VCs & Founders Shouldn’t Receive Any Tokens For 7+ Years
We would like to thank Charlie Sandor at CMT Digital for his contributions & feedback. This piece wouldn’t have been written without his input.
Let’s imagine a case where a crypto startup has raised capital from VCs for an equity entity and has future plans to raise further capital for the equity entity. The startup also has plans to launch a token at a future date. Let’s assume that the majority of the overall value created by the protocol will accrue to the token entity instead of the equity entity.
We propose that either a) no tokens should be allocated to equity investors and team or b) tokens allocated to equity investors and team should have a very long vesting schedule.
The token allocation portion that was planned to be allocated to equity investors and team should rather go to the equity entity. And the equity entity shouldn’t distribute the tokens to the shareholders until the underlying business reaches a maturity measured by certain business metrics.
If the above cannot be executed due to legal reasons, then tokens allocated to the equity investors and team should have a 10 years vesting schedule with the first token unlock starting at year 7. That said there should be pre-defined exceptions (KPI targets, acquisition) that would enable them to unlock their tokens earlier.
We are going to cover
- Longer Token Vesting Schedule Proposal
- Problem With Existing Token Vesting Schedules
- Traditional Early Stage Investing
- VC Model
Let’s try to understand the above statement with examples. Below is how the equity cap table would look like pre-token launch based on the startup’s fundraising plans.
The base assumption should be that 100% of protocol value accrues to the token entity -> obviously not the case, but anything less than 100% value accrual to the token introduces additional complexity that is hard to control for & weakens the proposal. Check our Token Cap Table article to better understand the value accrual concept.
Let’s say the startup raised a total of $20m in multiple fundraising rounds for the equity entity in exchange for 50% of the equity. Thus, the equity investors collectively own 50% of the equity entity. The equity entity is valued at $40m and the equity investors’ stake in the equity entity is worth $20m ($40m * 50%).
The startup also decided to allocate 50% of the token allocation to the community and 10% to the treasury. The remaining 40% will be shared between the investors and team on a pro rata basis. Since the equity entity has a 50/50 ownership, the remaining 40% token allocation should also have a 50/50 distribution. Thus, the ideal token allocation would be 20% equity investors and 20% team.
The intrinsic fully diluted valuation of the protocol is $100m — $40m equity valuation divided by 40% (token allocation of team + investors). The investors’ stake in the token entity is worth $20m (assuming the equity entity is almost worthless).
However, we propose that the remaining 40% token portion that went to the investors and team should instead go to the equity entity.
By far the biggest problem of token entities is that the pace & volume of token emitted to the circulation from the treasury is larger than the pace & volume of demand for the tokens from the market!
Token Emission Growth < Token Demand Growth | Token Price 👆
Token Emission Growth > Token Demand Growth | Token Price 👇
There are many ways to try solving this problem and this is a topic of another article but one direct solution relevant to this article is to delay the investor & team token unlock as late as possible.
Investor and team tokens are timelocked over a period of time. Once the tokens are unlocked, investors and team typically cash out immediately — which puts further sell pressure on the token price as the token supply emitted to the circulation becomes even larger.
Crypto projects are early-stage protocols that use token incentives to bootstrap user liquidity. Tokens are constantly emitted to the users to incentivize protocol activity. Thus, there is already an existing inflationary pressure to sustain and grow the ecosystem. Investors and team selling their portion of tokens before the platform is sufficiently mature, results in further sell pressure.
Additionally, as the founders cash out the tokens before the product is launched, they graudally lose the motivation & incentive to ship the product. The short vesting periods incentivize founders to be good snake oil salesmen — focusing on marketing the token by selling dreams to retail investors for a product that will never be released rather than focusing on actually building the product and understanding the customers’ pain points.
The same applies to investors; investors support the company and shill the token heavily until their vesting schedule ends. They then cut their ties with the company and don’t support it anymore — they have little incentive for the business to be a long-term success. As long as the price is high when their tokens are unlocked, they are happy. This is where the private investor incentives clash with that of the founders & community.
We argue that the investors and team shouldn’t be able to sell their stake until the platform reaches business maturity pre-defined by specific metrics. Doesn’t matter whether it takes 5 or 15 years for the business to reach those metrics!
Let’s look at some vesting schedule examples from existing projects
AXS (Axie Infinity)
AXS private sale investors are able to unlock their tokens every 3 months over a 2-year vesting period starting from the launch date. AXS allocated 4% to private investors which is a significantly low figure compared to other projects but the existing vesting period is pretty short.
