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As the crypto and blockchain industries continue to grapple with questions of ownership in digital networks, a new solution has emerged that offers numerous advantages: the incorporation of cooperatives into web3 projects. Credit unions, insurance companies, and agricultural producers are just a few examples of organizations that have often used this legal structure to operate and organize their businesses. By adding cooperatives into their ownership models, web3 projects can increase participation, reduce regulatory risk, and give users a greater sense of control and ownership of the digital networks they use. Furthermore, the US Securities and Exchange Commission (SEC) has consistently ruled that cooperative memberships are not securities, making it easy for cooperatives to distribute ownership and provide important protections to their members.
The decentralized nature of web3 projects has the potential to give individuals greater control over the digital networks they use and a stake in the value they create. However, existing models for distributed ownership, such as governance tokens and security tokens, often fall short due to severe regulatory challenges and limitations on participation.
Many web3 companies issue governance tokens to give users a sense of ownership in a project, often in the form of voting rights. Yet regulators increasingly view these tokens as subject to the same securities laws as stocks, leading to confusion among users about their rights and potential profits. Governance tokens can also experience significant value fluctuations, as was evident both before and during 2022.
Less commonly, web3 projects share ownership using security tokens, which confer rights similar to traditional stocks. Sharing ownership this way requires complying with securities laws, rules, and regulations - a process that can be costly and time-consuming. In addition, the vast majority of users are unable to purchase security tokens unless they have been registered with regulators or a valid securities exemption is used (which can be difficult to obtain in the context of a publicly available token).
A cooperative is a legal entity that gives its owners rights to governance, profits, and liquidation value, while also limiting their liability for the debts of the business. Cooperatives can be divided into two main categories: those owned by consumers and those owned by producers. Typically, cooperatives allocate economic benefits based on the volume or value of an owner's participation in the business, rather than their capital contribution. People can become owners, also known as "members," of a cooperative by acquiring one non-transferable membership "share" directly from the cooperative (often for a nominal price but sometimes for free) and signing a membership agreement. This grants them voting rights and makes them eligible to receive profit distributions in proportion to their participation in the business. In some cases, cooperatives may require members to purchase additional equity in addition to their non-transferable membership shares. However, this equity usually does not confer any additional voting or economic rights and is usually non-transferable. The cooperative may redeem this equity at face value if a member leaves the cooperative.
For new web3 projects, cooperatives provide a way to give users voting and economic rights without issuing tokens, although tokens can still be used in conjunction with a cooperative structure. New projects can simply incorporate a cooperative as part of their ownership model from the outset, while existing projects can add a cooperative component to their existing ownership structure. In either case, users can become members of the cooperative by acquiring a membership share and signing a membership agreement. In a web3 project, a cooperative could function in a number of ways. For example, members might be entitled to vote on key decisions affecting the direction of the project, such as feature development or changes to the network's protocol. They could also be entitled to receive profits from the project in proportion to their participation, rather than relying on fluctuating token values. In addition, the cooperative structure could provide important protections for members, such as limiting their liability for the debts of the project.
There are several benefits to using a cooperative structure in web3 projects. First and foremost, it allows for the easy and quick distribution of ownership to users without the need to comply with securities laws. This can reduce regulatory risk and increase participation in the project. In addition, the cooperative model aligns the interests of users and builders by rewarding users for their participation and potentially providing a stronger incentive for them to engage with and strengthen the digital network. This can ultimately lead to a better return on investment for builders and investors compared to models that rely solely on tokens.
Another advantage of using a cooperative structure is that it allows for greater user control and ownership of the digital network. Instead of relying on external tokens or securities, users can become direct owners of the cooperative and have a say in the direction of the project through their voting rights. This can foster a sense of community and encourage user engagement with the network.
Compliant ownership is the greatest advantage that cooperatives can bring to the web3 space. Cooperative memberships and the membership "shares" that represent them are not subject to federal securities laws, according to the U.S. Securities and Exchange Commission (SEC). The non-transferrability of these memberships also distinguishes them from transferable equity in a corporation, LLC or partnership, which are generally subject to federal securities laws. Cooperative memberships, which are owned by consumers and producers rather than passive investors, are not often the subject of financial speculation and can help protect against information asymmetry between management and owners.
There are many ways builders can use cooperatives to enhance participation and give ownership in a web3 project to users in compliance with securities laws. One of the most effective approaches involves holding or consolidating the productive assets of the project under a parent company and allowing a cooperative to join the cap table. This method ensures that builders, investors, and users can access the profits and governance of the entire business on equal footing. After adding a cooperative to the cap table, builders and investors maintain control over the business through their equity in the parent company until the user network is strong enough and the valuation of the project is high enough to permit a successful exit. Concurrently, users could gain increasing control over the project as the network grows and the cooperative earns or buys more equity in the parent company. Here are the seven steps builders could take:
This involves bringing all assets, including those controlled by governance tokens and those held by a corporation or other entity, under a single parent company or subsidiary.
Create governing documents that outline membership requirements, voting procedures, board composition, and other details.
Potential members should meet certain conditions, such as owning NFTs or tokens issued by the project, verifying their identity, and actively participating in the project. The cooperative can continue to add members after the initial group joins.
Utility tokens or digital collectibles can remain in use, but some projects may impose reasonable restrictions on their transfer to take advantage of SEC precedents that might not view them as securities.
The primary ways a cooperative can acquire equity in the parent company are by providing services in exchange for stock or purchasing it from builders, investors, or the parent company using funds from memberships, retained earnings, etc.
Members should have access to the profits and governance of the business on equal footing with builders and investors. Profits may be distributed to the cooperative in proportion to its equity interest in the parent company, or as otherwise agreed upon. Profits are generally tax-deductible to the cooperative and taxable to members who receive them.
When the user network is strong and the valuation of the project is high enough, builders and investors can maintain control of the business through their equity in the parent company until it is time for a successful exit. Users can gain increasing control as the network grows and the cooperative earns or buys more equity in the parent company.
Cooperatives provide a groundbreaking framework for addressing the complex ownership issues in the web3 space. By incorporating cooperatives into their ownership models, web3 projects can increase participation, reduce regulatory risk, and give users a greater sense of control and ownership of the digital networks they use.
The benefits of using cooperatives in web3 projects are clear: they align incentives, amplify growth, and provide a compliant solution for distributed ownership. If you are interested in using this model for your web3 project, Upside.coop will take care of the heavy lifting, so you can focus on your people. Don't let your most valuable asset, ownership, go underutilized.