Employee Incentive Vehicles for Digital Asset Companies

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GoodwinPeople are often the most valuable asset for growing technology companies, and attracting and retaining top talent is all-the-more important when dealing with emerging technologies like blockchain and cryptocurrencies.  For most private companies, the path for creating meaningful incentives for service providers is well-trodden—they can use a traditional equity incentive plan to issue options, restricted stock, RSUs, phantom equity or profit interests, which may appreciate in value as the company grows.  But creating service provider incentives for digital asset companies frequently requires a more tailored approach.  A growing number of our digital asset clients have chosen to establish “Employee Incentive Vehicles” or “EIVs” in order to enable them to offer incentives that best meet their recruiting and retention needs.

What is an Employee Incentive Vehicle?

An Employee Incentive Vehicle is a limited liability company (or other entity) formed by an operating company that holds one or more buckets of assets (e.g., cryptocurrency tokens).  The operating company retains control over the EIV, and the EIV creates a class of units for each bucket of assets that may share in appreciation in value of the applicable assets.  The EIV then can issue profits interests to the service providers of the operating company keyed to the applicable assets.

Shortcomings of Traditional Equity Incentive Approaches

There are a number of reasons that granting equity interests in the operating company or parent company may not provide an adequate or appropriate incentive for service providers of digital asset companies:

  1. Complex Entity Structures: In order to enhance blockchain networks’ decentralization and to comply with various regulatory schemes, cryptocurrency companies and other companies that produce digital assets regularly elect to have complex entity structures with a degree of independence or control-variation between various entities. Granting an equity interest in the entity that engages the service providers or its parent may not capture the appreciation in value that such incentive awards are intended to reflect.  For example, this deficiency comes into play where a blockchain network is administered by a non-U.S. foundation, but the service providers that aid the network are employees of a U.S. company that has entered into an arms-length services agreement with the foundation.
  2. Complex Operations: On the other hand, some companies with large digital asset holdings engage in a variety of activities, and their equity reflects the value of those activities in addition to the value of their digital assets.  If the issuing company wants the incentives to be tied exclusively to the appreciation in value of the digital assets, then granting traditional stock options would be overbroad.
  3. Service Provider Expectations: Many service providers developing or servicing blockchain networks want to receive the applicable cryptocurrency token or other digital asset directly. But under current regulatory frameworks, state and federal laws may prohibit service providers from holding such digital assets at this time. (Meanwhile, EIV profits interests are more directly tied to the value of the applicable digital assets than traditional equity incentive grants and, therefore, more closely align with service providers’ preferences.)

Benefits of an Employee Incentive Vehicle

EIVs provide a number of benefits over traditional equity incentive plans.

  1. Closely Tied to the Digital Assets: EIVs avoid the issues resulting from complex entity structures and complex operations by issuing EIV units the value of which is determined by direct reference to the applicable digital assets. Additionally, granting EIV units in lieu of equity of the operating company ‘shrinks the gap’ with service providers’ desire to hold the digital assets directly.
  2. Simplified Regulatory Framework: The EIV may be subject to a variety of regulations imposed by its home jurisdiction—and any other governmental authorities that claim jurisdiction—as well as other contractual restrictions and obligations governing the receipt and transfer of the digital assets. If service providers were to receive the applicable digital assets directly, the issuer and the service providers would need to navigate the regulations imposed by each recipient’s home jurisdiction (and any other governmental authorities claiming jurisdiction of any of the service providers), which would add layers of complexity to the company’s regulatory analysis.  Using EIV units as incentives instead of providing digital assets directly may simplify the regulatory analysis by reducing the number of jurisdictions that the company needs to navigate.
  3. Maximum Flexibility: By decoupling service provider incentives from the operating company’s equity, companies are able to create bespoke control rights, economic rights, redemption and distribution plans, and restrictions related to service provider incentives without affecting the rights and obligations applicable to their operating company’s or parent’s equity.
  4. Favorable Tax Treatment: If properly structure, issuing profits interests generally can be a tax efficient method for sharing appreciation in digital assets with service providers.  There are a number of economic, administrative and compliance parameters that need to be considered carefully, however, in order to effectively implement a profits interest plan.

Conclusion

EIVs are becoming a popular mechanism for digital asset companies to provide tailored incentives to service providers.  They are flexible and can be tax efficient for many companies, while also providing a clearer path for navigating regulatory considerations.  If you are interested in exploring an EIV, I recommend discussing potential EIV structures with your counsel, as the specific details of your EIV will depend on the tax and regulatory positioning of your digital asset holdings.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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