Equity and a prorated percentage of the insider token allocation

In 2017, there was a boom in initial coin offerings (ICOs). These crypto projects would pre-sell a token and then promise to bring a product to market. Most of those projects failed to deliver and the token value dropped to zero. That same year, an estimated 80-90% of all ICOs failed and only 8% of projects were successfully completed. Furthermore, 90% of the capital raised in the 2017 ICOs was lost, according to an April 2019 report from Boston College.

Web3 builders and investors have learned hard lessons from the ICO boom of the past. As a result, they are now designing their projects differently. Rather than simply issuing a token, the modern Web3 project seeks to build and validate a product through engagement from its community before releasing a token. This method of project development helps ensure that the project is supported 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 are raising 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 start-up funding round?

The short answer is that the best offer includes equity and gives investors a prorated percentage of the insider token allocation.

In any early-stage company, there are a number of changes and pivots that can occur, many of which are unplanned. As a result, investors want to make sure that however the company decides to organize and develop, they will be able to see some form of return on their investment. If the company remains centralized and follows the traditional start-up route, then the value will be in the company’s stock. However, if the company decides to decentralize and issue a token, the value will be in the token itself. Because of this, it’s important to structure your Web3 funding deal in a way that offers both equity and tokens. This way, you can ensure that regardless of which path the company takes, there will be a return on investment for investors.

Equity

The equity portion of the Web3 deal will be in the form of a simple agreement for future equity (SAFE) or a priced equity round based on standard Seed Series or National Venture Capital Association documents. Trading points will reflect a standard start-up financing round and should be structured in such a way that all parties involved are aware of the risks, rewards and expectations of the investment. Nothing exotic or novel should be included in the equity part of the deal.

Symbolic

The startup promises investors the right to the tokens if they create and distribute tokens, and the number of tokens awarded to an individual investor is often difficult to determine. This is because many of these deals are done before a startup has done any work on its tokenomics and solidified the token’s supply, attributes, and monetary policy.

In order for the startup to get the most out of its token distribution, it must ensure that the number of tokens given 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 value of the token rises. The startup must also take into account the founders, employees and community. It is not in their interest to have a community ruled by a few whales. By keeping these considerations in mind, the startup can make an informed decision about how to award tokens to investors in a way that benefits them and the investors. This poses a unique challenge for the startup, as it requires them to carefully consider the number of tokens to award to each investor.

symbolic instrument

The startup will grant rights to investors through a legal contract. In general, there are two types of agreements to issue rights to tokens: the token warrant and the token additional letter.

The token warrant is an agreement between the startup and the investor that entitles the investor to purchase future tokens at a specified price within a specified period of time. The token side letter effectively achieves the same goal as the injunction, but it does so in a less formal and mechanistic way.

Neither approach is particularly favorable to investors or founders. The choice of instrument is generally driven by the advice of investors. The instrument is less important than the chip set and the chip percentage. As a founder, it’s incredibly important to have a good understanding of both terms.

token pool

Imagine the tokens you are giving to investors like a slice of pie. The two key questions founders need to understand are (1) the size of the pie and (2) the serving size. In this metaphor, the size of the pie is the set of chips.

There are two approaches to defining a set of tokens: full supply either assignment of privileged information. The total supply is the total number of tokens distributed, while the internal allocation is the number of tokens reserved for insiders (investors, founders, employees, etc.). The insider allocation is smaller, typically 10-30% of the total supply. The full offer is favorable for investors, as it gives the whales outsized leverage. On the contrary, internal allocation is favorable for the founders and the community, since it encourages alignment and decentralization. Investors who insist on full supply may not support Web3, a red flag for founders. Negotiating the allocation of inside information is best, as it aligns incentives for investors and founders, and produces a more decentralized structure.

Chip Percentage

If the set of chips is the size of the pie, the percentage of chips is the serving size.

Again, there are two approaches to chip percentage: fixed either pro rata. A fixed percentage is a hard-coded percentage of the pool of tokens. Rather, the prorated percentage attempts to mirror the equity capitalization table and award the investor a percentage of tokens that is equal to the percentage of company equity.

When a startup raises follow-on capital, the investor with a fixed 5% suffers no dilution, while the founders, employees, and advisors suffer steep dilution. This misaligns founders and investors, and may result in the actual builders getting a slice of the pie. To avoid excessive token dilution, founders should negotiate the pro rata with their attorney.

In short, the optimal token mechanics for a Web3 agreement is a prorated percentage of internal allocation. Take a look at this video to learn more. For a deeper dive, read this guide.