November 23, 2022

When to Use Vesting vs Lockups For Your Tokens

Vesting and lockups each have their own purpose, and also legal, tax, and compliance considerations. Understanding the nuances is important so you can set up your token incentives properly.

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Token Vesting vs. Lockups

Crypto token vesting and lockups are easy to confuse. Projects often use the terms interchangeably, but they mean very different things!

Vesting and lockups each have their own purpose, and also legal, tax, and compliance considerations. Understanding the nuances is important so you can set up your token incentives properly.

What is token vesting?

Token vesting is when a beneficiary earns tokens based on certain conditions (usually time-based).

Companies will grant tokens to an employee that they earn incrementally over time as long as they actively work for the company. If the employee quits or is terminated, they lose the unvested (unearned) remainder of their token grant. Companies use vesting conditions to incentivize employees to remain with the company and mutually benefit from increasing the value of the tokens.

Time-based vesting

Companies will define a time period known as the vesting schedule to earn the full token grant.

Most companies will use a linear vesting schedule, where shares or tokens are distributed evenly over a defined period. For example, in a standard 4-year vesting schedule, 25% of tokens are released each year.

Cliffs in vesting

Cliffs are another way companies can align their team and thoughtfully distribute tokens. A cliff is a minimum time an employee, founder, or advisor must stay with the company to receive their earned tokens. They forfeit the right to their tokens if their employment ends before the cliff period. The benefit of the cliff is that it provides the employer additional time to assess if it’s the right fit before giving up the tokens. We commonly see a 1-year cliff attached to a 4-year vesting schedule.

Braintrust, which uses the $BTRST token, has a 4-year vesting schedule, monthly vesting, with a 1-year cliff for their early contributors. With this schedule, beneficiaries receive no tokens until they stay for an entire year. At the one-year mark, 25% of their allotted tokens are distributed, and afterward 1/48 of allocated tokens are distributed monthly.

What are lockups?

A token lockup is a restricted period of time where tokens cannot be sold or transferred.

The goal of the lockup is to prevent the tokens from being sold on the open market before the protocol releases them. In most cases, lockup periods are enforced across core team members, investors, and insiders for a period after the token launch date.

For example, companies will implement a token lockup 12 months after the token launch date to prevent token holders from selling or transferring the tokens. Goldfinch implemented a 12-month transfer restriction for US participants (link). dYdX implemented a gradual lockup schedule over 48 months (link).

Why use lockups?
  1. Lockups incentivize cooperation across all token holders due to longer-term ownership
  2. Manage compliance risk of applicable regulations for tokens
  3. Lockups create a more fair token release mechanism for both insiders and the token community

Difference between vesting and lockups

The critical difference between vesting and lockups is the classification of ownership. With lockups, owners already own the tokens — there is no condition to earn the tokens incrementally or to lose any unearned tokens after termination. In vesting, employees earn incremental ownership of the tokens over time, and the company owns any unearned tokens.

Lockups and vesting share a similar outcome of restricting tokens from being transferred or sold. In some cases, vesting and lockups are used in conjunction.

For example, an employee’s shares can be vested on a 4-year vesting schedule starting January 1, 2022, but have a lockup period of 1 year from the token launch date on June 1, 2022. By January 1, 2023, the employee earns 25% of their token grant after their first year of employment but will have to wait six more months before selling or transferring ownership of those tokens (June 1, 2023).

When to use vesting?

Typically, vesting is attached to founders, employees, and advisors who have to provide some service or contribution of labor to earn their tokens.

Vesting incentivizes the team to perform well and stay with the company. Without it, teams can quickly sell the company tokens and not drive toward long-term success.

Other types of vesting schedules

Companies sometimes employ a non-linear vesting schedule, where the rate of token distribution increases or decreases over the vesting period.

Using traditional equity as an example, Snapchat uses a back-weighted vesting schedule, where 10% of an employee’s stock grant is released the first year, 20% the second year, 30% the third year, and 40% the fourth year. Back-weighted vesting schedules encourages employees to pursue longer tenures.

On the other hand, Google has a front-weighted vesting schedule, where a higher portion of the stock options are released in the first two years. Front-weighted vesting schedules can make a huge difference in recruiting talent during a competitive labor market, since it accelerates earning potential.

For advisors and board members, companies will also elect to use shorter, 2-3 year vesting schedules. Compared to founders or employees, these advisors and board members usually serve a limited term and don’t grow with the company. Hence, a shorter vesting schedule.

Further, companies can also use milestone or outcome-based vesting schedules. These outcomes can include reaching a specific token price, hitting financial metrics, or closing a strategic customer.

Managing these vesting schedules can be tricky. Liquifi helps founders spend less time in Excel tracking token vesting schedules and managing token grants so they can focus on their core business.

When to use lockups?

Typically, lockups are enforced among core team members, investors, and insiders. The primary goal of a lockup is to prevent tokens from being sold when the protocol launches the token. Without lockups, insiders can also trade tokens with the unfair advantage of having access to material information that external community members or stakeholders do not have.

Managing token circulating supply and managing perception

Lockups can help manage the token circulating supply and external perception. Since drastic price movement in tokens can substantially impact project perception, lockups can “smooth” out selling pressure and ensure liquidity to team members or investors to prevent the token price from tanking.

For example, you could gradually release tokens over 12-24 months rather than have them all unlock in 12 months. Gradual unlocking mitigates the risks and impact of a concentrated selling date.

In addition, core team members and investors selling tokens can be a negative signal and lack of confidence in future token performance. Lockups create a forced mechanism to prevent early selling while the protocol is still building its foundation, reputation, and a sustainable token model.

Compliance considerations

Certain regulations, if applicable for tokens, may require projects to restrict the sale of any tokens only under specific conditions.

Regulations for tokens are still evolving, and it needs to be clarified where existing rules for shares may apply to tokens.

Governance Voting, Delegation, and Staking with Lockups

When implementing lockups, one consideration is whether you want the stakeholders to participate in governance or staking rewards for their locked tokens.

For example, dYdX has a clause in their token announcement that states, “Regardless of any lockup on $DYDX, investors and prior employees or consultants of dYdX Trading or the dYdX Foundation may use $DYDX to make proposals, delegate votes, or vote on proposals related to the Layer 2 protocol.”

Since investors often hold a material share of the token supply, having them participate in governance may be beneficial.

Exercise caution when choosing your token lockup solution or using a lockup implementation that does not support voting, delegating, or staking with locked tokens. Liquifi was built with this in mind and offers you this critical functionality.

Conclusion

Vesting schedules and lockups are some of the strongest tools available for aligning incentives between founders, employees, and investors. A properly implemented vesting and lockup strategy is often crucial for ensuring your venture’s stability and long-term success. Stay tuned for future posts on design and implementation of vesting and lockups.

At Liquifi, we’re building Carta for crypto. Liquifi is the leading provider of token vesting and token cap table solutions. We help you launch, distribute, and manage your tokens.

Visit Liquifi and get started today

Robin Ji
Founder and CEO of Liquifi