What the FAQ?! IP tokenisation

Q. Hi FAQ, I have been thinking about our prior discussion about stablecoins.  I also saw HLaw’s detailed report on the Bank of England’s proposals for the sterling-backed variety.  Now that I am following the subject, I have started to see references in the market to ‘tokenising’ IP rights.  At the risk of starting another lengthy discussion, what is IP tokenisation all about…?

FAQ:  It’s a new way for a company to monetise its intellectual property – patents, copyright, trade marks, design rights, trade secrets, and so on – in a way that does not dilute the equity shareholders or require the trading company to provide security over its assets.

Think of a music artist who owns or controls the IP in their back catalogue, or a biotech company with patents.

Q.  OK that sounds nice but what does it mean structurally, who is involved and how does the money flow?

FAQ:  You are quite right to press for further detail, Q.  There are different ways in which to structure a tokenisation and it’s a new concept still, but one way is as follows:

• a trading company or rights holder assigns or otherwise transfers IP into a wholly-owned subsidiary undertaking or a trust – a special purpose vehicle (“SPV”) – so as to: isolate the IP from the trading and insolvency risk; isolate the regulatory risk when issuing tokens (see below); and give the token holders direct exposure to value in the IP rather than in the wider trading business or wider portfolio of IP;
• the SPV licenses the IP back to the trading company, which continues to go about its business;
• the trading company agrees to pay royalties to the SPV in return;
• the SPV raises capital – fiat or crypto – by issuing tokens and the tokens represent a contractual, economic interest in the royalty flow generated by the IP;
• holders of those tokens have a right to receive a proportion of the royalties and to benefit from an income stream as a result; and
• the SPV lends the proceeds of the token raise to the trading company, which can then use them for working capital, growth, or other purposes.

There are many variations to that and there is certainly no standard UK approach; but that’s one of the more typical structural models and – I hope – fairly easy to understand for you Q.

Q.  I’ll be the judge of that, FAQ; but thank you for that explanation. Why wouldn’t the SPV just issue shares in itself instead to raise the finance or just borrow the money from a bank?

FAQ:  Great question.  Why invent something new and exotic when there is a tried and tested, traditional solution?  Well:

Equity finance: issuing shares usually means dilution (of ownership and/or control). Many business owners want to avoid equity dilution. And in an M&A context, issuing shares will mean the investors are involved in a sale or IPO and taking cash off the table then.

And issuing shares does not take place in a regulatory and legal vacuum: company law, legislation and regulation applies and issuing shares to large numbers of investors is by no means simple (and may involve preparing a full-blown prospectus which, if required under the UK Prospectus Regulation and if the shares are transferable securities, must be approved by the FCA as competent authority and verified carefully line by line).

And, crucially, a share is a bundle of rights to participate in the capital and income of the entire trading business for which a limited company of some kind is the vehicle, but investors and companies may wish only to focus on fractional interest in the IP (or parts of an IP portfolio).

Debt finance: traditional banks don’t usually lend to loss-making, fast growth technology businesses or to smaller rights holders (although, yes, ‘venture debt’ may be available at series A+ and beyond although coming with equity warrants and strict covenants). Even where they do, they typically won’t lend only against right and title relating to unproven software, data assets, model weights and so on or against a little-known back catalogue.

Taking in bank finance likely means the trading business or rights holder is going to need to provide security in the form of fixed and floating charges.  And the directors may be required to offer up personal guarantees.

Even if a bank will lend and can get the security it needs, the trading company is then finding itself needing to comply with banking covenants and so on, which for volatile technology companies can be something of a straitjacket from which some of them can’t escape.

Tell me then Q, are you starting to see why there might be this real-world use case for tokens?

Q.  I am not so sure FAQ, as you know I am pretty suspicious of techno-babble.  I live in the real world where I can, you know, pick stuff up, see it, eat it, throw it and so on.  Remind me again, FAQ, what is a token?

FAQ:  A token is a digital record on a blockchain.  You will remember that a blockchain is a decentralised ledger maintained by its nodes (which are the perhaps thousands of independent computers on which the blockchain software is running), achieving consensus via proof of stake or proof of work validation carried out by the nodes.

