January 29, 2022
Token compensation is filled with a lot of legal and regulatory uncertainty, especially when it comes to employee compensation. But there is one way to issue them in a manner that’s more familiar and palatable to government regulators, Restricted Token Units (RTUs).
Restricted token units (RTUs) represent a company’s promise to pay blockchain-based coins or tokens to a worker or employee once certain vesting conditions are met. Each unit represents an equivalent amount of the token, which can be at a ratio of 1:1.
Crypto companies that offer RTUs generally use existing tokens from their very own project as the underlying tokens to be awarded.
RTUs are similar to RSUs, except that tokens are issued upon a liquidity event instead of stocks. RSUs have a strong legal backing in 70+ countries around the world with existing precedents around their use which cryptocurrency companies can rely on when creating their token compensation plans.
The blockchain world is exploding in a good way. After years of hard work, we’re reaching a tipping point and consumer-friendly products are materializing.
This is an exciting time for the world as well as all the people who are pouring their blood, sweat, and tears into so many great projects and services.
With cryptocurrencies and tokens emerging as new asset classes, many projects are using their tokens in order to incentivize, pay, and otherwise reward their workers. While it’s easy to issue tokens to workers, there are a lot of issues that can come with using tokens as compensation.
Luckily there’s a simple legal solution available. It’s a solution that is very similar to the way most companies have solved these problems over the past 20 years by using Restricted Stock Units (RSUs).
Just like traditional equity compensation can be paid in the form of stock options, restricted stock awards (RSAs), and restricted stock units (RSUs), tokens may also be granted as token options, restricted token awards, and restricted token units (RTUs).
The vesting condition for some RTUS, especially single-trigger ones, is time-based. This means that the employee or awardee has to stay with the company for a set number of months or years before the RTUs start vesting.
An RTU plan can also have double-trigger vesting. Double-trigger RTUs, similar to double-trigger RSUs, ensure that the tokens will only vest and be paid out once a landmark event occurs..
Restricted Token Units (RTUs), are the crypto world equivalent of RSUs. As in the case of RSUs and equity compensation, RTUs allow companies to help avoid the negative tax and legal ramifications of issuing tokens as a form of compensation.
However, laws and regulations are slow when it comes to adapting to technological innovation. Hence, it comes as no surprise that the legal status of token-based compensation is still evolving.
So, before you start issuing tokens to workers, let's consider some ways in which tokens can be compatible within traditional legal frameworks that regulators around the world understand.
Here are the most important things to consider:
Federal and state taxation
Section 409A compliance
Labor and employment law
Sometimes it is challenging to know how your token will be treated and taxed across different jurisdictions around the world. If you’re compensating employees with a token, it is very easy to run afoul of employment regulations in various countries.
So let’s dive deeper into the major challenges and solutions to consider when issuing tokens as compensation:
A good starting point in understanding tokens within the proper legal perspective is to compare them to the treatment of shares and equity. For example, similar to a company’s shares of stock, tokens and security tokens may be publicly sold to raise funds and capital in Initial Coin Offerings (ICOs) and may be traded in cryptocurrency exchanges.
Government agencies have seemingly adopted this approach in their legal analysis. The SEC, for instance, has stated that virtual coins or tokens that are offered and sold in Initial Coin Offerings (ICOs) may be deemed as “securities” under the law.
When you’re starting off your company it’s important to know if your token is a “security” under the law. For example, if you’re planning to offer “utility tokens” (i.e., tokens that can be bought and exchanged for the goods and services of the issuer), you might be of the opinion that it’s not really a security as it is essentially a prepayment for future goods and services.
This distinction, however, is not always clear depending on your product and how your jurisdiction defines securities and characterizes utility tokens. Thus, proceeding with this assumption can be a bit risky.
The safest course of action is to treat them like equity and assume that the law on securities would apply to them. RTUs allow you to do this since it relies on the established legal framework of RSUs that government regulators may be more familiar with.
More importantly, except for some variations, it is generally built with the provisions and legal mechanisms of equity issuance in mind. In other words, RTU plans usually treat tokens in the same way as an issuance of equity or company shares and conservatively assume that securities regulation would apply to it.
Just as RSUs are not stocks, RTUs are not tokens themselves. Rather, they represent a company’s contractual undertaking to pay an equivalent amount of tokens once the conditions for their vesting are met. Given this premise, regulatory bodies might treat RTUs the same way as to reduce risks arising out of uncertainty.
Token options, the token counterpart of stock options, are also feasible for this purpose but there is still a lot of uncertainty (see “Section 409A compliance” below). Moreover, experts in the subject are of the opinion that RTUs would generally be more advantageous than token options in that only a few of them would be needed to have the same compensatory value and impact which, in turn, would leave more tokens available for issuance.
Another notable advantage is that, just like RSUs, workers awarded with RTUs do not have to pay anything in order to acquire them. With token options, a worker can lose money if the token’s market value falls below the strike price. The fluctuating token price can also become a stress factor that affects team members’ satisfaction with the company overall. In comparison, RTUs will always be worth something so long as the underlying token still retains some market value.
The IRS has also indicated that “virtual currency” or token awards, like stock-based compensation, should be treated as property whose fair market value must be determined for income tax purposes.
In many jurisdictions, if the worker is an employee or could be considered an employee, then depending on when the worker is given custody of the token, it could trigger a taxable event.
