for a variety of purposes. Over the course of those engagements, one of the most common reasons for performing a valuation is to satisfy tax compliance. Given the evolving nature of the cryptocurrency space, it can be difficult to know where to turn to on a variety of topics that frequently straddle the legal, tax, and valuation worlds concurrently. As such, we would like to share a brief summary of some key events to evaluate when a firm is contemplating the utilization of cryptocurrencies and tokens as a form of non-cash compensation for its advisors and employees.
In most cases, companies would like to take advantage of Section 83(b) of the tax code when making cryptocurrency or token distributions, as such an approach allows individuals to start the clock on the holding period required for long-term capital gains taxation rates – and do so at a potentially lower fair market value given the earlier stages of development commonly associated with related projects.
If the company plans to distribute the rights to the tokens before the token generation event (TGE), then a specific structure needs to be developed to satisfy the transfer rules of property. An example of this type of structure would be a “Funded Promise”, which is meant to comply with the definition of property under Section 83-3(e). Based on experiences, there is substantial grey area here with regards to the technical designation property, with many law firms taking varying perspectives on this concept. To that end, retaining knowledgeable counsel is highly advisable to help navigate the structuring process.
If the company plans to wait until the tokens are generated, then the process is a bit more straightforward from a structuring perspective. However, there can be specific rights associated with the receipt of the cryptocurrencies or tokens by advisors or employees where counsel can provide key insights (e.g. vesting, clawbacks, etc.). Waiting to conduct the distributions until after the TGE can also have an impact on the determined fair market value of the tokens as there is frequently more development on the project that has occurred by this point (or even sales of tokens,SAFTs, or related instruments).
Seek Robust Tax Advice
Given the potential for cross-jurisdictional transfers, as well as the conventional payroll ramifications of any compensation, we recommend that a highly experienced tax advisor is retained early in the process as well. A knowledgeable team will know how to navigate through the intricacies of the tax payments associated with the distributions, and can often be beneficial regarding the ramifications of potential intellectual property (IP) transfers as well.
The Valuation Process
Once the structuring of the cryptocurrency or token distribution is determined, and a plan exists for the overall allocation of said cryptocurrencies or tokens to associated individuals, the valuation process can commence.
If possible, initiating the process before a company has received any funding specifically associated with the cryptocurrency or token (e.g. private/public sales, or SAFTs) – or even any term sheets associated with such – is preferable. Once any potential indications of value are received, even in the form of a term sheet, they will likely have to be considered for incorporation into our analysis.
There are several methods that can be utilized within the valuation process, and as is typical with all valuations, the selection of the method depends on the facts and circumstances associated with each project and that are prevailing at the time of the valuation. At the early stages of a project, the asset and market approaches are typically considered most relevant; however, as more insight is gained into the project and the network monetization strategy, one might consider the income approach as well.
Having a breadth of experience in the industry can be a key differentiator, as seasoned valuation specialists can accurately determine the right valuation methodology for various, highly nuanced scenarios. Experience is especially important in these applications, given that neither the Securities and Exchange Commission (SEC) nor the Commodities and Futures Trading Commission (CFTC) have provided robust and concrete guidelines for the cryptocurrency and blockchain industries.
Limited Use of Reports
After the valuation is completed, the report has a limited use period of the earlier of fourteen calendar days, or a material event. There are a number of reasons for this:
- From an IRS perspective, having a valuation date with a close proximity to the execution of any transfer of property is typically viewed as favorable – especially when there are payroll tax implications.
- In general, there’s a higher level of volatility in the cryptocurrency markets (as compared to conventional securities and commodities markets), and since market data is incorporated in our analyses, we prefer to have our valuations utilized within short order following the valuation date.
- We would like to protect the report from potentially being misused in the event there is a high likelihood of an imminent material event (e.g., token sale, platform launch, etc.). As an example, a company could make token distributions based on a valuation of ours that is three weeks old and then turn around a week later and raise money at a specified token price. This could potentially put the client at risk as the valuation would not be defensible given its utilization outside of the authorized time window.
Any time a company plans to make token distributions outside of the report validity period, it’s recommended that a new report be commissioned. Ideally, if a company plans to make distributions to employees on an ongoing basis, it’s suggested that these are done on a more regular basis (i.e. quarterly, semi-annually, etc). If the tokens are eventually traded on an exchange, a valuation report is still recommended for distributions. Depending on the volume and trading metrics of a company’s token, there could be adjustments made to the traded value of a token. This can be assessed on a case-by-case basis.
Teknos Associates provides valuation and advisory services for emerging growth companies and their venture capital backers. Clients rely on our financial expertise, knowledge of technology markets, and high standards to deliver relevant and timely valuation reports and fairness opinions.
Special Note: From time to time, Teknos Associates has been retained by the Internal Revenue Service to perform valuation services. However, nothing in this communication may be taken to represent the official position or policy of the IRS. The opinions expressed herein are those only of Teknos Associates.
IRS Circular 230 Disclaimer: Pursuant to regulations governing the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, and appraisers before the Internal Revenue Service, unless otherwise expressly stated, any U.S. federal or state tax advice in this communication (including attachments) is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under federal or state law or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein.