Original author: Miles Jennings , Joseph Burleson , Zachary Gray
Original translation: TechFlow
Executing a successful token offering is a complex process that requires a great deal of strategic planning and a dose of luck. However, before a project even launches its tokens, the wrong token rights structure can undermine its future prospects. In early funding rounds, structuring legal rights associated with tokens is complex, and some investors may take advantage of the lack of clear definition of market standards to take advantage of unsuspecting entrepreneurs.
To help entrepreneurs better understand the market and ensure fair and sustainable deal structures, here are the principles we use to define the scope of token rights and restrictions. We also highlight the predatory behavior of some investors, discuss how these behaviors can harm projects, and provide an explanation of the terms we use.
Incentive Alignment: The Key to Success
Alignment of incentives between founders and investors is key to the success of any business. Misaligned incentives can lead to distrust and inefficient work, and limit project selection. Incentive alignment — by definition — helps ensure everyone is working in the same direction.
In a traditional equity structure, incentive alignment is straightforward. If the company becomes more valuable, both investors and founders benefit. But in Web3, the introduction of tokens makes incentive alignment more complicated. The blockchain systems deployed by Web3 projects are open source, decentralized, and generally designed to accrue value to the systems tokens rather than the companies that develop the technology - a subtle but important distinction. This design shifts value away from equity, resulting in a misalignment of incentives between token holders and equity holders.
This misalignment of incentives is most common when early-stage projects raise funds only by selling tokens directly to institutional and angel investors, which can lead to two problems:
Investors who focus only on tokens tend to have a shorter investment horizon and often pressure projects to launch tokens quickly to get faster returns. This unnecessary pressure can limit the potential of projects and cause them to take actions that harm their ecosystem - for example, launching tokens too early.
Selling token rights reduces the flexibility of the project in its overall design. When investors’ expectations can only be met through tokens, projects tend to prioritize the launch of tokens and the accumulation of token value. But tokens may not be the best path for every project, and some projects need more time to ensure their economic balance. Losing the flexibility to choose alternative paths may harm the long-term success of the project.
Therefore, early-stage projects are better off with a balanced deal structure that gives all stakeholders exposure to both equity and tokens. By keeping investors and entrepreneurs aligned, projects can maintain flexibility to design their systems in the best way and allow value to accrue to tokens, equity, or both. By aligning interests, both parties can focus on sustainable growth and long-term success.
Even in the case of early stage projects using balanced deal structures, incentive misalignment may still emerge after the public token offering: some individuals may hold tokens while others hold both tokens and equity. Due to this possible incentive misalignment, projects must guard against conflicts of interest. In some cases, a project may shut down the development company, meaning that every stakeholder becomes a token holder. In other cases, it may be beneficial for many companies to actively build and compete using the projects technology, in which case projects should prioritize creating a level playing field, develop procedural incentives , and even consider imposing strict and milestone-based token sale restrictions on employees, investors, and other insiders of the original development company to protect token holders. In most cases, the projects intellectual property should be controlled and owned by token holders.
Predatory Behavior and How to Avoid It (with Sample Clauses)
Here are a few clauses a16z Crypto and other large crypto VCs use to align incentives with entrepreneurs.
Token Rights
Founders should be careful to avoid granting investors fixed, non-dilutable token rights or unsustainable percentages of the network. These predatory terms limit a project’s flexibility and future growth potential. If a development company has granted existing investors non-dilutable rights to, say, X% of a token’s total supply, they may find it difficult to raise additional capital without offering the same non-dilutable terms to future investors. These terms can limit a company’s financing options or ultimately reserve too high a percentage of the token network for investors. Investors holding too large a percentage of the token network ultimately forces founders to sacrifice token incentives for builders — whether from the community, the development team, or both.
Founders should also be wary of VCs that ask them to pay tokens for their help with a token launch. In this case, there are usually two facts: first, you don’t want their help, and second, they are likely “value extractors” who will try to sell their tokens prematurely.
