Crypto Fundraising with Token Side Letters or Token Warrants
For early-stage crypto companies, there’s a new fundraising document called the “token side letter”, that is being used to raise capital from accredited and institutional investors.
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Foreword: Thank you to the Alliance DAO team and Lindsay for their insights and help in writing this article.
For early-stage crypto companies, there’s a new fundraising document called the “token side letter”, that is being used to raise capital from accredited and institutional investors. The token side letter represents the option to receive future tokens, alongside the equity, of these early-stage crypto companies.
Crypto companies differ from traditional companies in that they offer an alternative asset, the token. Tokens represent a tradable asset or utility that holders can use for a wide range of functions (e.g., voting, access to content, unlocking feature benefits, purchasing items or other digital assets). These tokens are used, similar to game credits at an arcade or tickets at a theme park, for interacting with decentralized applications (dApp). Investors not only want equity in the companies they invest in, but also the tokens that can be used to interact with these dApps because of their utility value. The two primary documents used for fundraising as a crypto company are:
The SAFE (simple agreement for future equity) with the ‘Token Side Letter’
At LiquiFi, we’ve observed that the SAFE with the Token Side Letter has emerged as the preferred fundraising strategy due to the flexibility and other benefits they offer to the company and the investors. LiquiFi provides examples of Token Side Letters with the most commonly used token pro-rata rights. You can view example token side letters with LiquiFi here.
What is a token side letter or warrant (with a SAFE)?
The token side letter or warrant represents a right, but not the obligation, to receive or purchase future tokens. The amount of tokens the investor can receive via the side letter or warrant is proportional to the equity granted via the SAFE. The tokens are not a replacement for receiving company shares as an investor — it’s complementary and used alongside the traditional equity agreement and cap table. While not the same, properly drafted token side letters and warrants are intended to achieve the same outcome and are used interchangeably for this article. *Consult with your legal counsel on whether to use a token side letter or token warrant. There are differences between token side letters and token warrants depending on the legalese.
Three main types of managing the pro-rata rights of the token supply:
Company allocation or insider’s supply method
Fully diluted supply method
Conversion rate method
For founders, how to think about the token side letter, which method to go with, and what terms to use?
1. What do investors prefer and what leverage do you have in the fundraising negotiations?
Each of the pro-rata right methods has its advantages and disadvantages for the company or the investors. Some investors prefer a guaranteed amount of tokens with the fully diluted supply or conversion rate method. Other investors prefer the direct alignment with the founders with the company allocation method. Their incentive is to get as much of the tokens for the amount of capital invested.
The fully diluted supply and conversion rate method gives investors a fixed token supply guarantee based on their equity ownership, while the company allocation method is subject to future token allocation decisions by the company. The latter can be seen as “riskier” due to the unknown token allocations that have yet to be made. Investors have a preferred method based on their own experiences, risk profile, and projections about the company’s future token allocations.
2. What’s the valuation and where will the value accrue?
If you and your investors have agreed to value the token warrant/side letter rights and equity together at some value, the formula for token allocation should reflect that. Depending on the business and how it leverages the tokens into the business model, investors will value the equity and tokens accordingly. Until a token launch, there is always some non-zero chance that tokens may never be issued. So the equity and the probability of not launching a token has to be valued accordingly and will be reflected in the token side letter terms.
3. What are your token allocation plans and how much do you want to give to investors and the company?
If you plan to allocate a large percentage of the tokens to the company, it may be better to use the conversion rate methodology. And if you plan to give a small amount of tokens to the company, it may be better to use the company allocation methodology (so that investors get fewer tokens for the same amount of capital). See below for an illustrative example where the method used can result in different outcomes for investors depending on the token allocation.
Scenario 1: 20% allocation of tokens for the company and insiders (founders, employees, company treasury)
Scenario 2: 60% allocation of tokens for the company and insiders (founders, employees, company treasury)
4. Negotiation and getting the best terms for you and the company.
Generally, founders want to raise more capital and dilute less equity/tokens, while the incentive is reversed for investors. As a founder, you should fundraise when you have the most leverage with measurable progress and traction for your business. General advice for startup fundraising applies here.
When fundraising, you want to have a valuation benchmark by looking at the market of comparable companies in recent fundraising. Your existing traction, team, strategy, industry (DeFi, DAO tooling, NFT, P2E gaming) may all result in different valuations, and comparable companies in your specific industry can be used as a part of your negotiation. Check out sources like Dovemetrics and fundraising announcements on Crunchbase and Twitter to get this data.
As a founder, you want to communicate the nature of the business, and how value may accrue to either the tokens, equity, or both token and equity. Based on these details, investors will arrive at a certain valuation for the equity and the tokens together. As a part of this process, investors are also pricing the equity valuation in a scenario where there is no token launch to make sure that their investment is protected.
For example, if you’re raising at $10M equity valuation for just the company, and you have tokens involved, you may also value the token network at $20M based on comparable companies. Your token side letter should reflect the 2:1 rights on the equity, reflecting the valuations of the equity and tokens together.
Make sure to be clear with the investors on the value of the equity and the tokens together so that you don’t end up with the wrong token side letter terms, or delay closing the deal because of misalignment on valuations.
What is a SAFT or (SAFTE)?
During the early ICO days and crypto fundraising, the SAFT (simple agreement for future tokens) was a document drafted to help crypto companies fundraise for their tokens. The SAFT and SAFTE (simple agreement for future tokens or equity) have largely fallen out of favor in the United States due to legal risk and violations of securities laws. Historical precedents have been set in previous court cases involving SAFTs (Kik, Telegram). This is not legal advice. Consult with your legal counsel on whether the SAFT or SAFTE is appropriate for your fundraising.
SAFT (Simple Agreement for Future Tokens) — investing capital for the right to purchase tokens or % of token supply at a specified price or discount rate.
“Simpler”, no need to manage the equity stake and the conversion of equity into tokens
More straightforward valuations on just the tokens alone, and not have to mix in the equity value component
SAFTE (Simple Agreement for Future Tokens or Equity) — similar to SAFT, but gives investors equity with the optionality of converting to tokens.
Similar to SAFTs, with the added benefit of providing investors the optionality of retaining equity
Rarely used anymore. SAFE with a token side letter or warrant has become more commonplace.
How do I get started with token side letters and fundraising?
Talk to your legal counsel to devise the right strategy for your situation and fundraising needs.
Come up with potential token allocations using recent token launches and benchmarks, understanding this could still change drastically in the future*.
Decide which token pro-rata right method you want to use by comparing outcomes with your token allocation and the three types of token pro-rata right methods.
Understand how much negotiating leverage you have when fundraising, and whether you need founder-friendly terms or investor-preferred terms for the token side letter to close the deal.
Have your token side letter docs ready to go with the terms that you want before you start fundraising. Drafting and negotiating on token side letters can take multiple days and weeks, which could delay closing a critical investment deal.
* It may be hard to determine the future tokenomics or token utility model as an early-stage company without product-market fit or a large community of users. Because your token strategy and business models are subject to change, you want to have as much flexibility for your future token allocation and minimal token dilution.