Executing a successful token launch is a complex process that requires a lot of strategic planning and more than a little luck. But long before projects even launch a token, they can derail their future prospects by making mistakes with how they structure their token rights. The structuring of legal rights related to tokens during early financing rounds is complex, and some investors can exploit the lack of clearly defined market standards to take advantage of unsuspecting entrepreneurs.
To empower entrepreneurs to better understand the market — and ensure fair and sustainable deal structures — below we share the foundational principles that inform how we define the scope of token rights and restrictions. We then highlight some of the predatory behaviors we’ve seen from some investors, and discuss how that behavior hurts projects. We also provide an explanation of provisions we use.
Aligning incentives between founders and investors is paramount to the success of any venture. Misalignment can lead to mistrust and counterproductive efforts, and can constrain a project’s options. Alignment — by definition — helps to ensure that everyone is pulling in the same direction.
With traditional equity structures, aligning incentives is straightforward. If the company becomes more valuable, investors and founders both benefit. In web3, the introduction of tokens can make aligning incentives trickier. The blockchain systems deployed by web3 projects are open source, decentralized and are often designed to accrue value to the system’s token instead of the company that developed the technology — a subtle but important difference. Such designs divert value away from equity, setting the stage for misalignment between tokenholders and equity holders.
This misalignment most commonly arises when early stage projects finance themselves solely through the direct sales of tokens to institutional investors and angels in private placements, which can result in two issues:
As a result, early stage projects are better off with balanced deal structures that provide all stakeholders with exposure to both equity and tokens. By keeping investors and entrepreneurs aligned, projects maintain the flexibility to design their systems in the way that best suits their project, and allows for value to accrue to tokens, equity, or both. By aligning interests, both parties can focus on sustainable growth and long-term success.
Even in cases where early stage projects use balanced deal structures, incentive misalignment can still arise following the public launch of a token: Some people might hold tokens while others hold both tokens and equity. Because of this possible misalignment, projects have to guard against conflicts of interest. In some cases, projects could wind down the development company, meaning that every interested party becomes a tokenholder only. In others, it may be beneficial for a number of companies to actively be building and competing using the project’s technology, in which case projects should prioritize creating a level-playing field, creating programmatic incentives and even consider imposing robust and milestone-based token selling restrictions on the original development company’s employees, investors, and other insiders to safeguard tokenholders. In most cases, a project’s lingering intellectual property rights should be controlled and owned by tokenholders.
Here are several provisions that a16z crypto and other large crypto VCs use to maintain incentive alignment with entrepreneurs.
Founders should beware of granting investors fixed, non-dilutable token interests or unsustainable percentages of the network. These predatory terms limit the project’s flexibility and future growth potential. If development companies have granted existing investors a non-dilutable right to, say, X% of the total token supply for a given token, they may find it difficult to raise additional capital without offering the same non-dilutive terms to future investors. Such terms can constrain a company’s financing options or end up reserving too high a proportion of the token network for investors. And a lopsided token distribution in which investors hold too large a portion of the network ultimately forces founders to sacrifice token incentives for builders — whether from the community, the development team, or both.
Founders should also beware of VCs who require them to pay tokens for help launching a token. In those cases, two things are likely true: First, you don’t want their help. Second, they’re likely to be “value extractive” and will look to dump their tokens early.
Fixed token allocations are predatory. They can lock early stage projects into allocations that no longer make sense at the time of launch, and they can make it difficult for projects to raise future funding rounds when those projects run out of tokens to allocate. Token rights should be proportionate to equity ownership and subject to dilution. This ensures that token allocations are flexible and aligned with long-term project development. Projects can raise additional rounds of financing to continue developing as needed, instead of rushing a token launch because they ran out of other options.
