How to Choose the Financing Method and Legal Documents for Web3.0 Blockchain Project Financing?
Choosing Financing and Legal Documents for Web3.0 Blockchain ProjectsAs the US Securities and Exchange Commission (SEC) becomes increasingly unfriendly towards cryptocurrencies, SAFE+Token Warrant/Token Side Letter is gradually replacing SAFT (Simple Agreement for Future Tokens) as the most common transaction mode and legal document in Web3 project financing.
Specifically, if a Token is used for fundraising purposes, it may not pass the Howey Test, the SEC’s standard for determining securities. To solve this problem, cryptocurrency venture capitalists and startups are increasingly favoring the combination of equity and Token in their financing methods. In theory, these Tokens are nominally granted and have no value.
This transaction mode is particularly suitable for early-stage projects that have not yet registered Token SPVs (Token Special Purpose Vehicles, responsible for the initial issuance and distribution of Tokens, usually registered in jurisdictions where Token issuance is allowed by law and clear rules for the sale and taxation of Tokens are provided) and have not yet established a complete Tokenomics (an economic model and theory based on blockchain and cryptocurrency technology to achieve economic incentives, value exchange, and community governance).
0 1 SAFE
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SAFE (Simple Agreement for Future Equity) is a contract and a financial instrument commonly used for startup financing, which is used for transactions between investors and startups. It allows investors to provide funds to the company in exchange for future equity. Unlike traditional equity financing, the SAFE agreement links the interests of investors and companies without immediately giving investors shares.
Traditional equity financing may involve complex equity structures and legal documents such as Share Purchase Agreements, Shareholders Agreements, Memorandum and Articles of Association, and require detailed legal due diligence at the early stage. This is costly in terms of both economic and time costs for startups and investors. SAFE provides a simple way for investors to support startups at an early stage and obtain future equity. It was introduced by the well-known startup incubator and venture capital firm YC (Y Combinator) in 2013 to simplify the financing process, reduce the complexity of legal documents, and improve the speed and efficiency of transactions, providing an easier, more flexible, and faster financing method for early-stage startups.
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Core Terms
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Investment Amount: The amount of funds agreed upon by the investor to be provided to the startup company.
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Conversion Event: An agreed-upon triggering condition that, when met, will result in the SAFE agreement being converted to equity in the company at a specified ratio. Common conversion events include the next round of financing, the company’s sale, or IPO.
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Conversion Ratio: The ratio that determines the proportion of the investment amount that can be converted into equity in future financing rounds.
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Optional Terms
(1) Valuation Cap
Valuation Cap is used to constrain the upper limit of the company’s valuation in future financing rounds. It provides investors with a protective mechanism to ensure that they can convert their equity at favorable terms in future fundraising rounds. Valuation Cap is a maximum valuation limit set to determine the price at which investors will receive equity in future financing rounds. When the company’s valuation in a future financing round is lower than or equal to the Valuation Cap, investors will convert their investment amount into equity at a predetermined ratio. This allows investors to enjoy more favorable terms for converting equity as the company’s valuation grows.
For example, suppose an investor invests a certain amount of money when signing a SAFE agreement and sets the Valuation Cap at $10 million. If the company raises funds in the future at a valuation of $50 million, the investor’s SAFE agreement will be associated with this valuation at the agreed-upon conversion ratio, thereby determining the number of shares into which the investment amount will be converted.
The main role of Valuation Cap is to protect the rights and interests of investors, especially when the company’s valuation grows rapidly. If the company’s valuation in future fundraising rounds exceeds the Valuation Cap, investors will convert their equity based on the Valuation Cap to ensure that they can obtain equity at a relatively low price and enjoy investment returns.
(2) Discount
Discount is used to determine the discount rate at which investors will convert their equity at a preferential price in future fundraising rounds. Discount is the preferential discount that investors enjoy when converting the SAFE agreement into equity. It is expressed as a discount rate, usually as a percentage. The discount rate generally ranges from 10% to 30%, with the specific value determined by negotiation between the two parties.
For example, suppose an investor invests a certain amount of money when signing a SAFE agreement and agrees to a 20% discount. When the company finances at a price of $10 per share in a future financing round, the investor can convert equity at a price of $8 per share according to the agreed discount. This means that the investor obtains equity at a lower price and enjoys a discount compared to investors who did not sign a discount agreement.
The main purpose of the discount is to reward early investors and reflect their risk-taking in the early stages of the company. Since early investors face higher risks and the valuation of the company is usually lower, giving them a discount on equity conversion is an incentive to attract more early investors.
(3) Most Favored Nation (MFN)
MFN (Most Favored Nation) aims to ensure that investors receive the same treatment as other investors in future financing rounds. The MFN clause protects the interests of investors and prevents them from being treated unfairly in subsequent financings. According to the MFN clause, if the company provides other investors with more favorable terms or conditions after signing the SAFE agreement, investors have the right to demand that these more favorable terms or conditions be applied to their SAFE agreement.