Fixed token allocations are harmful. They can lock early-stage projects into allocations that are no longer justified at launch, and can make it difficult for these projects to raise future funding rounds when they run out of allocable tokens. Token rights should be proportional to equity ownership and subject to dilution. This ensures flexibility in token allocations and alignment with long-term project development. This way, projects can raise additional funding rounds as needed to continue development, rather than rushing to launch tokens because they have exhausted other options.
a16z Crypto’s transaction files are designed in two ways.
Entitles investors to a portion of the total token supply equal to their percentage of equity in the company at the time of token creation. This option sets clear expectations for investor token allocations from the outset.
Gives investors the right to receive a pro rata share of tokens allocated to the development company and its employees, advisors, investors, and other shareholders, provided that the allocation meets a minimum percentage of the total token supply. This option sacrifices clarity for flexibility, allowing projects to determine shareholder allocations (i.e., how many tokens will be allocated to employees, advisors, and investors) versus community allocations (i.e., how many tokens will be airdropped, reserved for community project funding, etc.) prior to issuance.
Sample Clauses
Option 1: If the Company (or any of its affiliates, foundations or nominees) creates any Crypto Tokens, Investors will be entitled to receive a pro rata allocation of the total possible supply of such Crypto Tokens representing half of their fully diluted ownership at the time of token generation (e.g., representing [X]% after the Planned Financing).
Option 2: If the Company (or any of its affiliates, foundations or nominees) creates any Crypto Tokens, Investors will be entitled to receive a pro rata distribution of the Crypto Tokens allocated to the Company and its officers, directors, employees, shareholders and other investors (collectively, “Insiders”). The amount allocated to the Company and Insiders shall not be less than [X]% of the Total Crypto Token Supply.
Lock-up period
Founders should be wary of short-term lockups. Investors may push for their tokens to unlock as quickly as possible for early sales, which could undermine the stability and growth of the project, cause irreversible reputational damage to the project, and introduce existential legal and regulatory risks. Pushing for shorter lockup periods is both dangerous and irresponsible.
The lockup schedule should be consistent across investors, founders, employees, and other shareholders of the original development company. This ensures that all parties are equally concerned with the long-term success of the project.
a16z Crypto’s table term sheet structure provides that all internally held tokens are locked up for at least one year following the public token offering or the date the tokens become transferable (if the tokens are not transferable at the time of offering). Generally, a16z Crypto promotes a four-year lockup schedule for internally held tokens, where all such tokens are fully locked up within one year, followed by three years of periodic unlocking. This helps maintain stability of the token network in the initial days following the token offering and ensures that all insiders bear significant market risk for at least one year following the token offering.
Such a lock-up period can also strengthen the project’s regulatory stance with respect to securities laws applicable to a particular token. The table clause also ensures that all tokens held by insiders unlock on the same schedule, further strengthening the incentive alignment between entrepreneurs and investors.
Sample Clauses
Any lock-up schedule for such tokens shall be agreed upon, provided that such lock-up period shall be (1) at least one year from the date of issuance of the cryptographic tokens, (2) at most four years from the date of issuance of the cryptographic tokens, and (3) no more stringent than the schedule applicable to the tokens of the Company or any officer, director, employee, shareholder or other investor of the Company.
Protective Clauses
Founders should be wary of unconditional approval rights for token offerings. These predatory clauses could allow investors to delay token offerings in order to renegotiate a better deal, causing unnecessary delays and strategic misalignment.
Investors should generally not have approval rights over the timing of a projects token issuance. Token issuance can be associated with significant risks , and determining the timing of an issuance is essentially a business decision that founders are better suited to make. They are better positioned to decide when and how to best structure a token issuance. Approval rights could allow investors to exert undue influence over these decisions to maximize their desired economic outcomes (e.g., delaying a token issuance, forcing a project to partner with an investors other portfolio companies, etc.), which could adversely affect the development of a project.
a16z Cryptos table clause structure allows projects to issue tokens without the need for investor approval, as long as the issuance does not circumvent any investors token rights. Generally speaking, if each investor receives its agreed-upon token allocation, investor approval is not required. This provides operators with maximum flexibility while maintaining incentive alignment with investors.
