Founder’s Guide: Web3 Funding

How Web3 Deals Are Different Than Typical Startup Deals?

Startup financing is about the process of converting investments into value.

The value accrues to the users of that product when the startup solves a problem for them. If the startup is good enough at creating value for users at scale, then the founders, employees and investors (owners) ultimately realize that value in the form of a return on their investment of time and money.

This is true for standard tech startups as well as Web3 startups. There are several paths to convert investments into value. For our purposes, the three most relevant are discussed below.

The IPO Path

For standard Silicon Valley tech startups, the most common path is the path to an initial public offering (IPO). The product is built by a centralized and hierarchical team. That team is organized as a company, typically a Delaware C-Corp. Their goal is to grow the user base of their product, typically fueled by five or six rounds of venture capital funding, until they reach the scale that they are able to offer their stock to the public in an IPO. At this point, owners get a return on investment. This process typically takes seven to ten years.

The ICO Path

In contrast to the IPO path, in 2017, a new path became popular for crypto startups: the initial coin offering (ICO). Before a product is built, the team drafts a white paper that details the proposed product and/or token. The team is generally loosely affiliated and has often not formed a legal entity. In order to pre-fund product development, they launch a token to the public in an ICO. Buyers of the token are often generally motivated by speculation, not the value of the product. They are betting that the token price will increase, and they’ll be able to sell it for a profit. Due to a great deal of hype, many of these ICOs raised tens of millions of dollars in mere hours. The team realized the financial value immediately. But unfortunately, 80-90% of these projects were never able to bring a product to market, and the tokens became worthless. By committing to a token offering up front, the team can become distracted from actually building a great product and a great community. In many cases, startups journeying down the ICO path put the cart before the horse.

The Decentralized Path

Currently, many modern Web3 startups are choosing a middle path, one that incorporates elements of both the IPO and the ICO paths. They aim to create an ecosystem, not just a company.

The ecosystem is built around a core team of developers and builders. At inception, just like a typical startup, the core team will form a company, raise pre-seed/seed capital. They will build and release a minimum viable product. If the users/community respond positively to the product, then they will often need a Series A to build out the product, hire a team and build the community.

So far, this looks exactly like the IPO path. However, rather than raising a Series B, C, D and E, and then going public, the goal of Web3 companies is to exit to the community. The process is: (1) build a product, (2) build a community around that product, (3) give ownership to that community.

As a company decentralizes ownership and sometimes governance of the company transfers from the core team inside the company to the community that has grown around the company. It’s a transition from centralized ownership to decentralized ownership through a token offering. This native digital token is the best way to coordinate and align community action once the product is ready.

The Decentralized path first focuses on creating a valuable product in a centralized core team, then moves toward progressive decentralization as the community takes on more ownership and governance. The time horizon for full decentralization, sometimes called an “exit to community”, would likely be around two to four years, so it’s not immediate like the ICO, but much less time than the seven to 10 years of the IPO. Upon decentralization, the owners may see a return on investment (or they may choose to hold / HODL the token and help increase its value). Through the token issuance, the community contributes both financial and sweat equity and are incentivized to ensure growth over time.

How should Web3 founders structure deals?

Flexibility is critical for startup success. The Decentralized path provides the most optionality for startup founders. If you stay on the Decentralized path, you’ll progressively move from centralized to decentralized. However, in every startup, there are a number of pivots, and it’s possible that you may pivot and ultimately choose to never exit to the community. In this scenario, the Web3 startup will transition to the IPO path.

Equity, or stock in the company, ensures that owners get a return on their investment if the startup ultimately choose the IPO path. Tokens ensure that owners get a return on their investment if the startup chooses the Decentralized path. So, in order to prepare for both possible paths, you should structure your Web3 funding deal to include both equity and tokens.

Equity

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. The deal points will mirror a standard startup funding round. There should be nothing exotic or novel about the equity portion of the deal.

If you want to dive deeper into this, check out the relevant guides below:

  • Founder’s Guide: SAFE
  • Founder’s Guide: Series Seed
  • Founder’s Guide: Series A

Token

If your startup is on the Decentralized path, you did not launch a token at the outset of the project. That would be an ICO. The startup is promising investors rights to tokens if and when they create and distribute tokens. Since many of these deals are done before a startup does any work on their tokenomics and have settled on the token’s supply, attributes and monetary policy, figuring out how many tokens to grant to an investor is challenging. Below, I’ll discuss the different approaches.

Token Instrument

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 warrant is a riff on the standard stock warrant that has been used in startup financing for years. Except instead of promising stock in the company, they are promising tokens.

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. My experience is that more old school funds prefer a warrant, and newer crypto funds and angels prefer side letters. The side letters are generally much shorter and more straightforward, so they may help the deal close a little smoother. Either way, you’ll want counsel to review the token instrument to ensure that you are clear on the impact of the agreement.

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.

Token Pool

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. The total token supply means the total number of tokens distributed by the company. The insider allocation is the number of tokens within the total supply that are reserved for insiders like investors, founders, employees, advisors, contractors and other early contributors. The insider allocation is also a subset of the total supply and is by definition smaller. Every project is different, but the insider allocation generally ranges between 10% and 30% of the total supply.

So, the insider allocation pie is orders of magnitude smaller than the total supply. The pie size will greatly impact the number of tokens issued to the investor.

Granting a percentage of total supply is investor-friendly and will likely lead to a community with a number of whales. This approach gives outsized influence to investors and crowds out the community. Conversely, granting a percentage of insider allocation is founder-friendly and community-friendly. In this scenario, the investors and founders incentives are aligned and not divergent, there are less whales and the community members get more tokens. In short, it yields a much more decentralized ownership structure.

Founders should negotiate hard to ensure that the token pool is the insider allocation. Investors that insist on total supply may not truly be embracing the Web3 ethos. This is a red flag for founders that the investor is not the right fit for the company.

Token Percentage

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.

Where these two approaches diverge is when the startup raises follow on capital.

Let’s assume that there are 100 tokens in the insider allocation, and the investor gets 5% while the other insiders split the additional 95%. Let’s assume that the startup is growing and raises another round of capital before issuing their tokens.

If the investor had a fixed 5%, the new investors will now be sharing that other 95% along with the existing insiders. So, the founders, employees and advisors suffer a pronounced dilution, but the investor suffers no dilution.

This misaligns founders and investors. Additionally, it’s highly likely that if a startup offers a fixed percent to the early investors, the follow-on investors will want that same term, which multiplies the issue. The net result is that the actual builders are left with a sliver of the pie and the investors get a fat slice.

For this reason, founders should work with their counsel to negotiate for pro rata to avoid excessive token dilution.

To recap, the optimal token mechanics for a Web3 deal are a pro rata percentage of the insider allocation.

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