For example, suppose an investor signs a SAFE agreement with the company, agreeing on the investment amount, conversion ratio, and other terms. Later, the company conducts the next round of financing and provides more favorable terms to other investors, such as a lower share price or higher equity. If the SAFE agreement contains an MFN clause, investors can require that these more favorable terms be applied to their SAFE agreement under the terms of the MFN clause to receive the same treatment as other investors.
The existence of the MFN clause helps ensure equal treatment among investors and encourages the company to treat all investors consistently and fairly in subsequent financings. The purpose of this clause is to prevent investors from facing unfavorable conditions or dilution risks in subsequent financings, thereby protecting their interests and investment returns.
Valuation Cap, Discount, and MFN are not terms that must be included in all SAFE agreements. Their use depends on the specific design of the investment agreement and negotiations between investors and the company. Different investors may have different requirements for Valuation Cap and Discount, so when drafting SAFE agreements, both parties need to negotiate and clarify their respective interests and expectations.
In addition to the three common optional clauses mentioned above, additional clauses can be added based on specific circumstances, such as priority rights and information disclosure requirements.
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Advantages of SAFE
(1) Delayed pricing
The SAFE agreement delays equity pricing until future financing rounds, avoiding the difficulty of valuing the company in the early stages. When signing the SAFE agreement, investors do not directly acquire shares, but rather associate the investment amount with the valuation cap of the future financing round. This delayed pricing feature allows both parties to more accurately determine the value of the company.
(2) Simple and efficient
Compared to traditional equity financing forms, the file structure of the SAFE agreement is relatively simple, reducing the complexity and time cost of the transaction. This enables start-ups and investors to reach a transaction more quickly and efficiently.
(3) Investor protection
The SAFE agreement usually includes some clauses that protect the interests of investors. For example, the valuation cap can ensure that investors can obtain the corresponding equity ratio when the company’s future valuation exceeds a certain level. Additional clauses may also involve priority rights, information disclosure requirements, etc. to protect the rights of investors.
(4) Flexibility
The SAFE agreement is relatively flexible, allowing both parties to negotiate and adjust investment amounts, conversion conditions, and additional clauses to meet specific investment needs and conditions.
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Matters to be aware of when drafting and reviewing SAFE
(1) Determine the conversion event
Clearly define the conversion events in the SAFE agreement, such as the next round of financing, company sale, or listing, etc. Conversion events should be specific, quantifiable, and easily verifiable, such as financing amount, valuation reaching a specific level, or a specific date, etc. This can avoid ambiguity and disputes, and ensure that investors can convert to equity under specific conditions.
(2) Determine the conversion ratio
Agree on the ratio of investment amount to equity that can be converted in future financing rounds. This ratio should be negotiated based on the company’s needs, investor expectations, and risks. A higher conversion ratio may have an impact on the equity structure of start-up companies, so it needs to be carefully considered.
(3) Understand the Investor Protection Terms
SAFE agreements typically contain terms that protect the interests of investors. These terms may involve valuation protection, priority rights, information disclosure requirements, trigger events, and more. Make sure to clearly understand and evaluate the impact of these terms on the allocation of rights between the company and investors.
(4) Evaluate the Impact of the Financing Structure on Equity
When using SAFE agreements for financing, it is important to carefully evaluate the impact of the financing structure on the company’s equity. High conversion ratios and valuation caps may have a significant impact on the company’s equity structure, particularly in subsequent rounds of financing that may lead to dilution of investors. Therefore, it is necessary to consider future development, equity distribution, and investor expectations in order to determine the most appropriate financing structure.
0, 2 Token Warrant / Token Side Letter
As SAFE agreements mainly involve equity investment and future equity conversion, they only deal with equity-related legal arrangements. Therefore, if investors wish to acquire rights related to token subscriptions, both parties need to arrange matters related to token subscriptions, often requiring the signing of Token Warrants or Token Side Letters.
Firstly, certain projects or specific token issuances may require additional terms and conditions to meet specific needs and agreements. Token Warrants or Token Side Letters can provide more specific and customized terms to meet project needs and investor requirements.
Secondly, the risk factors and regulatory requirements involved in token issuance may be different from those of traditional equity investment. Token Warrants or Token Side Letters may contain specific risk disclosures and legal terms related to token issuance to ensure that investors have a clear understanding of the risks and comply with relevant regulatory requirements.
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What is a Token Warrant?
Token Warrants are documents frequently used by Web3 projects to attract early investors. They grant investors the right to purchase a portion of the tokens during the initial token sale and fix the price of the tokens.
(1) Core Terms of Token Warrants
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Token allocation: how many tokens are reserved for investors.
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Token generation event: a deadline can be specified for greater flexibility.