It’s also important to consider the volatility of your token (more on this in the subsection below). For example, what happens when you give someone a token that’s high in value one year, and the worker owes a lot of tax on it, but the next year it tumbles in value. Will the worker then be left with a large tax bill that they will be unable to pay? These are important questions to consider if you’re thinking about paying employees with tokens.
RTUs are also aimed at preventing tax compliance issues associated with Section 409A which generally apply to stock options and—by analogy—token options.
Although it is still unclear as to whether Section 409A requirements really apply to tokens and token options, the safest course of action would still be to assume that they do. Thus, you shouldn’t take the risk of being subjected to all the complications associated with Section 409A by using token options.
It is also not yet clear whether it is lawful for companies to fully compensate employees with just tokens. The Fair Labor Standards Act (FLSA) requires wages to be paid in “cash or negotiable instrument payable at par.” Cryptocurrencies and tokens may or may not satisfy this legal requirement.
Moreover, there is also the possible issue with state minimum wage laws. If you use tokens as a major component of your employee compensation, falling prices could accidentally result in the violation of minimum wage laws.
These issues are something to be very careful about as violating employment laws is not to be taken lightly in most countries. If you are planning to issue tokens, a well-crafted token compensation plan is indispensable in ensuring compliance with the applicable labor laws.
If payment of the tokens is deferred until retirement or the termination of employment under the token compensation plan, the same might be subject to the coverage of ERISA depending on how the plan is specifically structured.
In such a case, a poorly designed token compensation plan can unnecessarily expose an employer to ERISA regulation. As an employer, this could mean additional reporting requirements and even the assumption of fiduciary obligations. Worse yet, this could result in liability in case of noncompliance. These are regulatory risks that one has to watch out for when drafting a token compensation plan.
In traditional equity systems workers are often given the promise of equity after they have stayed with the company for a predetermined period of time or after completing certain tasks or project requirements. There are various systems in place to have similar outcomes using tokens instead of equity, like locking tokens in a smart contract which then issues the tokens after a period of time or after certain requirements have been met. But then there is the issue of who has custody over the tokens and whether or not there is a taxable event.
Alternatively, if you want to promise someone a number of tokens over a number of years and you give them the tokens upfront for work done in the future, say the first year, how do you get them back if work isn’t completed? Or if you promise them a number of tokens each year, are you triggering a taxable event with each vesting?
These are some of the issues related to vesting that a company planning to provide token compensation has to address in coming up with their token compensation plans.
Something that you should be aware of, is how these tokens are being accounted for? If they are compensation for future work, how will your accountants and bookkeepers log these entries?
There are no rules that specifically deal with tokens and token-based awards under the Generally Accepted Accounting Principles (GAAP) nor under the International Financial Reporting Standard (IFRS). The Association of Certified Public Accountants has a publication called Accounting for and auditing of digital assets which offers suggestions on how to account for blockchain tokens and similar assets. But this suggestion is far from conclusive and the accounting treatment of tokens may vary depending on the circumstances.
With all the issues we just enumerated, what makes RTUs desirable for crypto companies? The answer is flexibility.
RTUs and token-based awards allow for a type of employee compensation that is “non-dilutive” in nature. Since tokens are not company shares, issuance does not affect or dilute the stake of existing shareholders.
For blockchain and cryptocurrency companies, it has the unique advantage of enabling worker alignment and engagement without issuing shares of stock. In other words, it provides the advantages of equity compensation without having to actually issue equity.
Does this mean though that blockchain and cryptocurrency companies should always go for token-based compensation? Well, that depends on the situation.
In the first place, some workers prefer to receive traditional equity instead of tokens. If a token’s value tanks or becomes worthless, workers would in effect receive nothing for their efforts.
But unlike tokens, equity is backed by the company’s assets. So even if the blockchain project becomes a total flop and the tokens become worthless, workers are assured that the equity they are holding still has value as long as the company’s assets are more than its liabilities.
Considering the uncertainty and risk associated with blockchain tokens, some people still lean towards receiving equity instead. In which case, equity compensation might prove to still be a much stronger motivator and catalyst for true worker alignment.
In any case, equity compensation and token-based awards are not incompatible. They may even serve to complement each other and allow for much-needed flexibility for certain companies. Some companies may even choose to use a combination of equity, tokens, and cash.
When the underlying award is a token instead of stock, at some point you and your workers will have to face whatever rules and regulations apply in your jurisdiction. Trying to explain to a regulator what your token is and if it’s a security or utility may not be how you want to be spending your time.
When talking to a regulatory body in your jurisdiction that you’re in contact with, it’s a lot easier to talk about an existing legal framework. It’s a lot easier to talk about RTUs’ similarities to RSUs than it is to try and explain why your token shouldn’t be considered a security.
RTUs allow you to fall under the umbrella of deferred compensation as it’s known around the world which enables you and your worker to defer a lot of these issues down the road to a point if and when your company has the resources to tackle the issue of token issuance in different jurisdictions. It's a bit like kicking the can down the road until you have the resources to pay.
RTUs and token-based compensation align with Upstock’s mission of universal equity and our ultimate goal of seeing a world where companies are at least 30% worker-owned by 2030. With all these technological innovations and disruptions, we are truly excited about the future of equity compensation and how it can change everything for the better.
If equity or token-based compensation is something that interests you, we’d be happy to talk to you about it.