The a16z crypto deal documents can be structured one of two ways. Option 1 entitles investors to a portion of the total token supply that is equal to some fraction of their equity percentage interest in the company at the time tokens are created. This option sets clear expectations around investors’ token allocations from the outset. Option 2 entitles investors to a pro rata portion of the tokens that are allocated to the development company and its employees, consultants, investors, and other stockholders, provided that allocation meets a minimum percentage of the total token supply. This option sacrifices clarity for flexibility by permitting a project to determine the stockholder allocation (i.e., how many tokens will go to employees, consultants, and investors) versus the community allocation (i.e., how many tokens will be airdropped, reserved for community project funding, and so on) prior to launch.
Option 1: If the Company (or any affiliate, foundation, or nominee thereof) creates any Crypto Tokens, investor will be entitled to a pro rata portion of the total possible token supply for such Crypto Token that represents half of its fully-diluted ownership at the time of the token generation (for example, representing [X]% following the contemplated financing).
Option 2: If the Company (or any affiliate, foundation, or nominee thereof) creates any Crypto Tokens, investor will be entitled to a pro rata portion of the Crypto Tokens allocated to the Company and the Company’s officers, directors, employees, shareholders, and other investors (collectively, “insiders”). The amount allocable to the Company and Insiders shall be no less than [X]% of the total amount of Crypto Tokens ever to be created.
Founders should beware of short lockups. Investors may push for their tokens to unlock quickly to sell early, which can disrupt the project’s stability and growth, cause irreparable reputational damage to the project, and introduce existential legal and regulatory risk. Pushing for shorter lockups is both dangerous and irresponsible.
Lockup schedules should be consistent across investors, founders, employees, and other stockholders of the original development company. This ensures that all parties are equally invested in the project’s long-term success.
The a16z crypto form term sheet is structured so that all insider-held tokens are locked for at least one year following the public token launch or the date that tokens become transferable (if tokens are non-transferable at launch). In general, a16z crypto pushes for four-year lockup schedules for insider-held tokens, during which all such tokens are fully locked up for one year, followed by three years of periodic unlocking. This helps maintain the stability of token networks in their earliest days post-launch, and ensures that all insiders bear significant market risk with respect to all of their tokens for at least one year post-launch.
Lockups like this can also buttress a project’s regulatory posture to the extent securities laws are applicable to a particular token. The form term sheet also ensures that all tokens held by insiders unlock on the same schedule, further reinforcing incentive alignment among entrepreneurs and investors.
Any lockup schedule on such tokens shall be agreed, provided that such lockup shall be (1) at a minimum, no less than one year from launch of the Crypto Tokens, (2) at a maximum, no more than four years from launch of the Crypto Tokens, and (3) no more restrictive than the schedule applicable to tokens issued to the Company or any of the Company’s officers, directors, employees, shareholders or other investors.
Founders should beware of unqualified approval rights over token issuances. These predatory terms could allow investors to hold up token launches to renegotiate better deals for themselves, causing unnecessary delays and strategic misalignments.
Investors should generally not have approval rights over when a project issues a token. Token launches can come with significant risk, and the decision to launch is inherently a business decision that founders are better positioned to make. They are better equipped to decide not only whether and when to launch a token, but also how best to structure that launch. Approval rights may empower investors to exert undue influence on these decisions to maximize their expected economic outcome (e.g., holding up a token launch, forcing projects to partner with an investor’s other portfolio companies, etc.), which could be detrimental to the project’s development.
The a16z crypto form term sheet is structured to allow projects to issue tokens without investor approval, as long as the issuance doesn’t circumvent any investor’s token rights. Generally speaking, if each investor receives their agreed allocation of tokens, then investor approval isn’t required. This provides operators with maximum flexibility while maintaining incentive alignment with investors.
Approval of a majority of the Preferred Stock required prior to any creation, reservation, sale, distribution, issuance, or other disposition of tokens, coins, crypto assets, virtual currencies, or other assets built on blockchain technology (“Crypto Tokens”), provided, however, that such restrictions shall not apply to a sale, distribution, issuance, or other disposition of such assets that is made (i) in a manner that does not conflict with the “Token Rights” provision below or (ii) pursuant to certain customary exceptions.
