In recent years, the rise of cryptocurrency and web3 startups has added a new chapter to the book on what early-stage investors need to know. It’s no longer enough to understand the ins and outs of stock options, stock warrants, and other mechanisms of traditional equity. A growing number of web3 startups are turning toward mechanisms that allow them to issue equity to investors in the form of their native tokens. Chief among these mechanisms are ICOs (Initial Coin Offerings), SAFTs (Simple Agreements for Future Tokens) and token warrants, the last of which we’ll explore in this guide.
Token warrants bear some key similarities to traditional stock warrants. Just as a stock warrant allows the holder to buy shares of stock in the issuing company at a specified price in the future, a token warrant allows the holder to buy a certain amount of the company’s tokens at a specified price in the future. And, as with stock warrants, token warrants are generally issued to investors, banks, and third-party partners (rather than to employees, consultants, and other service providers).
Token warrants aren’t the only way to issue token-based equity, but they may come with some regulatory and practical advantages. If you’re the founder of a web3 startup looking to attract venture capital investors, issuing token warrants could help you translate your protocol or dApp’s tokens into equity that fuels your startup’s growth. But, as with all things crypto (and equity, for that matter), you won’t want to dive in blindly.
- What is a token warrant?
- How do token warrants work?
- How do token warrants fit into my startup’s cap table?
- Simplify your startup’s token equity with Pulley
What is a token warrant?
Blockchain technology has enabled a number of new equity types that may change the future face of startup financing. These equity types generally allow investors in web3 startups to receive a certain number of tokens commensurate with the size of their investment.
When we say “tokens,” we’re referring broadly to blockchain-based digital assets. Many web3 companies develop their own crypto tokens as part of a blockchain-based project, and these companies can theoretically mint as many tokens as they want. But in order for the tokens to maintain a relatively healthy and stable value, their developers must pay attention to tokenomics principles such as supply-and-demand and providing ongoing incentives to holders.
Of course, a web3 company may want to offer its tokens to venture capital and accredited investors as a means of fundraising. One increasingly popular way to do this is via the issuance of token warrants.
A token warrant is a derivative that allows the warrant holder to purchase tokens in the issuing company at a specified price on or before a specified expiration date. The number of tokens issued to the holder upon exercise of the warrant is typically commensurate with the holder’s investment stake in the company, though it may also be affected by the total allocation of tokens for investors.
How do token warrants work?
Token warrants are an increasingly popular fundraising option among web3 startups, but there are a few peculiarities to how they work. To better understand token warrants, let’s review them through the lenses of tokenomics and how they relate to another token equity mechanism called a SAFT (Simple Agreement for Future Tokens).
Token warrants and tokenomics
The holder of a token warrant isn’t obligated to exercise it. But if they do, the company must mint new tokens equal to the number of tokens in the exercised warrant. This is why it’s generally a smart idea for web3 startups to think twice before offering a massive token warrant to an early-stage investor.
Oftentimes, a project’s tokenomics model develops over time, and it can be difficult to predict the future value of an individual token so early in a project’s life. If an early investor exercises a token warrant that results in the minting of a huge number of new tokens (and their subsequent flooding of the marketplace), the immediate supply may outstrip the demand and devalue the token. Similar supply-demand issues may arise if a bunch of separate warrants are exercised at the same time.
One way a company can avoid this out-of-control minting of new tokens is by setting aside a certain percentage of its total token allocation for investors. A company might issue warrants with the option to purchase future tokens based on each investor’s equity ownership percentage multiplied by the total token allocation for investors.
This may result in the investor receiving a percentage of the total token allocation that’s lower than their equity ownership percentage. For example, say 20% of all tokens are allocated to investors. An investor with a 10% ownership stake would be entitled to purchase only 2% of the total tokens (10% x 20% = 2%).
Token warrants and SAFTs
Token warrants are often mentioned alongside another token-based equity mechanism known as a SAFT, or Simple Agreement for Future Tokens.
The structure of a SAFT is based on a similar equity-based mechanism called a SAFE (Simple Agreement for Future Equity). A SAFE is a sort of investment contract that an early-stage startup makes with an investor, in which the investor agrees to pay money now and receive shares of company stock later. Similarly, a SAFT is an agreement in which an investor pays money upfront for the right to own a certain number of tokens once the network is completed.
SAFTs act somewhat like token warrants, in the sense that both entitle the holder to future tokens. One key distinction is that a token warrant represents a right, not an obligation, to purchase future tokens. A SAFT, on the other hand, essentially represents a promise on the company’s part to deliver future tokens to the investor at a later date.
Many companies hoped the SAFT framework would serve as a means to issue “utility tokens” to investors without having to register them as securities. In recent actions brought against the messaging startups Telegram and Kik—both of which attempted to use the SAFT for unregistered securities offerings—the U.S. Securities and Exchange Commission (SEC) has suggested that it sees otherwise.
While securities laws around tokens and digital currencies are still evolving, some may view SAFTs as carrying more legal and regulatory risks than token warrants. This is speculative and due in part to 1) token warrants’ optionality, and 2) the fact that the SEC has specifically called out issues with SAFTs’ “promise” to deliver future tokens to investors.
Given the shifting nature of regulation in this space, we recommend consulting with your legal counsel before moving forward with any type of token-based equity.
How do token warrants fit into my startup’s cap table?
While some web3 startups have moved more aggressively into token-based equity, the fundraising ecosystem hasn’t changed overnight. It’s not uncommon for the cap table of a web3 startup to include both traditional equity (RSAs, stock options, etc.) as well as tokens.
In some cases, token warrants may even be used in conjunction with SAFEs or other more traditional equity mechanisms. This allows investors to receive company shares as well as tokens, and it’s becoming an increasingly popular way to invest in web3 startups.
If you don’t plan ahead, you could quickly run into the complication of using separate systems to manage equity and tokens. Fortunately, Pulley makes it easy to track both traditional equity and tokens in the same place.
Simplify your startup’s token equity with Pulley
With Pulley, you can create a single source of truth that allows you to issue, track, and record all token agreements and token sales the same way you do with your equity agreements. Our tools connect to third-party token custodians such as Coinbase to help you issue and track token liquidity from one simple interface.
We also offer a number of tools and features with employees and other token holders in mind. Automatic vesting ensures that tokens are seamlessly moved to connected wallet addresses upon vesting, and token holders can access advanced views that help them track the projected future value of their tokens.
To learn more about how Pulley can help your startup usher in its Web3 future, schedule a call with us today.