By contrast, your fiat current account is a ledger maintained only by the bank and you are able to access it only through the bank as intermediary.  Only the bank updates its ledgers and deposit holders rely on the bank to do so in line with what the bank has promised to do.  Sometimes there is a run on a bank and it goes bust.  Sometimes banks are told what to do by central banks or by governments in ways that affect their despot holders.

Tokens can be fungible – i.e. mutually interchangeable within their own class – or non-fungible, as is the case for ‘NFTs’.  Tokens issued in the context discussed are by definition fungible since the idea is to take the IP and fractionalise a royalty stream attaching to it.

And, Q, a challenge in the UK is that, although it is clear that tokens can form types of personal property, it is not at all clear what type of property rights all the different types of token will confer on the holder.  HLaw wrote about this extensively in November 2024.

Q.  Good grief that makes my head spin FAQ…

FAQ:  It’s you asking the questions Q, but if you have grasped at a basic level that a token is a digital record on a blockchain, and if you have grasped that a blockchain doesn’t have a central intermediary processing transactions then we are getting somewhere…

Q.  Don’t get short with me again FAQ, yes I have grasped that. Going back to the structure outlined above then, who is operating the blockchain on which the SPV issues the token?  Presumably the trading company isn’t building it itself?

FAQ:  That’s right, the SPV typically issues the tokens on an existing public blockchain operated by thousands or more of independent nodes – i.e. those computers running the program and validating changes to the blockchain in return for the blockchain’s native tokens.  The public blockchain is entirely independent from the SPV or the trading company.

The public blockchain might be Ethereum, Polygon, Solana, Avalanche, Base or another.

Sometimes those nodes are called miners – way back in 2019 HLaw wrote a detailed piece about how mining works, and not much has changed since then although proof of stake as a consensus mechanism has since overtaken proof of work for many major chains (Ethereum made the change in 2022).

The SPV and trading company don’t typically build their own blockchain as it will be too expensive, it won’t have anywhere near enough nodes, by definition it won’t be decentralised, and so on.

Public blockchains provide – or claim to provide – instant global infrastructure, auditability, thousands or more or nodes to do the validation, interoperability with wallets and exchanges, liquidity for token holders, and so on.

Q.  Got it. Love that HLaw are a crypto OG.  But how easy is it to run and organise a tokenisation?  Presumably it takes a lot of technical skill? I would not know where to start…

FAQ:  Most issuers will use a third-party tokenisation platform such as Tokeny, Securitize, Polymath or another.  These platforms are themselves regulated, are or should be engaging with applicable regulators and are or should be holding applicable licences and permissions etc.

Those platforms supply access to the mechanics by which:

• investors can be onboarded and run through KYC & AML checks;
• the investors wallets – somewhere to store the public and private keys by which tokens are controlled – can be connected to or created on the platform;
• the tokens can be issued to investors; and
• smart contracts can be…

Q.  Always so much jargon FAQ – I am on my limit here!!! Smart contracts…?

FAQ:  A smart contract is software deployed on a blockchain to define and automate how tokens are moved around.  It’s not necessarily a contract in a legal sense.  It’s probably confusing to think of them as legal contracts, although under English law contracts do not have to be in writing and if a smart contract satisfies the requirements for offer and acceptance, consideration, intention to create legal relations, and so on, then it could be a legally binding contract.

Q.  So it’s not a contract but it could be a contract?

FAQ:  Confusing, isn’t it?  Think instead of smart contracts as the technical plumbing by which tokens are moved around automatically and without human involvement, typically on an ‘if X happens, then Y happens’ basis.  They may or may not be legally binding contracts, but that is a second order question for present purposes.  If you think of smart contracts as the mechanics for execution, then that may help you understand their place in the world of Web3.

And tell me Q, do you think that a traditional contract can enforce itself?

Q.  Well, obviously not FAQ – to enforce one must go to Court or into arbitration or some such.  Paper contracts have no life or agency of their own.  How do smart contracts enforce themselves then, how does that work in the context of IP tokenisation…?

