How to Legally Structure Fundraising in Web3 Part 4: Decentralized Web3 Projects with Protocol Tokens

November 10, 2022
TABLE OF CONTENTS

How to Legally Structure Fundraising in Web3 Part 4: Decentralized Web3 Projects with Protocol Tokens

November 10, 2022

This guide is Part 4 of the series on fundraising for Web3 founders and investors. Check the rest of the series here: 

What are decentralized Web3 projects with protocol projects?

This type of startup includes companies whose goal is to build a decentralized protocol for exchanging data, liquidity, or other values ​​(on-chain digital goods), which users can currently exchange only with centralized companies (cloud services, hosting providers, financial institutions, etc.). Among these startups, the following categories can be identified: large layer 1 blockchain protocols (Ethereum, NEAR, Solana), DeFi protocols (SushiSwap, Uniswap), and ecosystem NFT marketplaces (OpenSea).

Categories of Web3 projects

Among the features of this category of startups, the following can be distinguished:

  1. The presence of a native token that is necessary for the protocol's operation. Decentralized protocols of these startups have their native tokens, which are necessary for building decentralized applications (DApps) using such protocols. For example, this native token can be used to pay for the "gas" required for the operation of the protocol or the commission of validators/oracles, who ensure the operation of the protocol and confirm transactions in it.
  2. Decentralized earning of the protocol in its native token. All commissions earned by the protocol are structured in the native token of the protocol and are NOT distributed among the founders in the form of dividends. Instead, commissions are sent to the treasury of the DAO, which is the decentralized owner and manager of the treasuries and also the owner of the protocol. Further use of such protocol earnings includes validators’ rewards, community grants, etc.
  3. The absence of off-chain elements in the project. The operation of decentralized protocols usually does not involve any off-chain elements (fiat payment options, working on centralized servers, etc.), and the protocols are open-source, completely decentralized, autonomous, and permissionless.

The token's role in calculating the valuation of projects with protocol tokens

The investment attractiveness of protocol Web3 startups lies in the fact that the more data/liquidity/other assets their protocol processes, then the more new services (decentralized applications) are built based on this protocol, and finally, the greater the adoption of this protocol in the market. Ultimately, the greater the protocol adoption, the greater the demand for its native token, which is necessary for building decentralized applications based on such a protocol. And when the demand for a native token grows, its price increases too. Therefore, Web3 venture funds analyze these protocol growth metrics to determine the growth multipliers of a Web3 startup and to calculate its valuation.

The liquidity event of Web3 startups with protocol tokens occurs when the native token of the protocol starts to be traded on crypto exchanges. At this moment, investors and founders can cash out their tokens (if vesting/lockups of their tokens at the time of the listing have already unlocked them).

The process of issuing and distributing protocol tokens and the formation of their value

It is important to note that the initial issuance and distribution of protocol tokens is centralized. It is organized and controlled by the founders of the Token Issuance & Distribution company in accordance with the Token Cap Table and Token Distribution Plan. However, once this initial issuance and distribution are complete, the Token Company transfers the token minting/burning protocol and undistributed tokens to the ownership and management of the DAO (Foundation). After that, the DAO will organize any future additional distributions, emissions, or burnings of tokens following the results of the decentralized voting.

In the end, this allows for achieving a model in which the project's main beneficiaries are token holders who are members of the DAO. DAO members are motivated to support the protocol ecosystem and vote only for those decisions that will have the best impact on the further growth and development of the protocol and the ecosystem around it, as the value of the native token of the protocol, which they own, will depend on this.

Thus, correctly constructing protocol tokenomics and a decentralized management model of such a protocol and its treasury (DAO model) allows Web entrepreneurs to build a closed and self-sufficient system based on the principles of mutual alignment of all participants and ensure its stable growth. This growth and its rate, in turn, is a determining factor for calculating the multiplier that investors will use to calculate the valuation of a project with protocol tokens BEFORE the tokens become liquid. This is because, after the token liquidity event, the valuation of the startup will be determined by the aggregate value of all liquid tokens on the market, and the valuation will likely appear on cryptocurrency market capitalization trackers as Coin Market Cap.

