How tokens can attract top talent: A compensation primer for web3
Tokens are one of the most powerful tools available to crypto companies. They can incentivize good behavior, align stakeholders, and engage distributed communities. And, over the last decade, they’ve also become a way to attract, compensate, and reward talent — from third-party developers and open source contributors to board members and employees.
Because most projects are developing open source software — which generates value separate and apart from the company leading the project and its equity — it’s important to make sure that employees are compensated for their contributions to those ecosystems. Many teams accomplish this using tokens as part of compensation. Meanwhile, web3 company leaders, talent teams, and HR departments are developing increasingly sophisticated methods for using tokens to build out the overall compensation package, so they can compete with other companies and even attract talent from a wider pool of web2 industries.
Incorporating tokens into compensation comes with unique complexities, challenges, and opportunities. For instance, there are many, many ways to structure compensation — and what’s right for one company may not be right for another. So in this post, we explore how tokens fit into a larger compensation strategy for anyone considering token compensation; then dive into specific details of structuring token grants, from vesting schedules and lockups to taxes.
But first, tokens are not equity
While many strategies for token compensation are rooted in compensation models established by web2 and other traditional companies, let’s be clear: Tokens are NOT equity. They’re not even a proxy for equity, so companies should approach this analogy with caution in both internal conversations and explanations to potential employees.
From an employee perspective, receiving tokens and receiving equity are two different experiences, with different risks and rewards. Protocols, for example, are autonomous software, not companies — and unlike equity, no board or management team is dedicated to maximizing the value of a token.
There are also many broader considerations and factors in allocating tokens overall — of which employees and others are just one part. For more on token allocations, go here. There are also many legal and regulatory considerations that are unique to tokens and web3, which startups will need to think through when figuring out what role tokens should play in their strategy.
Now, let’s dive into some important principles for token compensation…
Structuring token compensation: A quickstart guide
Token compensation is a balancing act within a larger compensation strategy — the ultimate goal of which is to reward work and retain employees, without losing engagement or creating a distracting work environment. This involves designing strategies that shift attention away from token prices and focus it on building for the future.
All of this may seem like setting off into uncharted waters, especially for talent teams managing token compensation for the first time. The good news is that, despite the differences we emphasize above in web2 and web3 compensation, HR teams can still borrow quite a lot from successful web2 models. In fact, they will need to if they are to compete with legacy companies for talent, particularly in trending industries like AI.
To kick things off, start with first principles: It’s crucial to build out a well-defined, transparent, and easily understood compensation philosophy. Those three qualities are critical to any good compensation program. Transparency and fairness around compensation has been shown to have a significant impact on employee engagement — companies can’t afford to get this wrong.
Once established, this compensation philosophy will guide decisions on hiring, leveling, and salary bands; long-term incentives (token grants, equity, or both); promotions, merit increases, and refreshers; and more.
A good compensation philosophy will also answer questions like:
- How much base salary will be associated with a given job?
- How much of an employee’s total comp package will come from tokens, equity?
- What percentile of the market is the company targeting for base and total compensation?
- How much of the total compensation number is the company targeting for every role?
- How does the company define the market? For example, who are their peer companies? And who are they most likely to be competing with for talent?
Once these questions are answered, the company can then start digging into the specifics: How often should employees receive tokens? What is the balance between cash and tokens? And more.
Balancing cash compensation vs. tokens
In traditional compensation packages, base salary is an important counterbalance to the risk-reward spectrum that comes with equity. The same is true of token compensation, which is just one part of a larger “total compensation” package for full-time employees.
For web3 companies, that package can include:
- Base salary and performance bonuses that make up the total cash compensation and usually paid in fiat currencies
- Equity, which encompasses non-qualified stock options (NSOs), incentive stock options (ISOs), employee stock purchase plans (ESPPs), and more
- Token compensation, made using a project’s tokens, or other tokens (commonly Bitcoin or Ethereum), and stablecoins
A simple rule of thumb is to offer a healthy total cash compensation that’s competitive with what peer companies are offering. What’s the percentage breakdown between cash and tokens in total compensation? We generally see something like this:
- Total cash: 75th percentile of the market
- Total comp (Total cash with bonuses, plus value of equity): between the 75th and the 90th percentiles of the market. Total cash includes base salary and other cash components like performance bonus
- Premium: Some teams may also explore a “premium” for hard-to-find skills like protocol or smart contract engineering, or for those specializing in crypto security. These premiums are reflected in higher base salaries and total compensation
We often hear the question, “Should we give employees the freedom to choose the balance between tokens and cash in their comp?” While there are no hard rules, it’s generally better to cap the token portion at some specific percentage of total compensation, rather than let employees choose a percentage.