Founders should beware of deals that have no restrictions or unconditional restrictions on how investors and founders can use company technology. The absence of any restrictions could allow certain investors to exploit loopholes to gain control over the network, undermining the founders’ original vision and the project’s goals. Conversely, an unqualified restriction could inhibit synergistic development and decentralized value creation.
Investors and founders should be restricted, for instance, from launching competitive platforms using technology developed by the company with investor funding. This protects investors’ and founders’ interests and ensures the integrity of the project. At the same time, any restrictions should be sufficiently balanced to ensure that they don’t impede necessary partnerships and integrations for the project.
We’ve recently updated the a16z crypto form term sheet to limit both investors’ and founders’ ability to exploit technology developed by the company for their personal gain or in a way that competes with the goals of the company, subject to customary exceptions that permit ordinary, non-commercial, and non-competitive use of company technology. These exemptions might include a founder’s personal use of a company-developed protocol as an ordinary end user, in connection with university-led research, in their capacity as an advisor to other blockchain protocols, or in partnership with services compatible with the company-developed protocol. These exemptions allow founders to contribute to the industry in keeping with the open source and collaborative ethos of web3, while ensuring that they are able to develop company technology in a way that doesn’t compromise their obligations to investors and their alignment with the community.
The Company, the founder(s), and the investors shall agree that they will not utilize or exploit the Company’s network or protocol for commercial purposes other than directly through the Company, subject to certain customary exceptions.
Investors who do not prioritize regulatory compliance make for poor partners in web3 projects. Some investors may be entirely uninterested in — or prefer to remain ignorant of — the laws and regulations that apply to blockchain networks and the products built on top of them. Avoid them. Given the significant regulatory uncertainty of the industry and the existential risk that uncertainty imposes, compliance obligations have to not only be addressed but prioritized.
In theory, both founders and investors should want token networks that are compliant with applicable law, minimizing risk and enabling sustainable, long-term growth. In practice, however, not all stakeholders in web3 share that point of view. Short-sighted, predatory investors will prioritize gains from regulatory arbitrage over compliant development, and sacrifice the project’s stability in the process.
The a16z crypto form deal documents include a number of provisions that ensure projects are approaching network design, product development, and token launches with due care, and that investors support that process. These include, among other items, requirements that companies (i) develop a comprehensive compliance policy, (ii) take reasonable efforts to inform investors of any laws or regulations that may apply to, and adversely affect, any of their blockchain-based products or services, and (iii) engage counsel to specifically assess the legal and regulatory risks of any such products and services and employ appropriate safeguards. These covenants further enable investors to provide support with each of these processes.
Before the public launch of a new blockchain-based product or service, including distribution of Tokens, if ever, the Company shall engage counsel to assess and analyze the risks to the Company (with consideration given to security holders, including the Investors) of the form, mechanism and structure of the product or service and distribution of the Tokens, if applicable. To the extent the Company requests any Investor to provide advice with respect to the planning or design of any such blockchain-based product or service, including any digital tokens, cryptocurrency or other blockchain-based assets relating thereto, the Company shall engage additional outside counsel agreed to by the Company’s Board of Directors to review the assessment and analysis of risk associated with any such products or services, and use best efforts to ensure any such products are services are only offered in accordance with all applicable laws.
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Getting token rights correct in a project’s earliest stage is imperative to the future success of the project. Yet many projects — through no fault of their own — can find themselves subject to predatory terms, which can be difficult if not impossible to unwind further down the line. By adhering to the guidelines and sample provisions outlined here, founders and investors can create a balanced framework that fosters alignment amongst stakeholders, innovation, and project stability. This approach not only mitigates the many risks inherent to venture and web3 deals but also positions projects to thrive in the evolving web3 ecosystem.
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