FAQ:  In my worked example:

1. the SPV receives the royalties – in real, value-bearing assets – from the trading company or rights holder in fiat currency (£, $, €, etc), stablecoins (crypto tokens pegged to fiat currency or other real-world asset), or the public blockchain’s native token (e.g., ETH is the Ethereum blockchain is being used);and
2. the SPV pays the royalties to the investors as real, value bearing assets rather than in the project’s own tokens; and does so in line with proportionate holdings of the projects tokens or however the tokenisation has been set up to work.

If there are no fiat payments in that process, all of it can be made to work in the code of the project’s blockchain using smart contracts and without human involvement.  If there are fiat payments involved, then there will have to be human involvement and ‘off-chain’ processes.

But tell me, Q, can there really be no real-world, fiat payments in all of that?

Q.  Well, if the royalties are paid by the trading company in a native token then there isn’t any fiat entering the system. 

But to have got hold of those tokens, the trading company will have needed to have exchanged value so as to have acquired them.  The trading is going on in the real world, and so the genesis of that value is ‘off chain’.

FAQ:  You are right, Q.  Note again that the SPV doesn’t receive the royalties in the same tokens that the SPV issues to the investors, because that is circular and collapses the economic model – there is no value entering the system and the project tokens cost the SPV nothing to mint.  The model above has real value – fiat, stablecoins, native tokens – going into the SPV as royalties and real value going out to the investors as holders of tokens.

Q.  Golly, interesting stuff; so, going back a step again, a smart contract is not at all unlike a vending machine where if I put in my £2 I get a can of Cola or some such?

FAQ:  Bang on Q!  The SPV deposits the royalty payments into a treasury wallet or distribution contract, and the smart contract automatically calculates each token holder’s entitlement and distributes the funds, all without human involvement.

Q.  OK, I have just about got it. And I am guessing that all this can’t be done in a legal and regulatory vacuum…?

FAQ:  No, quite right – you need clever lawyers involved such as the good folk at HLaw.

1. Structure: there is an overarching structural piece by which to assess: the type of SPV, the place of its incorporation, the structure of the royalty payments, the features of the SPV’s project token, the public blockchain to use, the intermediary to use, the investors that can be safely approached, the tax treatment, the means by which the IP can be identified and then assigned into the SPV, and so on and so on. It’s a major project in and of itself, and some of the findings may need to be set out in the project’s ‘white paper’.

2. Regulatory perimeter: some tokenisation platforms appear to be marketing themselves as able to structure transactions so that no regulated activity is being carried out by the issuer, but that should be fully diligenced on the issuer side if not also the investor side.

The regulatory perimeter needs to be established, the supervising authority understood, the applicable licences, authorities and consents need to be applied for, and so on.  There are all manner of somewhat terrifying bear traps to avoid (most of which if sprung come with criminal sanction), including accidentally establishing an unauthorised collective investment scheme, or creating an e-money token (with its own regulatory perimeter) or creating a regulated security, and so on.

What can be marketed about the tokenisation, where and to whom will be a major theme.  So too, investor KYC & AML.  Due diligence should be carried out on the token issuance platform itself.

Since October 2023, the UK’s financial promotion regime has extended to crypto assets (including those that are not securities), so the issuer if in the UK or marketing into the UK will need to either apply for FCA authorisation in order to communicate marketing materials or work with an FCA-authorised firm which has the permissions in place to do the approving, or work extremely carefully within the applicable exemptions.

3. Tax: the tax position for the SPV, the trading company and the token holders needs to be established and in particular as regards: the tax treatment of the assignment or transfer of the IP by the trading company to the SPV (from a capital gains tax, transfer pricing, and perhaps other perspectives), the tax treatment of the payment of royalties to the investors (and whether withholding tax applies among many other issues), the VAT position, whether the tokens themselves are revenue or capital assets, and more. If the structure generates significant dry tax charges for those involved then that is likely to be severely sub-optimal.

4. SPV: there is a corporate piece for the incorporation of the SPV, choice of jurisdiction in which to incorporate, and the drafting of its constitutional documents and so on.