Here’s the AXS private investors’ vesting period in detail
Tokens allocated to Sky Mavis (the equity entity) are unlocked over a 4.5 year period — at first glance this looks like a relatively long-term vesting period but the devil is in the details.
19% of the Sky Mavis token allocation is unlocked on the day of token’s launch. So effectively 4% of the total token supply is held unlocked by the equity entity. We do not know whether these tokens were held by Sky Mavis or distributed to team members or equity investors (who might have cashed out).
YGG (Yield Guild Games)
25% of YGG tokens are allocated to investors with a vesting schedule of a total of 5 years. However, ~30% of investor tokens are unlocked on the token’s public sale date. Effectively, that is 7.5% of the total token supply! 2 years after the token is launched, ~80% of investors are unlocked. This is definitely not a long-term vesting schedule.
Traditional Early-Stage Investing
Crypto has enabled founders and investors to have early exits without even shipping a product by just selling a “dream” or an “experience” to retail investors. Let’s look at how exits in traditional early-stage investing work.
VCs invest in a startup and cannot exit until i) the company goes public (IPO), ii) the company is sold. The path to exit can easily take 10 years based on data from Crunchbase.
There is a third option — a VC selling its illiquid, non-public equity stake to another VC through a peer-to-peer transaction. These transactions are called secondaries and might depend on approval from the startup’s board of directors based on the shareholders’ agreement. Additionally, there might not be sufficient buyer VCs willing to pay the price that the seller VCs want to execute the trade at.
Due to the long-term commitment VCs have to make, they typically spend a significant amount of time on due diligence to ensure that they bet on the right horse and once they do make the investment, they have a strong incentive to add as much value as possible. Not having a short-term exit option also keeps VCs accountable for their investment decisions — there is a big difference between the mentality of a VC that invests 10 years from now and a trader that makes a 1-year bet.
Founders & employees have the same options as VCs. Due to shareholders' agreement and other legal reasons, for them to sell their illiquid, non-public equity stakes is even more difficult. So they are fully incentivized for long-term exit-driven success and as the company performs better, they can justify paying themselves higher salaries.
Thus, the traditional early-stage investing industry participants, investors and founders, are incentivized to build a long-term viable business and don’t have any early exit opportunities.
VCs are not managing their own capital — they invest other people’s money in startups. VCs are merely an agent whose fiduciary duty is to look after the best investment opportunities for their clients, execute on those opportunities and return back the capital after 10 years.
The “other people” described above are called limited partners — they are wealthy individuals, sovereign wealth funds (Saudi, Norway, etc.), pension funds (Yale, BP), endowments/foundations (Gates Foundation) and other capital allocators. These institutions do not have the talent and expertise to form their internal team to directly invest in these deals so end up investing in VCs that specialize in a specific area and have a track record of past successful investments.
The typical agreement between the VC managers and limited partners is that the VC will not return the funds for a minimum of 10 years — in other words, the fund will have a life of 10 years. The VC spends the first 3–4 years making investments and the remaining years harvesting its returns.
The conclusion from the VC model is that VCs are not in a rush! Their mandate is to make long-term investments and they do not need to exit an investment in less than at least 5–6 years.
Why Have An Equity Entity? Why Not Just Have A Longer Token Vesting Period?
- Allocating the tokens to an equity entity enables token protocol-related governance decisions to be made unilaterally in addition to giving more control & legal power to the shareholders.
- If there is a potential acquirer for the protocol, it would be easier for them to acquire 40% of the tokens and the legal benefits of the equity entity rather than having to collect the tokens from the public or having to negotiate with each investor bilaterally.
What Are The Potential Problems With Equity Entity Owning A Large % of Tokens?
- SEC suggests a regulatory framework for digital tokens based on the level of decentralization of the token network. An equity entity owning 30–40% of the token network might not pass SEC’s minimum decentralization requirement.
- Another potential problem could be double taxation. Once the underlying business reaches maturity and decides to distribute tokens as dividends (payment-in-kind) or is acquired by another company — the investors might need to pay double taxes.
We propose that no tokens should be allocated to equity investors and team — tokens should rather be allocated to the equity entity. Those tokens held by the equity entity shouldn’t be unlocked and distributed to the shareholders until the business reaches a maturity pre-defined by certain business metrics. As the business metrics are reached, the shareholders should be allowed to partially or fully rewarded their pro-rata share of the tokens. This makes the equity entity more “acquirable” for potential acquirers.
Alternatively, the token vesting period should be extended to 10+ years with pre-defined exceptions of business KPI targets or a potential M&A.