How to Legally Structure Fundraising in Web3 PART 3: Centralized Web3 Projects with Ecosystem Tokens

November 3, 2022
TABLE OF CONTENTS

How to Legally Structure Fundraising in Web3 PART 3: Centralized Web3 Projects with Ecosystem Tokens

November 3, 2022

This guide is Part 3 of our series on fundraising for Web3 founders and investors. This part will define centralized Web3 projects with ecosystem tokens. We'll explain what role tokens play in these startups' fundraising and exit strategy. We'll also cover how to approach valuation and the instruments for structuring the investment deal.

Check out other parts of this series here:

What are centralized Web3 projects with ecosystem tokens?

This type of startup includes companies that build complex ecosystems with their marketplaces, metaverses, DApps, and internal utility/payment fungible tokens i.e., ecosystem tokens. Tokens give access to these ecosystems and enable payments within them. Some examples of these projects include:

  • GameFi projects (play-to-earn games like Axie Infinity with their ecosystem token AXS).
  • SocialFi projects (for example, move-to-earn projects like Sweatcoin with their ecosystem token SWEAT).
  • Centralized crypto exchanges (for example, Binance with their ecosystem token BNB).
  • Crypto payment systems (for example, Crypto.com with their ecosystem token CRO)
  • Staking/DeFi/DEX projects (for example, SushiSwap with their ecosystem token SUSHI).
Categories of Web3 projects for fundraising
Categories of Web3 projects

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

  • Centralized business model: All profits flow to the accounts or crypto wallets of the company. The shareholders of that company centrally manage and distribute these profits.

  • Earnings are in the form of both fiat/cryptocurrency and the project's ecosystem token: Part of the earnings of centralized Web3 startups is generated in the form of the ecosystem token. Ecosystem participants can use the tokens to pay within the ecosystem or get access to specific products within the ecosystem using such tokens. Also, with tokens, they can receive discounts or special conditions for using the said ecosystem. This explains why the core token is usually issued as a fungible (interchangeable) token. At the same time, centralized Web3 projects with ecosystem tokens often issue NTFs as auxiliary tokens, which might be used as in-game characters/items/skins, special offers, or access tickets within the ecosystems (like in Web2 solutions with utility NFTs). Also, fiat and other cryptocurrencies remain an alternative way of payment within the project ecosystem.
  • Centralized on-chain elements of the project: This pertains to the utility tokens described above, like discount tokens, loyalty tokens, credit tokens, reputation tokens, internal payment tokens, and more. They are, in most cases, centrally issued (emitted) by the company that owns the ecosystem. The same company also decides on the maximum amount of tokens (token cap) and controls these tokens' additional emissions/burns and the demand/supply ratio. Examples of such tokens include:

    - BNB token (Binance ecosystem token)
    - AXS (token of the Axie Infinity play-to-earn games ecosystem),
    - GMT (token of the pay-to-earn STEPN ecosystem).

    We must emphasize that the main product of these projects (CEX, play-to-earn game, etc.) comes first. The tokens are used as an auxiliary tool to strengthen the main product and the primary business model. Also, ecosystem token helps to keep the liquidity inside of the ecosystem, making it more closed and, therefore, more stable in terms of growth. 

💡 Worth checking: Token types, their legal status, and choosing the best jurisdiction for token issuance.

Token's role in calculating the valuation of projects with ecosystem tokens

In most cases, founders of such projects are interested in the liquidity of their ecosystem tokens. Therefore, at a particular stage of development, tokens first appear on the internal marketplaces of these projects and as an option for in-app/in-DApp purchases. Later, they are listed on centralized and decentralized exchanges. 

The value of the token grows alongside the process of growth of users in the ecosystem. It also grows as the number of services increases in the ecosystem itself. The more use cases a token has within the ecosystem, the more value it can generate. For instance, adding new games in the play-to-earn ecosystem or financial products in a centralized exchange ecosystem.

After the tokens of the project become liquid and get a market price, the question arises for the founders: how to calculate the valuation of the startup? Should they tie it to project tokens or company shares? The answer to these questions boils down to who controls the emission of tokens. That's because the one who owns the token minting protocol can influence the token's value and token price in the future.

Approaches to fundraising strategy for centralized Web3 projects with ecosystem tokens

Because the company fully controls the token and its emission, we find ourselves in a centralized environment. As such, it may be too risky for investors to reduce the entire valuation of the startup solely to the total value of all issued tokens. Tokens are an asset, the supply of which can be manipulated by founders and thus influence its valuation. At the same time, calculating valuation based on the product’s market demand is a more traditional approach to determining the valuation. 

Therefore, we would like to note that the token plays an auxiliary role in evaluating such startups and their fundraising strategy. Namely, it significantly strengthens the valuation of the startup company's shares, as it is a powerful tool for motivating users to use the service more actively. It also allows for more user interaction within the community.

Valuation calculation, legal structuring of fundraising, and exit strategy for Centralised Web3 projects with ecosystem tokens

Since tokens play an auxiliary role in the fundraising process, investors mainly expect to receive BOTH company shares (long-term exit strategy) and tokens (short-term exit strategy). That's because the liquidity event for tokens occurs faster than for equity. In the early investment stages, SAFTE (Simple Agreement for future tokens and equity) is signed with investors.

At later investment stages, Token Sale clauses are included in the Shares Subscription Agreements under which shares are transferred. Investment contracts may also provide the possibility to "swap" shares into tokens in the future. It may be a separate type of liquidity event for investor shares.

Now, onto the calculation of the valuation for these startups. The formulas are applied primarily to the shares of the company since even the profit of the company, which will be generated in ecosystem utility/payment tokens, will be centrally aggregated on the accounts of the centralized company limited by shares and will capitalize its shares.

📚 Read more: Token warrant, SAFT or Token Sale Agreement: a guide to choosing a Web3 fundraising document. 

Fundraising strategy for Centralised Web3 projects with ecosystem tokens

Summarizing this guide, we can say that the fundraising process for Centralised Web3 projects with ecosystem tokens is quite different from Web2 solutions with utility NFTs. The main difference is that projects with ecosystem tokens provide more options for liquidity to investors. Investors are also interested in receiving project tokens along with the company shares.

At the same time, the project's valuation is mainly tied to the company shares. All the profits from token sales and product revenue are centrally aggregated on company accounts, much like with Web2 solutions with utility NFTs.

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 fundraising and exit strategies for Web2 solutions with utility NFTs or Decentralized Web3 projects with protocol tokens, check out the other 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.

{{fund-guide-1="/blog-temp"}}

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.

Subscribe to our monthly Web3 legal newsletter