5. IP: there is a major IP workstream where the assets that are to be assigned or transferred into the SPV are established, the means of assignment and transfer is thought through, and then assignment and transfer actually takes place; and then the licence back of the IP to the trading company needs to be properly thought through and documented.

And bear in mind, the SPV (as the new IP owner) or the trading company (as licensee) and likely both must still handle enforcement of IP rights against infringers and maintenance of registrations going forward.  Query what happens to new IP developed by the trading business or rights holder.  Query how to deal with IP that is non-transferable or where the rights of the author are inalienable.

6. Debt finance: after the SPV has raised the funds from the initial issuance, these need to be loaned back to the trading company and there is a workstream there for the debt finance lawyers. Great care would need to be taken if the trading company already has senior debt and a security package in place, and the senior lenders’ lawyers will be involved and looking at the documents of course and there may be the need for intercreditor agreements and so on.

7. Platform Ts&Cs: the terms and conditions of the intermediary that manages the token issuance would need to be looked at (particularly around custody, liability, and control of smart contracts), and not in a vacuum either – what is signed up to there must not cut across what is needed as regards those other workstreams above.

8. And more…

Q.  What contracts do the investors sign up to, the people who invest into the SPV and hold the project tokens?

FAQ:  They will typically sign a ‘token purchase agreement’ to govern the terms of their initial subscription, issuance, custody and transfer of the tokens, warranties from the SPV as issuer, warranties from the investor, and so on.

Q.  What about the royalties…?

FAQ:  Those will be in the ‘token rights agreement’.  It will define the royalty entitlement, set out the distribution waterfall, deal with payment of royalties, deal with term and termination, and so on.  It’s a document kept separate from the token purchase agreements because the latter must apply to token holders who acquire their tokens by transfer after the initial issuance.

Q.  Now my head is spinning again. If the royalties are paid out under the token rights agreement, why do you need tokens at all?  Why not just leave it as a contractual right?

FAQ:  The answer is that contractual rights are not freely transferable (an assignment or novation is needed or ‘off-chain’ issuer consent is needed) and do not easily create a liquid market (even if, conceptually, they can).

Q.  Yes, I can see that – in practical terms one cannot easily go around acquiring small fractions of rights arising under contract law, choses in action I believe they are called under English law.  Yes, a chose in action is prima facie freely assignable.  But moving them around comes with administrative difficulties because assignments need to be drafted and signed, etc. 

FAQ:  Yes, and purely contractual schemes of that kind can also be challenging from a regulatory point of view and tend to fall into the realm of collective investment schemes.

A token by contrast can attach – via the token rights agreement, which gives the right to the royalties to whomever holds the token – as an identifier of a contractual right to receive the royalties and can then be transferred nearly instantly (subject to KYC checks etc) and without geographic restriction and at any time of day and – back to the blockchain and decentralisation – without any intermediary or central authority involved.

The token rights agreement contains the contractual right to the royalties; the token is the identifier of the current holder of that right.

Q.  Thanks FAQ – I can see how a value could attach to the tokens themselves.  I guess that value may go up after issuance if there is demand for the tokens in the secondary market.  If, upon issuance and as part of the tokenisation, the SPV has held back and not issued a proportion of the token supply, then those tokens could be held in treasury and have a value that will change in line with market demand and liquidity conditions.

FAQ: You are right, Q – the materials marketed to the investors should explain and make clear what the SPV intends to do with those tokens to be left in treasury after the initial issuance; but, yes, in structuring the issuance the SPV may choose to maintain a portion of the total supply of tokens in treasury, which it can issue periodically to raise further finance.

Do you see then Q why tokenisation might be of interest to holders of substantial but illiquid IP portfolios?

Q.  Yes, I guess so – there’s not much of a liquid market in buying and selling a trading businesses’ IP outside of insolvencies and special situations. And ordinary people don’t much buy a whole movie or the Beatles’ back catalogue.  But isn’t this just securitisation by another name?