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Token purchase rights: investors have the right to purchase tokens up to a certain limit. Token purchase rights are the right to purchase tokens in the future. To determine the best way to construct it, it is necessary to evaluate the preparation of the project’s tokenomics. If the project’s tokenomics have not been determined, you can negotiate a discount rate for investors to purchase tokens. Then, based on the investor’s equity percentage, calculate the number of tokens they can purchase at the discounted price.
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Purchase price: the fixed price at which investors will purchase the tokens.
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Token transfer: various restrictions on token transfer, such as a lock-up period.
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Exercise terms and rights: First, the project team should notify investors of the exact date of the token generation event in advance. Secondly, investors are given a specific deadline during which they may exercise their right to purchase tokens.
(2) Characteristics of Token Warrant
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It legalizes the right rather than obligation of investors, who can freely choose whether to purchase Token.
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Token Warrant is not used for automatic (unconditional) issuance, and if an investor decides to exercise their Token purchase right, they must pay additional consideration for Token.
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The future price at which investors will purchase Token is determined by Token Warrant. Therefore, investors are in a better position when purchasing Token than buyers during the initial Token sale period, as the actual price of Token is usually much higher when the Token generation event occurs.
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What is a Token Side Letter?
Token Side Letter is a document that represents the right (rather than obligation) to receive or purchase future Token, and is signed together with convertible equity investment documents such as SAFE.
(1) Characteristics of Token Side Letter
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No specific date is specified for conversion to Token.
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The price of Token is not fixed.
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The purpose of Token is not defined.
(2) Advantages of Token Side Letter
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Token Side Letter protects project development companies from any risks related to regulatory uncertainty regarding specific Token status in various jurisdictions by stipulating that future Token issuance will be carried out by an independent Token SPV.
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Token Side Letter allows founders to avoid making specific commitments to their Token in the early stages of development. It allows them to experiment with Tokenomics flexibly while providing investors with a guarantee of Token in the future.
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What are the applicable scenarios for Token Warrant/Token Side Letter?
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Investors are interested in both Token and stocks and need a supplemental document to ensure their rights to Token. The primary document for investment transactions is convertible equity instruments such as SAFE.
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Token has not yet been issued, and in most cases, Tokenomics has not been determined.
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The project team has only registered one product development company. Therefore, Token Warrant/Token Side Letter is signed by this product development company rather than a Token SPV.
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What are the commonalities between Token Warrant and Token Side Letter?
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There are common signatories, i.e. the project development company.
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It is a supplement to convertible equity investment documents, such as SAFE or Convertible Note.
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The same formula is used to calculate the tokens that investors can receive.
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What is the difference between Token Warrant and Token Side Letter?
First, the distribution of tokens is different. For Token Side Letter, the project development company that signs it is also responsible for distributing the tokens. To do this, it first receives the tokens it needs to distribute from Token SPV. It then transfers them to the investors holding Token Side Letter, as well as other key contributors to the project ecosystem, such as developers, consultants, etc. who hold Token options and have signed contracts or are employed by the project development company. For Token Warrant, Token SPV will be responsible for the sale of tokens. When Token SPV is established or Token generation event happens, the project development company distributes the tokens to Token SPV. Then, Token SPV sells the tokens to investors at the fixed price already specified in Token Warrant.
Second, Token Side Letter does not require any additional token payment details: the consideration is included in the price of the convertible equity agreement. On the other hand, Token Warrant often requires an agreed-upon transaction price to take effect. Therefore, in some cases, Token Side Letter appears more attractive to investors than Token Warrant, as it does not involve any extra payment.
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How to choose between Token Warrant and Token Side Letter?
When a Web3 project chooses the appropriate financing document for itself before the seed round, it is important to consider any regulatory restrictions that local regulators may impose on Token transactions of the project development company. If they are stricter or there is a high risk of regulatory uncertainty (such as in the United States), it is better to use Token Warrant.
Because, in the case of Token Warrant, its signatories are not responsible for the conversion event. Therefore, the project development company does not participate in the sale of tokens, it only confirms that qualified investors can buy tokens at a discount or reservation price. The project development company authorizes the distribution of tokens to Token SPV when it is created or before the Token generation event. Then, investors buy tokens directly from Token SPV, which is the actual issuer and is authorized to sell tokens according to regulatory permissions. This helps the project development company avoid participation in the process of selling and distributing tokens. An independent Token SPV can handle these processes, thus making the project development company immune to any impact of participating in the token distribution process. All in all, Token Warrant is more suitable for project development companies registered in the United States. As for project development companies registered outside of the United States, their choices are more flexible.
SAFE + Token Warrant / Token Side Letter transaction combines the advantages of traditional venture capital tools and blockchain technology. It simplifies the investment process, reduces the complexity and cost of transactions, and provides more flexibility and choice for investors and startups. However, it should be noted that the specific terms and conditions of this transaction structure may vary depending on the specific circumstances of the project and the transaction. Before engaging in any investment activity or signing related documents, it is recommended to consult a professional legal advisor for specific legal advice and protection.
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