In 2017, there was a boom in initial coin offerings (ICO). These crypto projects would pre-sell a token, then promise to bring a product to market. Most of those projects were not able 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 a successful completion. Furthermore, 90% of the capital raised in 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 designing their projects differently now. Instead of just issuing a token, the modern Web3 project seeks to build and validate a product through the engagement of its community before releasing a token. This method of developing projects helps to 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 term.
In many cases, Web3 companies are raising Pre-Seed, Seed or even Series A funding rounds before they issue a token. This leads to an important question: How should these early-stage funding deals be structured? Are they similar or different from a traditional startup funding round?
The short answer is that the best deal includes equity and gives investors a pro rata percentage of insider token allocation.
In any early stage company, there are a number of changes and pivots that can happen, many of which are unplanned. As a result, investors want to make sure that, however the company chooses to organize and develop, they will be able to see some kind of return on their investment. If the company remains centralized and follows the traditional startup route, then the value will be in the stock of the company. However, if the company decides to decentralize and issue a token, then the value will be in the token itself. Because of this, it is important to structure your Web3 funding deal in a way that provides for both possibilities: equity and tokens. This way, you can ensure that no matter what path the company takes, there will be a return on investment for the investors.
The equity portion of the Web3 deal will either be in the form of a simple agreement for future equity (SAFE) or priced equity round based on either the Series Seed or National Venture Capital Association standard documents. The deal points will mirror a standard startup funding 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 portion of the deal.
The startup is promising investors the right to tokens if and when they create and distribute tokens, with the number of tokens granted 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 have solidified the token’s supply, attributes and monetary policy.
In order for the startup to make the most of their token distribution, they must make sure that the number of tokens granted 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’s not in their best interest to have a community ruled by a few whales. By taking these considerations into account, the startup can make a well-informed decision on how to grant tokens to investors in a way that will benefit both themselves and the investors. This poses a unique challenge to the startup, as it requires them to carefully consider the number of tokens to grant 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 certain time frame. The token side letter effectively achieves the same goal as the warrant, but does so in a less formal and mechanistic manner.
Neither approach is particularly investor- or founder-friendly. The choice of instrument is generally driven by the investors’ counsel. The instrument is less important than the token pool and token percentage. As a founder, it’s incredibly important to get both of those terms right.
Imagine the tokens you are granting to investors as a slice of pie. The two key questions founders should understand is (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 supply or insider allocation. Total supply is the total number of tokens distributed, while 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 total supply is investor-friendly as it gives whales an outsized influence. Conversely, the insider allocation is founder- and community-friendly as it incentivizes alignment and decentralization. Investors who insist on total supply may not be Web3-friendly, a red flag for founders. Negotiating for insider allocation is best, as it aligns incentives for investors and founders, and yields 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 the token percentage: fixed or pro rata. 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 grant the investor a percentage of tokens that’s equal to equity percentage in the company.
When a startup raises follow-on capital, the investor with a fixed 5% suffers no dilution, while the founders, employees and advisors suffer a pronounced dilution. This misaligns founders and investors, and can result in the actual builders getting a sliver of the pie. To avoid excessive token dilution, founders should negotiate for pro rata with their counsel.
To recap, the optimal token mechanics for a Web3 deal are a pro rata percentage of the insider allocation. Check out this video to learn more. For a deeper dive, read this guide.