FAQ:  I did wonder how long it would take you to say that.  It’s a big topic, but securitisation is – if it meets the legal definition – typically about an SPV getting hold of illiquid receivables (i.e. repayments of loans, mortgages, auto loans, etc) and then issuing loan notes as debt securities – dealing in, and arranging deals in, securities as a principal or agent is a regulated activity under the UK’s Regulated Activities Order and the FSMA 2000.

If the notes are offered to the public, that will also engage the UK or EU prospectus regime unless applicable exemptions can be found to apply.  The cash flow from the original loans is used to pay the interest on and finance redemptions of the SPV’s debt securities.

By contrast, the SPV as token issuer issues no debt – assuming the model works as outlined as discussed already – and the tokens themselves are – as discussed – the record of who has the right to the revenue under the token rights agreement.  There is no principal to repay, no interest, no credit enhancement, no tranching, no trustees, no rating agencies, and no machinery designed to shift or slice default risk.

Q. Hard for me to follow FAQ, it still sounds like kind of the same thing to me, just that the token issuers are using their new technology as an excuse to navigate around the rules everyone else must abide by.

FAQ.  Well, some people will say that you are right and do bear in mind that legislators know very well that technology and the means of production generally evolve from time to time and the rule books that regulators apply are often technology neutral, looking at the substance much less than the form.

Q.  A bit like the US Supreme Court’s ‘Howey test’ for determining whether crypto assets are securities?

FAQ.  Yes, if it walks and quacks like a duck, it’s probably a duck.  One of the many risks with a tokenisation of the kind discussed is that the way in which it is structured causes the tokens issued to be treated as specified investments — or even as units in a collective investment scheme — bringing them squarely within the UK’s regulatory perimeter.

And where there is cross over is in the diligence that a prudent investor ought to carry out in the real-world assets from which the cash flowing to investors is generated.  In securitisation, this means looking into the bundle of receivables that has been acquired by the SPV.  In tokenisation, that means looking at the IP that has been assigned or transferred into the SPV by the trading business or rights holder and then the prospects of the trading business or the rights holder being able to keep up with the royalty payments.

Q. Zooming out, it sounds like tokenisation will be a document heavy process generally?

FAQ:  Right again Q, if it is to be done properly – key documents and workstreams to think about might be as follows:

• a ‘white paper’ – if in scope of the EU’s MiCAR – or an investment memorandum or – if applicable – a prospectus-type document or some other marketing document depending on where the token sits in the regulatory perimeter, in each case for the marketing of the SPV’s project token, very-much ideally verified line by line as to its accuracy and with appropriate disclaimers in line with an established regulatory perimeter;
• constitutional documentation to set up the SPV (having thought about where to incorporate, if not the UK);
• extensive documentation to identify the IP, assign or transfer it into the SPV, and then deal with any registrations and filings;
• the licence of the IP from the SPV back to the trading company;
• contracts between the tokenisation platform and the SPV;
• token purchase agreements between the investors and the SPV;
• the token rights agreement;
• terms and conditions of platform use between the tokenisation platform and the investors;
• the documentation for the loan of the proceeds of the issuance back to the trading company (structured carefully to avoid adverse tax or violating any existing debt covenants);
• legal opinions, perhaps, for investors as regards key regulatory and tax points;
• and more.

Now tell me Q, why in the UK do you think that tokenisation of IP is not more widely adopted?

Q.  Well, it’s new. But new things take off from time to time and become established as the norm. Clearly there is a great deal of red tape and documentation to sort out, but that is also true if you are raising debt finance and equity finance in particular.  I guess it’s not helpful that the legal status of tokens has not been clearly demarcated in the UK (beyond saying that they can be types of personal property).  I guess that the lack of a UK rule book on how to run a compliant token issuance makes things difficult, even if there might be one to come in 2026.  And of course, even if a token issuance is non-dilutive as to the equity and isn’t putting debt onto the balance sheet, the royalty payments go onto the trading businesses’ P&L and come off the bottom line.

FAQ:  You are right Q.  One should not go into a tokenisation lightly and without sourcing in advice from suitably qualified professionals.

Q.  I am not fully convinced FAQ, but that’s enough for now – thanks as always. I am going for a lie down. See you next time.

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