"Blockchain-Compliant Legal Docs" or How to Avoid Mistakes When Preparing Documents for Web3 Startups
"Blockchain-Compliant Legal Docs" or How to Avoid Mistakes When Preparing Documents for Web3 Startups
Preparing documents for Web3 startups goes beyond legal compliance and requires the consideration of rules specific to the blockchain network.
This article explores the main differences between Web2 and Web3 contracts. It also provides a checklist of important factors to consider when preparing a document for a Web3 project. By addressing these factors early on, Web3 founders can prevent potential problems that may affect the project in the future.
Please note, everything contained in this article is for informational purposes only and is not to be considered as legal advice or legal opinion.
This article is brought to you by the Legal Nodes team. Legal Nodes is a legal platform that helps global businesses and Web3 projects create global legal structures and stay compliant with regulations as their businesses grow. We’ve helped many Web3 projects create compliant legal agreements. Speak to us to get started.
3 essential elements for writing a good contract
What is considered as a well-prepared legal contract? Generally, it's a contract that serves the following three criteria:
- It meets the business needs of the parties. The type of contract should match the type of relationship it regulates, for instance: relationships involving the execution of work and their payment are formalized by a contract of employment.
- It covers all applicable regulatory requirements. The type of contract should include mandatory features of a contract (offer, acceptance, consideration), and be concluded in the appropriate form (for example, written), as without these, the contract might be declared invalid.
- It incorporates relevant judicial practices. Judicial precedents help to detail parts of the contract not regulated by law. For example: the law may not detail the process of transferring IP rights from a contractor to a client, however, there are court cases that describe how this process occurs in practice and, accordingly, how to best reflect this in the contract.
Traditionally, these three criteria are essential elements of a good legal contract. However, with the advent of Web3 businesses, it’s important to assess whether we can consider these criteria as equally valid for both Web2 and Web3 projects.
Web2 contracts vs Web3 contracts
We can confidently say that the checklist above is valid for traditional ("off-chain") contracts that:
- Have a textual expression; fixed in a Word file or on paper.
- Regulate relationships with off-chain assets; assets like physical goods, real estate, and money in bank accounts. These assets are centrally controlled and can be frozen or seized when a law has been violated.
- Have a predetermined place and body for dispute resolution. Should disputes between the parties arise, for example, when one party fails to fulfill its contractual obligations, the issue will be resolved by a predetermined organization or individual, like, for example, a court of law.
However, when it comes to Web3 projects, this issue requires more detailed analysis. Let’s start by considering the following features of the Web3 sphere:
- Smart contract relationships. Relationships between parties in the Web3 sphere are formalized in the form of smart contracts, not in a Word file or a paper document.
- On-chain assets. The smart contracts regulate relationships with on-chain assets such as tokens and cryptocurrencies, which are often stored in a Web3 protocol in a permissionless and ownerless form.
- Autonomous rule implementation. The fulfillment of obligations by the parties in Web3 relationships does not require the involvement of third parties (e.g., courts, police, etc.), as the rules for the relationship are provided in autonomous smart contracts, and it is these smart contracts that execute the rules autonomously.
So, what should a legal agreement for a Web3 project look like in order to satisfy both the off-chain and on-chain requirements?
The future of legal agreements in the Web3 industry
Before we proceed to answer the question posed above, it's important to consider things from a long-term perspective.
Today, the Web3 industry is in a transitional phase where on-chain protocols still require off-chain attributes. This means they need legal wrappers and off-chain entities, written/paper contracts, fiat interaction, and legal structures that act as bridges between the on-chain and off-chain world. This necessity exists because the Web3 industry is still in the process of acquiring a critical mass of liquidity, which is required for it to operate fully autonomously and independently. You can read more about this in our 2-part series, starting with our article On-chain Law Series Part 1: Why Blockchain Networks are New Legal Systems.
Once the Web3 industry has amassed this critical liquidity, there likely will no longer be a need for paper contracts and state entity registrations (which, by their very nature, are legal fiction). Instead, all agreements will be deployed directly into blockchain networks (like Ethereum, Cosmos, NEAR) in the form of smart contracts. In the near future, these smart contracts will be written not by lawyers, but by AI agents, using input data (prompts) obtained from the contract parties. We’ll delve further into this subject of AI/blockchain singularity in a future article.
Until we reach the point of technological singularity in the legal sphere, the Web3 industry will still require traditional (off-chain / textual) legal documents.
Preparing contracts for Web3 projects
Today, it is generally accepted that legal documents (and legal structures as a whole) for Web3 projects should primarily comply with the laws and judicial practice of the countries in which these projects operate.
However, considering that virtually every Web3 project ultimately aims for full decentralization and transformation into a DAO, the following question arises: “Will it be possible in the future to 'decentralize' the legal structures and documents that were created by lawyers without considering the possibility of 'transforming' the documents into on-chain protocols / smart contracts?”
In other words: “How do we prepare a legal document for Web3 that, on the one hand, meets legal requirements, and on the other hand, can be scaled on-chain at later project stages?”
This question is critical, and any Web3 project that ignores or overlooks it may face problems in the future.