Not only is it chaotic for finance teams to keep track of a wide variety of bespoke arrangements, but sharp changes in token prices could derail a company’s overall comp strategy. For example, suddenly sinking prices might force people to renegotiate their compensation packages. Spiking prices, meanwhile, could leave some employees with sudden wealth that’s way out of scale with everyone else’s salaries — a demoralizing experience for other employees.
Choosing a vesting schedule for tokens
Just because you have a fixed percentage for tokens doesn’t mean the balance of tokens to other comp won’t change over the years.
The token component itself can play out in a number of different ways, depending on when and how the tokens are distributed. Companies have a lot of options here: short-term incentive plans, long-term incentive plans, and classic mechanisms like vesting schedules and bonuses.
The model that works best will depend on a company’s specific circumstances and comp philosophy: Is the token launched publicly, or in the works? What type of token is the team offering? Are there any restrictions on how the token can be traded? The answers to these questions and more will define the company’s approach.
Here we outline a few common schedules — along with their pros and cons — to help founders unfamiliar with the best practices. Note that these best apply to projects with publicly traded tokens that have reserved a number of tokens for ongoing employee incentives.
Founders will need to balance using token reserves and structuring employee rewards against efforts to spur third-party contributions to drive decentralization. It’s important to work with outside counsel to evaluate these options, and their implications under applicable laws.
Four-year vest with a one year cliff
In this model, employees get a batch of tokens when they’re hired. The first quarter of the grant vests after the first year, and a percentage of the remaining tokens vest each month (or quarter or year, etc).
- Pro: Rewards employees for their work on the project.
- Con: People hired in different months of the same year can have very different outcomes, especially in periods of volatility. The long timeframe can also create a distracting emotional rollercoaster for employees — unless there’s a mechanism like annual performance-based refreshers to smooth things out.
Annual grants
Given how much token prices change over time, some teams find that it doesn’t make sense to grant tokens over multiple-year periods. This model therefore favors offering awards on a yearly basis. Each employee would get an annual market-rate token grant. Then, after the first grant, talent teams typically add performance metrics to the calculation.
- Pro: This approach reduces employees’ exposure to both the upside and downside of a volatile token, making comp more predictable and less distracting.
- Con: Reducing exposure to the potential for asymmetric upside compared to a four-year grant may make it trickier to compete for talent versus competitors with longer-term incentive plans.
Backloaded four-year vest
This model is designed to keep employee engagement high — by increasing the size of the vest over time, starting with a smaller percentage (say, 10%), and working up to 100% vested at the end of four years. This model also often involves a 1-year cliff – very few companies would offer tokens that vest without a cliff.
- Pro: Increasing rewards encourage employees to stay longer, thus also retaining institutional knowledge.
- Con: With a smaller short-term benefit to employees, this model can make recruiting more difficult. Only a few web3 companies are currently pursuing this structure, but more may adopt it as the industry grows.
It’s a good idea to minimize the outsized impacts of day-to-day price swings common in tokens for any of these vesting schedules, so consider using something like a 90-day moving average when pricing grants and refreshers. Companies should also ask their counsel to run through all of the vesting variations they have seen to combat volatility in the markets.
Finally, keep in mind that many tokens, particularly those close to launch, will also need to plan for lockup periods. Token lockups — that is, “locking” down the ability to trade or redeem token value for a certain period following launch — not only help ensure the long-term success of a project, but are important for aligning the interests of all stakeholders; more on lockups here.
Setting and communicating lockup periods
Founders should ensure that “insiders” (employees, investors, advisors, partners, and more) have the same lockup periods and rules as each other. If some of these groups can sell before others (read: at the first opportunity), it can sow mistrust, create unpredictable incentives, run afoul of securities laws, and otherwise negatively impact the protocol.
For U.S. employees, companies should plan for a lockup period of at least one year (for legal reasons explained here). Three to four years is probably better for positioning a project to succeed over the long term, as longer periods reduce downward price pressure and signal confidence in the project’s long-term viability.
This can require a little bit of education for candidates coming from web2, where lengthy vesting schedules and regular lockups can feel burdensome. Assuming that lockups apply to all pre-launch token holders (as they should!), candidates should want to see lockups in their offer, because it signals the founders are prioritizing the stability of a protocol and believe it has real utility.
