In 2017, there was an explosion of Initial Coin Offerings (ICO). These crypto projects would pre-sell a token and then promise to release a product. Most of those projects failed to deliver and the value of the token dropped to zero. That same year, an estimated 80-90% of all ICOs failed, with only 8% of projects reaching successful completion. In addition, 90% of the capital raised in ICOs from 2017 was lost, according to one Report April 2019 from Boston College.
Web3 builders and investors have learned hard lessons from the ICO boom of the past. As a result, they now organize their projects differently. Rather than just issuing a token, the modern Web3 project seeks to build and validate a product through community involvement before releasing a token. This method of project development helps ensure that the project is backed by a strong and engaged community and that the token itself is likely to be more valuable and viable in the long run.
In many cases, Web3 companies raise Pre-Seed, Seed, or even Series A funding rounds before issuing a token. This leads to an important question: how should these early stage financing agreements be structured? Are they similar to or different from a traditional startup funding round?
The short answer is that the best deal includes equity and gives investors a prorated percentage of the insider token allocation.
In any early stage business, there are a number of changes and pivots that can occur, many of which are unplanned. Therefore, investors want to be sure that no matter how the company organizes and develops, they can see some sort of return on their investment. If the company remains centralized and goes the traditional startup route, the value is in the company’s inventory. However, if the company decides to decentralize and issue a token, then the value is in the token itself. That’s why it’s important to structure your Web3 financing deal in a way that accommodates both: equity and tokens. This way you can ensure that whatever path the company takes, there will be a return on investment for the investors.
The equity portion of the Web3 deal will take the form of a simple future equity agreement (SAFE) or priced equity round based on either the Series Seed or National Venture Capital Association standard documents. The deal points reflect a standard round of funding for startups and should be structured so that all parties involved are aware of the risks, rewards and expectations of the investment. Nothing exotic or new should be included in the equity portion of the deal.
The startup promises investors the right to tokens if and when they create and distribute tokens, with the number of tokens awarded to an individual investor often difficult to determine. This is because many of these deals are done before a startup has done any work on their tokenomics and solidified the token’s offerings, attributes, and monetary policy.
In order for the startup to get the most out of their token distribution, they must ensure that the number of tokens awarded to each investor is fair and equitable. This ensures that investors have an incentive to help the startup succeed, as they will benefit when the token’s value rises. The startup must also consider its founders, employees and community. It’s not in their best interest to let a few whales rule a community. By taking these considerations into account, the startup can make an informed decision about allocating tokens to investors in a way that benefits both themselves and the investors. This poses a unique challenge for the startup, as it requires them to carefully consider the number of tokens to be awarded to each investor.
The startup will grant rights to investors through a legal contract. There are generally two types of agreements to issue token rights: the token warrant and the token side letter.
The token warrant is an agreement between the startup and the investor that entitles the investor to purchase the future tokens at a specified price within a specified time frame. The token side letter essentially accomplishes the same purpose as the warrant, but does so in a less formal and mechanical way.
Neither approach is particularly investor or founder friendly. The choice of instrument is generally determined by the investor’s adviser. The instrument is less important than the token pool and the token percentage. As a founder, it’s incredibly important to get both terms right.
Imagine the tokens you allocate to investors as a piece of cake. The two most important questions founders need to understand are (1) the size of the pie and (2) the size of the slice. In this metaphor, the size of the pie is the token pool.
There are two approaches to defining a token pool: total offer or insider assignment. The total supply is the total number of tokens distributed, while the insider allocation is the number of tokens reserved for insiders (investors, founders, employees, etc.). Insider allocation is smaller, typically 10-30% of total supply. The overall offering is investor friendly as it gives whales an excessive leverage. Conversely, internal allocation is founder and community friendly as it encourages alignment and decentralization. Investors who insist on a total offering may not be Web3 friendly, a red flag for founders. Negotiating insider allocation is best because it aligns incentives for investors and founders and provides a more decentralized structure.
If the token pool is the size of the pie, the token percentage is the size of the slice.
Again, there are two approaches to token percentage: made or proportionally. A fixed percentage is a hard-coded percentage of the token pool. Conversely, the pro rata percentage attempts to mirror the equity cap table and assign the investor a percentage of tokens equal to the percentage of equity in the company.
When a startup raises follow-up capital, the fixed 5% investor suffers no dilution, while the founders, employees, and advisors suffer marked dilution. This misaligns founders and investors and may result in the actual builders getting a piece of the pie. To avoid excessive token dilution, founders must negotiate pro rata with their counsel.
To summarize, the optimal token mechanisms for a Web3 deal are a pro rata percentage of the insider allocation. Checking out this video learn more. For a deeper dive, read this guide.
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