Sample Clauses
Approval by a majority of the Preferred Shares is required prior to the creation, retention, sale, distribution, issuance or other disposition of tokens, coins, crypto assets, virtual currencies or other assets built on blockchain technology (“Crypto Tokens”), provided that these restrictions do not apply to sales, distributions, issuances or other dispositions (i) made in a manner that does not conflict with the “Token Rights” clause below or (ii) made pursuant to certain customary exceptions.
Network Utilization
Founders should be wary of deals that place no restrictions on how investors and founders can use the company’s technology. The lack of any restrictions could allow certain investors to exploit loopholes to control the network, undermining the founders’ original intentions and the goals of the project. Conversely, unconditional restrictions could inhibit collaborative development and decentralized value creation.
For example, investors and founders should be restricted from using the technology developed by the company to launch competing platforms. This protects the interests of investors and founders and ensures the integrity of the project. At the same time, any restrictions should be balanced enough to ensure that they do not hinder the partnerships and integrations required by the project.
We recently amended a16z Crypto’s table terms to restrict investors and founders from using company-developed technology for personal gain or in a manner that competes with company objectives, subject to customary exceptions for ordinary, non-commercial, and non-competitive use of company technology. These exceptions may include founders’ personal use of company-developed protocols as ordinary end users, use in connection with university-led research, as advisors to other blockchain protocols, or engagement with services compatible with company-developed protocols. These exceptions allow founders to contribute to the industry in a manner consistent with the open source and collaborative ethos of Web3, while ensuring that they can develop company technology in a manner that does not interfere with their obligations to investors and alignment with the community.
Sample Clauses
The Company, Founders and Investors should agree that they will not use or exploit the Company’s network or protocols for business purposes except directly through the Company, subject to certain customary exceptions.
Compliance
Investors who do not take compliance seriously are unsuitable partners in Web3 projects. Some investors may lack interest in, or prefer to remain ignorant of, the laws and regulations applicable to blockchain networks and the products built on them. Avoid working with them. Given the significant regulatory uncertainty in the industry and the existential risks it poses, compliance obligations must not only be addressed, but prioritized.
In theory, founders and investors should want token networks to comply with applicable laws, thereby reducing risk and achieving sustainable long-term growth. However, in practice, not all Web3 stakeholders hold this view. Short-sighted predatory investors prioritize gains through regulatory arbitrage over compliant development, sacrificing project stability in the process.
a16z Cryptos transaction documents contain multiple clauses that ensure that the project takes appropriate care in network design, product development, and token issuance, and that investors support this process. These clauses include requiring companies to (i) develop a comprehensive compliance policy, (ii) make reasonable efforts to inform investors of any laws or regulations that may apply to their blockchain products or services and the adverse effects that such laws or regulations may have, and (iii) retain counsel to specifically assess the legal and regulatory risks of these products and services and to take appropriate protective measures. These covenants further enable investors to support each of these processes.
Sample Clauses
Prior to the public offering of a new blockchain product or service, including the distribution of tokens (if any), the Company shall engage counsel to evaluate and analyze the risks to the Company (with regard to security holders, including investors) of the form, mechanism and structure of such product or service and the distribution of tokens (if applicable). In the event that the Company requires any investor to provide advice on the planning or design of any such blockchain product or service, including any digital tokens, cryptocurrencies or other blockchain assets related thereto, the Company shall engage additional external counsel as agreed by the Company’s Board of Directors to review the risk assessment and analysis associated with any such product or service and to use its best efforts to ensure that any such product or service is provided only in accordance with all applicable laws.
Correctly determining token rights in the early stages of a project is critical to the future success of the project. However, many projects — through no fault of their own — may find themselves subject to predatory terms that may be difficult or even impossible to unwind at a later stage. By following the guidelines and sample terms outlined here, founders and investors can create a balanced framework that promotes alignment among stakeholders, innovation, and project stability. This approach not only mitigates many of the risks inherent in venture capital and Web3 transactions, it also positions projects to thrive in the evolving Web3 ecosystem.