Common mistakes in documents for Web3 projects
Any web3 project founders (or their lawyers), who ignore the question outlined above, risk encountering the following problems (often called ‘collisions’) with their legal documents in the future:
- At the early stage of a Web3 project's fundraising, the token warrant stipulates that a company (often a DevLab) sets the lockup and vesting of investor tokens. However, in practice these processes are structured at the level of permissionless smart contracts and can only be changed in the future by the decision of blockchain network validators or DAOs.
- During the preparation of a SAFT (simple agreement for future tokens), it is stipulated that the company has ownership rights to pre-minted tokens. However, according to the rules of the blockchain network where tokens are minted, the tokens appear in the pool of validators / liquidity pool and are distributed decentrally according to the rules laid down in the protocol at the time of its deployment.
- When registering a private foundation for launching a blockchain protocol, Web3 projects may encounter problems if the private foundation’s charter didn’t take into account the possibility of on-chain voting by DAO members for changes to the protocol in the future.
For a contract to be ‘good’ for a Web3 project, it’s not enough for that contract to simply comply with traditional laws. Instead, it must also take into account the rules of the blockchain network or, in other words, the provisions of “on-chain” law, within which the Web3 project is launched. Otherwise, there is a risk of collision between “on-chain” and “off-chain” law, which may lead to the aforementioned problems of scaling and decentralization of the Web3 startup.
The concept of "blockchain compliance" for legal documents for Web3 projects
In the context of the examples set out above, it is logical to conclude that both legal entity registrations and document preparation for Web3 projects must be synchronized with the rules of the blockchain network where the Web3 project is launched. For legal entity registrations, this will enable the voting rules in the legal entity, written in its charter, to be transferred to on-chain processes when a DAO is launched. This also means that any rules for the distribution/transfer of tokens stipulated in the contracts would be synchronized with the rules of operation of smart contracts, which will control token allocations, lockups, and vestings.
This can be compartmentalized into a separate compliance matter, namely “blockchain compliance”. The conformity of the legal structure to the rules of the blockchain network is no less important for Web3 projects than regulatory compliance (the conformity of the legal structure to legislative requirements). The essence of this new type of compliance can be identified as: “Each Web3 contract, in addition to legislatively defined requirements, must contain a description of the on-chain rules (provisions) that will be incorporated into smart contracts in the future.”
On-chain provisions in Web3 contracts
As mentioned earlier, the execution of contracts in Web3 partially or entirely takes place on-chain, as it involves on-chain assets (tokens, cryptocurrency), and is also programmed in permissionless smart contracts, which autonomously execute such Web3 contracts according to predefined rules.
As for dispute resolution that might arise concerning Web3 contracts, these disputes are resolved either by oracles or decentralized arbitration / DAOs. For example, if the dispute pertains to whether an off-chain event occurred that should have triggered the autonomous execution of operations with virtual assets by a smart contract, then an oracle may be used to resolve the issue. If the issue relates to an early release of lockups from investor tokens in cases where the crypto market conditions have significantly changed, then some form of decentralized arbitration or DAO involvement can resolve the matter.
In each of the above-described scenarios, the processes will start operating in an entirely decentralized manner in the future, through decentralized on-chain voting of the DAO, and/or through on-chain actions of decentralized oracles/validators of the blockchain network. This in turn does not require any off-chain intermediaries such as courts or police in the case of Web2 contracts, but in the early stages of a Web3 project, these should be correctly described in traditional legal documents.
How to prepare a 'blockchain-compliant' legal document
To prepare a ‘blockchain-compliant’ legal document, the following steps must be executed:
- Analyze the rules of the blockchain network (Ethereum, Cosmos, NEAR) in which tokens will be issued, and where the issuance of the tokens will initially be regulated by legal (off-chain) documents (e.g., token warrant/SAFT).
- Analyze the role of validators/oracles of the blockchain network that play in the process of deploying the protocol, initial minting, and distribution of tokens. Consider how they affect ownership of pre-minted tokens and the initial distribution of the tokens, and which token incentives they expect in exchange for supporting the protocol in the blockchain network.
- Design the possibility of ‘decentralizing’ the ownership and governance of tokens in the protocol in the future through the launch of a DAO and the transfer of powers to the DAO for making various decisions.
- Reflect the details mentioned above in the legal documents for Web3 projects (token warrants, SAFTs, DAO Constitution, etc.), to reduce the risks of discrepancies between investors' expectations regarding token issuance and ownership, and how this is structured in the blockchain network where the tokens are issued.
Build blockchain-compliant documents
Just as lawyers today specialize in the law of individual jurisdictions (for example, English law or Swiss law), to work with Web3 projects, lawyers also need to understand the rules of blockchain networks to be able to properly account for these rules when preparing contracts for Web3 projects. Only then will lawyers be able to create blockchain-compliant legal documents. That's why at Legal Nodes, we started to develop open-source legal documents for Web3 projects, which take into account not only regulatory requirements but also the rules of individual blockchain networks. Consequently, these documents are blockchain-compliant.
Although all the documents published by the Legal Nodes team are blockchain-agnostic, we have embedded provisions in the design of these documents that take into account the participation of blockchain network validators and foresee the involvement of DAOs in the future. To learn more about how blockchain-compliant legal documents work, and how to customize a Web3 document template according to the rules of the blockchain network where tokens are issued, please fill out a form on our website and we'll be in touch.
Disclaimer: the information in this article is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice. Any mention of any of assets or third party services or products in this article is not an endorsement to purchase them.