The method by which cryptocurrency and digital asset companies issue their blockchain-based tokens into the market has evolved, pushed along by regulatory developments and technological advancements. We have observed the popularity ebb-and-flow of direct token sales, Simple Agreements for Tokens (‘SAFTs’), genesis tokens convertible into principal tokens, and gifted distributions. This article summarizes a different method for issuing initial stakes of tokens and strengthening the health and distribution of blockchain networks—the “Node Agreement”. Over the past year, more companies have been choosing to issue tokens via Node Agreements because it enhances market participation and distribution.
What is a Node?
A blockchain network exists as a collection of distributed information across numerous electronic devices or storage spaces, which are referred to as “Nodes.” These Nodes will store the network’s information and perform tasks such as validating the blockchain, creating blocks on the blockchain, processing transactions, and/or voting on a variety of inquiries. Operating a Node can involve significant costs resulting from computing resources and energy usage. When launching a new blockchain network or trying to grow an existing one, it can be difficult to convince new node operators to participate in your network and to incentivize existing node operators to spend more time and computing power on your network.
What is a Node Agreement?
Pursuant to a Node Agreement, a third party (the “Node Operator”) agrees to operate one or more Nodes on a blockchain network for a specified amount of time (e.g., continuously for 12 months) in exchange for earning tokens from the blockchain-based company (the “Company”). The tokens are often issued on the Node Agreement’s effective date and subject to time-based or performance-based vesting, with the intention of allowing the Node Operator to take advantage of the tokens’ then-low(er) value for tax purposes when filing an Section 83(b) election.
Why Use Node Agreements?
Goodwin’s blockchain team developed our version of a Node Agreement as a means to serve both regulatory and business goals for our cryptocurrency and digital asset clients.
From a regulatory perspective, Node Agreements may be viewed to limit securities enforcement risk, as regulators regularly consider the phase of development of a blockchain network when evaluating whether newly-issued tokens should be treated as securities or non-securities assets. Building a robust network of Node Operators that underlie the platform on which tokens will be used is an important factor to support an argument that the eventual users of the platform are purchasing tokens for their consumptive purpose, rather than the hope that the tokens may be valuable on a future functioning platform.
From a business perspective, the more Node Operators and greater distribution that a blockchain network has, the more secure it is from attacks, which is attractive to token participants. Blockchain networks can have a snowball effect—it is much easier to convince the 10,000th Node Operator to participate in your network than the 10th Node Operator.
The Node Agreement addresses both goals by ensuring that there are active, engaged Node Operators prior to (or simultaneous with) the issuance of new tokens.
What Does a Node Agreement Look Like?
Node Agreements may be used when a blockchain-based Company wants to increase the number of Nodes in its blockchain network—e.g., at its initial launch or another inflection point in the network’s life cycle. Consequently, a Company needs to leave itself flexibility to make changes to its protocol or node operations beyond the initial Node group, based upon feedback received once the launch or inflection point occurs. To that end, it is customary for Node Agreements to be more streamlined than other types of commercial agreements and grant discretion to the Company (or the Company and a majority of Node Operators) to adjust certain terms that are often more fully fleshed-out in commercial arrangements (e.g., downtime protocols and support). We typically see 10-25 page Node Agreements, and the following provisions are often the most material to blockchain-based Companies and Node Operators:
- Performance standards and guidelines for operating a Node
- Note that the Company is often granted discretion to change some or all of the standards and guidelines.
- Terms governing the issuance of tokens to the Node Operator, including a vesting schedule based on node operating time.
- These provisions should be discussed with tax counsel.
- Termination provisions
- The purpose of the Node Agreement is to ensure that Nodes will be operating on the blockchain network; however, as a result of legal or market changes the Company and/or the Node Operator may want an escape hatch. These provisions may be heavily negotiated.
- Indemnification and limitation of liability
- The right balance of indemnification and liability should be based on the relevant risks arising from the structure of the network and regulatory considerations.
- Covenants related to regulatory/securities compliance, if applicable
- Before entering into node agreements, consider consulting with regulatory counsel.
Many blockchain-based Companies would be well-served by considering Node Agreement transactions as a mechanism for launching a network and/or increasing network participation. Before entering into Node Agreements, we recommend consulting with regulatory and tax advisors.