The ratio of tokens and shares and the legal structuring of pre-seed/seed rounds

It is also important to note the role of shares for decentralized projects with protocol tokens. UNTIL the launch (deployment) of the protocol in the mainnet, as well as before pre-minting tokens for their further distribution, the shares of the company developing the protocol play the role of a control tool for early investors rather than a capitalization instrument. At this stage, early investors can control the process of developing the protocol, its intellectual property, and the process of further issuance and distribution of the protocol's native token through ownership of shares of the developer company and a seat on the board of directors.

At the same time, early investors know that the main capitalization asset of the protocol will be its native token. Along with the shares of the protocol development company that they receive from SAFE (Simple Agreement for Future Equity) or SPA (Shares Purchase Agreement), such investors often ask to sign a Token Warrant Side Letter, which they expect will reserve a portion of the tokens for them if the tokens are issued in the future. Thus, the combination of SAFE + Token Warrant Side Letter is one of the most popular forms of structuring early-stage investments (pre-seed/seed) of Web3 startups.

SAFT and legal structuring of late seed/round A for decentralized projects with protocol tokens

After the project team has developed tokenomics and launched the MVP of the protocol in the testnet, they move to the next round of investments (late seed/round A), the purpose of which is to: 

  • attract investments for testing the MVP of the protocol;
  • deploy the protocol in the mainnet; and
  • launch a token for community building around the protocol.

The most popular legal document for this stage is the SAFT (Simple Agreement for Future Tokens), which is usually signed by the newly created Token Issuance & Distribution company. At the same time, Token Warrant Side Letters of early investors can be converted into SAFTs with more details on the conditions of token issuance for this category of investors.

The conversion event of the SAFT is the moment of deployment of the protocol in the mainnet and pre-minting of the native tokens of the protocol, after which such tokens can be distributed among founders, advisors, investors, the community, and the DAO Treasury in accordance with the Token Cap Table. Also, immediately after the pre-minting of protocol tokens, the team starts working on its listing on crypto exchanges and wallets, which will be the liquidity event for the investors and the team. Another type of liquidity event might be a Token Generation Event (TGE) according to which the token minting and token distribution will be done simultaneously according to the register with token pre-orders (Token Wait List).

Public distribution of protocol tokens and the launch of a DAO

After the protocol has been launched in the mainnet, and the native token of the protocol has become liquid, the project team begins to work on building a community around the protocol. The goal is to attract as many enthusiasts as possible who will be ready to support the protocol as validators and build decentralized applications on the protocol. For this, the team organizes a public distribution of tokens, which can be paid (for example, IDO, LBP, and launchpads) and/or free (including airdrops, and token bounty programs).

After building the primary community of token holders, the founders organize this community in the DAO by implementing a decentralized governance model and creating an on-chain treasury that the DAO will manage. The part of tokens that remained undistributed as a result of the initial distribution of tokens is transferred by the Token Company to the on-chain DAO treasury, after which the DAO makes all decisions regarding further actions with the undistributed tokens (usually, issuing token grants for ecosystem builders like founders of DApps, new validators/oracles, etc).

At this point, the project starts working as a fully decentralized autonomous organization, and the valuation of the project is equal to the value of all native tokens of this protocol. Early investors' interest in the shares of the company developing the protocol will probably be lost at this stage, as this company will become one of the dev shops that technologically supports the open-source protocol and builds new decentralized applications using it.

Fundraising strategy for decentralized Web3 projects with protocol tokens

Whether you're looking to attract investments or make a decision to invest in a Web3 project, we recommend the following action plan:

  1. Understand what role the token plays in the project;
  2. Categorize the Web3 project depending on the role of its native token;
  3. Decide on a fundraising strategy (rounds and milestones that must be achieved);
  4. Select an exit strategy. Will the main asset of the company's capitalization be shares or tokens? At what moment will the liquidity event of each of these assets occur?;
  5. Choose the most appropriate legal documents to structure the fundraising.

To learn more about the fundraising and exit strategies for Web2 solutions with utility NFTs or centralized Web3 projects with ecosystem projects, check out the previous parts of this series:

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.

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Nestor is a Co-founder & Head of Web3 Legal at Legal Nodes. Having over seven years of legal consulting experience, Nestor loves working with innovative startups and Web3 projects, helping them navigate the regulations and scale on global markets.

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