Fundraising is one of the biggest challenges for Web3 founders, according to our data from talking to more than 200 founders of different Web3 projects in the last year. And structuring the fundraising process is not only challenging for founders but for investors too. How to calculate the valuation of the Web3 company? Which investment documents to sign and when? How do tokens impact the valuation and investment strategy? These questions arise both for founders and investors early in the fundraising process. We'll try to help you answer them with our series of guides about shaping the fundraising and exit strategy for any Web3 project.
In this piece, Part 1 of the series, we'll discuss the common challenges of Web3 fundraising and what categories we suggest using to classify Web3 projects from a fundraising standpoint based on the token's role in the project's structure.
The other three parts of this series include:
- How to legally structure fundraising in Web3 Part 2: Web2 solutions with utility NFTs (on-chain analytical solutions, NFT collectibles platforms, etc.)
- How to legally structure fundraising in Web3 Part 3: Centralized Web3 projects with ecosystem tokens (play-to-earn games, CEXs, crypto payment systems, staking/DeFi projects)
- How to legally structure fundraising in Web3 Part 4: Decentralized Web3 projects with protocol tokens (layer 1 blockchain networks, oracle/validator services, etc.)
🏴 NEW: If you're not sure where to begin with the legal tasks for your token distribution, check out our latest playbook: How to Build a Legal Strategy for a Token Project in 2024
Web2 vs. Web3: the differences in fundraising
Traditional Web2 startups began experimenting with approaches to determining their valuation, ways of signing venture deals, and exit strategies as far back as the 1970s. This early start helped them evolve and develop market standards for creating so-called fundable legal structures, i.e., companies in which venture funds will be ready to invest. Today, the market standard is that these companies must own IP rights to the product, centralize business profits and have a Cap Table that includes founders, investors, and optionees, who may get dividends distributed in the future and who will be able to make an exit by selling their shares.
But do these same structures work for Web3 startups? When the first Web3 startups began to attract the first venture investments 7-8 years ago, it became obvious that the existing market standards and legal structures in the Web2 industry needed to be revised for the Web3 industry. These new Web3 companies often have open-source intellectual property, decentralized treasury management, and protocol tokens instead of company shares. That means it's practically impossible to apply the same standards to Web3 startups, and they need different fundraising and exit strategy approach.
What challenges of structuring venture deals in Web3 founders and investors face?
The lack of market standards for Web3 venture deals and one's inability to apply Web2 standards to Web3 venture agreements caused questions for Web3 founders and investors, namely:
- What do investors receive for their investments: shares, tokens, or a combination of both?
- What is the calculation of the Web3 company's valuation tied to? Shares or tokens?
- How and when the founders and investors of the Web3 company will be able to make an exit?
- How are the shares and tokens of a Web3 company related to each other for investment purposes, and how is this reflected in a venture agreement?
If these questions aren't answered, they often become deal breakers in negotiations between investors and Web3 startups, as currently, there are no best practices in Web3 venture funding that both founders and investors can refer to.
Questions that investors ask Web3 startups' founders during fundraising
When the founders of a Web3 project decide to attract investments from venture capital funds, they must prepare themselves to answer investors' questions.
Here are 3 top questions that potential investors in a Web3 project would ask:
- What is the main goal of the founders? Is it developing a centralized business model to grow the company's profits and distribute them to shareholders, or is it developing a decentralized protocol to grow the number of applications built on it, increase the protocol's adoption, and, consequently, the value of the native protocol token?
- What will the capitalization of the Web3 project be tied to? Will it be linked to the shares of the company, which will give the right to dividends in it, or will it be linked to the tokens of the protocol, which will grow in price in the process of increasing its adoption?
- How to apply the multipliers to calculate the valuation of a Web3 startup? Should multipliers be applied to the growth metrics of the traditional startup's business model (ARR, GMV, etc.) or the growth metrics of protocol adoption and the value of its native token?
These questions are essential for venture capital funds as the answers to them allow investors to predict:
- How the valuation of the Web3 startup will grow, and what approach to use for its calculation
- At what moment will the liquidity event occur, and the venture fund will be able to make an exit: when the startup is sold, during the IPO, or when listing the protocol token on exchanges
- What investment return can a venture capital fund expect at an exit
With no answers to these questions, investors usually cannot decide whether to invest in a Web3 startup. That's why founders' uncertainty about either of the above points can be a deal breaker for a potential investment deal.
💡 Worth checking: Web3 investment rounds: angel, strategic, private & public token sale and their legal structuring.
Three main categories of Web3 startups and their fundraising and exit strategies features
As we already see, different approaches to using a token in the project's business model require different approaches to developing a fundraising and exit strategy for a Web3 startup. That's why we have prepared a series of guides that categorize Web3 startups depending on the role played by tokens in the startup structure to help Web3 founders avoid dealbreakers in the fundraising process. In these guides, we will cover more differences in the fundraising process for each Web3 startup category and offer options for fundraising and exit strategies.
The main criterion for categorization is the role of the token in the project, as well as the token's correlation with company shares during fundraising and exit. Based on this, we categorize Web3 startups as Web2 solutions with utility NFTs, Centralized Web3 projects with ecosystem tokens, and Decentralized Web3 projects with protocol tokens. See the detailed breakdown in the table below:
Instead of a conclusion
Summarizing Part 1 of our series of guides on fundraising in Web3, we can say that Web3 projects require different approaches in the fundraising process than Web2 startups. The main thing that founders of a Web3 project need to understand before fundraising is how their token will influence the business model of the project and what role it will play in the project’s future. To help with this, we suggest classifying Web3 projects into 3 categories: Web2 solutions with utility NFTs, Centralized Web3 projects with ecosystem tokens, and Decentralized Web3 projects with protocol tokens.
To learn more about the fundraising and exit strategies for each category, check out the next parts of this series that we will be releasing in the coming weeks:
- How to legally structure fundraising in Web3 Part 2: Web2 solutions with utility NFTs
- How to legally structure fundraising in Web3 Part 3: Centralized Web3 projects with ecosystem tokens (play-to-earn games, CEXs, crypto payment systems, staking/DeFi projects)
- How to legally structure fundraising in Web3 Part 4: Decentralized Web3 projects with protocol tokens (layer 1 blockchain networks, oracle/validator services, etc.)
Disclaimer: the information in this guide is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice. Mentioning any of the assets in this article is not an endorsement to purchase them.
Prepare your Web3 project for fundraising and structure it legally
Nestor is a Co-founder & Head of Web3 Legal at Legal Nodes. Having over eight years of legal consulting experience, Nestor loves working with innovative startups and Web3 projects, helping them navigate the regulations and scale on global markets.