Finally, as a practical matter, lockups can be managed via smart contract and administered by a token management provider. Once the tokens have vested and any lockup periods are over, employees can send their tokens to any wallet they choose. This ensures that token distribution is hard coded into the smart contract and helps create greater trust with employees.
Structuring token grants: RTAs, TPAs, and RTUs, explained
There are three main ways U.S.-based web3 companies currently structure token grants (as outlined by Toku, a comprehensive, global solution for token compensation and tax compliance). All of these are modeled on equity awards, which provide the most common template for asset-based compensation — but again, to be clear, tokens are not equity:
- Restricted Token Awards (RTAs), which are similar to equity options that pre-IPO employees might get in a traditional company. RTAs can be given to employees who join after the token has been minted, but before it’s available to the public.
- Token Purchase Agreements (TPAs), which are another way of structuring a pre-launch token grant that has different tax implications (see below).
- Restricted Token Units (RTUs), which are not dissimilar to Restricted Stock Units (RSUs). RTUs are used when the token has been launched and begins trading.
RTAs and TPAs are two ways that companies can offer token compensation to employees who are hired after a token has been minted but before it has been launched to the public. They’re often compared to the stock options that are offered by conventional pre-IPO companies.
Both RTAs and TPAs can be offered on any of the vesting schedules we outlined earlier, and both typically come with:
- Lockup periods, during which they can’t be sold or transferred to another wallet;
- And forfeiture rights, which allows the company to take back tokens before they vest
The main way RTAs and TPAs differ from each other is in their tax implications, so founders should speak to counsel when assessing which types of awards might be best. For example, timing of taxation for the recipients is a key consideration, and depends on the type of token award issued.
RTAs
RTAs allow U.S. recipients to file an “83(b) election” with the IRS to recognize income when the token is received based on the fair market value as of the grant date. This may be favorable for employees, particularly if the value of the tokens is expected to increase. Further, filing an 83(b) guards against potential risk that an employee may owe taxes on tokens that vest, but that the employee is unable to sell. Note that an “83(b) election” must be filed with the IRS within 30 days of the date of the grant.
TPAs are similar to RTAs in that they may be awarded to employees before public launch, and also allow employees to file a “83(b) election”. But unlike RTAs, they require employees to purchase the tokens for a specific price, also known as a “strike price”.
Unsurprisingly, employees tend to prefer RTAs, but TPAs do have some tax advantages. Unlike RTAs and RTUs, which are taxed as ordinary income, there is no tax obligation that comes with a grant of TPAs. Taxation is deferred until an employee exercises their options and/or sells their tokens; and upon exercise, income is recognized only to the extent that the value of the token has increased as compared to the strike price.
RTUs
RTUs, on the other hand, are most often given to employees who join after the token has launched, and are similar in philosophy to the RSUs that are offered at many major corporations.
RTUs are granted at the beginning of employment and are subject to one of the vesting schedules outlined above. Once vested, employees can generally transfer the tokens to a wallet of their choosing, unless they are subject to a lockup period. Because the tokens are taxed as income at their current fair market value upon vesting, some companies will opt to withhold and sell a portion of each employee’s grant to cover their tax responsibility.
While this discussion focuses on recipients, companies should also consider its tax withholding obligations, which are required to be paid in cash.
Note that none of the above should be construed as tax advice. But we hope it gives a broad overview of the various strategies companies use. We strongly advise web3 talent, legal, and tax teams to work together on the best course of action for their company and strategy. And if liquidity is the main driver for tokens, there are other strategies like conducting secondary offerings, so employees can gain liquidity as a company raises more capital.
Operational considerations: Setting up token compensation
This may all seem complex, but the good news is that there is an increasing number of companies building products and tools to make token compensation easier to manage operationally. Generally, startups will have a wallet (from a company like Coinbase, Anchorage, or BitGo) and a token management system (from a company like Toku or Pulley) that handles all of the administration.
Employees will then receive their tokens through a wallet that they can access through the token management system. They should also be able to use such a system to see how their vest is progressing, or access pre-vest staking if offered, and other calculators or tools.
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Web3 companies are still coming of age. By using well-tested and sophisticated compensation strategies, they can manage the challenges associated with attracting top talent who might balk at a lack of liquidity.
The bottomline is to make sure tokens are part of a well-designed compensation strategy. One that is transparent, fair, and motivating — and that not only attracts and retains some of the best talent short term, but that ensures proper rewarding of productivity.
While there are other strategies companies can pursue, like offering secondary offerings to employees as they raise more capital, token compensation remains an attractive level for web3 companies to level the playing field.
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