What is Tokenomics and How It Impacts the Legal Structure of a Web3 Startup

June 7, 2022
TABLE OF CONTENTS

What is Tokenomics and How It Impacts the Legal Structure of a Web3 Startup

June 7, 2022

Tokenomics covers all aspects of a token's creation, management, and even removal from a network. Understanding tokenomics and how it impacts the legal structure of a startup is vital. Without a good understanding of the supply and demand characteristics of the cryptocurrency a startup is using, web3 projects may hit barriers that prevent success.

What is tokenomics?

The tokenomics of a Web3 project is essentially the combination of token demand and token supply, which allows Web3 projects to:

  1. achieve high token liquidity i.e. to use the token in the project’s ecosystem or exchange it for other virtual assets;
  2. grow demand for the token among users of the ecosystem where the token was launched; and
  3. avoid token inflation (depreciation).

How to design tokenomics: demand & supply

In most tokenomic models Token Use Cases are responsible for the token’s demand. These use cases outline all the different ways that tokenholders can use the token in a Web3 project, including the value they get that motivates them to actively earn or buy tokens. 

As for the token supply, Web3 founders handle it via the Token Cap Table, which summarizes the total number of tokens that will be issued and details the structure of their distribution among the market players.

Picking the right combination of demand and supply is going to allow the founders to kick-start a network effect for the use of their token in the Web3 industry. It also secures a stable growth of the token’s value for the ecosystem, which will in turn affect the price and liquidity increase.

Creating token liquidity

You can achieve the token liquidity by:

  1. giving your token utilities that allow the tokenholders to get added value from using your Web3 product. In other words, your token use cases should maximize the repetition of the token use; and
  2. listing tokens on virtual asset platforms (cryptocurrency exchanges and wallets with a token swap function) where tokenholders are able to buy and sell their tokens, depending on how many tokens they need to use your Web3 project.

From a legal perspective, the preparation of a Token Legal Opinion covers the mechanisms that create token liquidity. Token Legal Opinion specifies the legal qualifications of the token's functions and the token's legal status. You'll also need this document to list the token on exchange platforms, as most cryptocurrency exchanges and wallets request it.

Read more: Token Types, Their Legal Status and Choosing the Best Jurisdiction for Token Issuance. 

Growing the token price: organic or artificial

The token price can be increased by growing its demand. There are a few ways to do it. The most legally compliant way to do it is via organic token price growth. You can achieve it by developing your Web3 project, increasing its functional value to the tokenholders, and, subsequently, the value of the token that grants access to this functionality or other benefits of your project.

It's best for founders and the project to avoid any artificial token price growth. This includes manipulations on cryptocurrency exchanges or promises of investment income for purchases. In most countries, this could qualify as a violation of securities and capital market laws, which may result in financial or even criminal liability. To prevent any such incident from occurring, each marketing campaign promoting the token has to be subject to a preliminary legal analysis.

Risks of token inflation (depreciation)

To avoid the depreciation of the virtual asset, its supply has to be assured by an appropriate demand. Preparing the Token Cap Table becomes an important task on the founder's to-do list, long before any tokens are introduced to the project. The Token Cap Table has to meticulously explain the token supply, in particular, the total emission of tokens and how the supply will be distributed.

To avoid the oversaturation of the market with tokens, their distribution is often planned in stages. This includes the stages of a private token sale, a public token sale, and token vesting via Token Incentive Schemes. Sometimes, after the tokenholders come into possession of tokens, a lock-up, the prohibition to dispose of them for a defined period, is imposed on the assets.

At this stage, important legal work is undertaken, mostly to correctly identify the distribution stages, the token pricing at each stage, and any vesting and lock-up rules, etc. Founders should give special attention to the rules of additional emission or the burn of tokens, aimed at balancing the demand and supply.

Read more: Models of token distribution and how to legally structure them.

Conclusions

Tokenomics of a Web3 project should entail a well-defined balance between token demand and supply. It is designed to make the founders and investors of the project not only sure of stable token growth but also to act as a powerful stimulus for end-users of the Web3 project to actively participate in it. In other words, it has to serve as motivation to actively buy tokens and spend time on the project.

All of these reasons mean that a correctly-prepared Token Cap Table and well-thought-out token use cases are a cornerstone of any Web3 project’s successful development and are vital to sparking strong interest from venture capitalists. 

If you need help with the legal side of your Web3 project, book a Legal Discovery Session, where a Legal Nodes expert will help you clarify your legal needs, share the best practices for your case, and create a Legal Roadmap. After creating a roadmap, Legal Nodes can assign you a Virtual Legal Officer who will manage your legal tasks like obtaining a Token Legal Opinion or registering a token issuer company. 

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.

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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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