Many Web3 projects plan to attract venture capital to fuel their growth and there is now an increasing number of Web3 funds within the venture industry. As a result, the number of Web3 venture agreements is multiplying.
Each Web3 fund has its own internal Web3 startup selection process, which includes due diligence such as checking legal documents, doing background checks, and doing financial data checks, for example, before making an investment decision. Also, most Web3 funds have their standard investment conditions, for example, some are only interested in Web3 project tokens, while others invest in both tokens and Web3 startup shares.
This guide aims to give Web3 founders a complete overview of all the activities they should undertake or consider if they plan to attract VC investment into their project.
Legal Due Diligence of a Web3 startup
A Web3 startup needs to prepare several legal documents and materials for its project to negotiate with venture capital firms (VCs) successfully. Having all the critical docs in place will help quickly conclude an investment agreement through the negotiation and verification process (Due Diligence).
The process of legal Due Diligence of a Web3 startup by VC usually includes:
- analysis of token documentation;
- analysis of authorisations/licenses to be obtained by the company that will issue such tokens; and
- analysis of statutory documents and intellectual property of the token issuer company (if they plan to invest in tokens AND company shares).
📚 Read more: Investor Due Diligence Checklist for Web3 Founders
Token Capitalisation Table Analysis
Before making an investment decision, the Web3 fund needs to clarify the following:
- how many tokens does the project plan to issue, and what will be their value;
- how do founders plan to distribute tokens within the pools and how many tokens an investor can receive for their investment;
- how many tokens do founders allocate to themselves, and whether they have developed a motivation system for employees (such as a token incentive scheme).
The Token Cap Table of the project needs to include all the points described above. The first two points are essential for the analysis of the project tokenomics, as only a successfully operating tokenomics strategy will ensure stable growth of demand for tokens and, consequently, provide the investor with a return on investment (ROI).
The third point gives the investor an understanding of whether the members of the Web3 startup team have sufficient motivation (whether the Token Incentive Scheme is well designed) and whether the number of tokens reserved for founders will not create conditions for market manipulation by the latter.
📝 Free template: How to Prepare Token Cap Table With a Free Template
Obtaining a Token Legal Opinion
After analyzing the Token Cap Table, investors proceed to examine the token legal status. For this purpose, they usually ask the founders to send the Token Legal Opinion, which contains the legal qualification of the token prepared by a qualified lawyer.
Investors want to be sure that the legal status of the token and the legal consequences associated with it will not be an obstacle to the token's liquidity in the future. For example, crypto exchanges can delist a token due to the features of financial instruments that the token may have. Also, investors want to have guarantees that the regulators will not ban the token. Therefore, Token Legal Opinion is a legal guarantee for the investor to a certain extent.
Regulatory compliance of a Token Issuer Company
When a fund invests money in a startup, it expects the team to hire new people, launch new marketing campaigns, and do other things for the project's growth. None of the investors wants their money to be spent on fines. Also, none of the investors would like their investments to be associated with money laundering or other violations of financial legislation.
To avoid these risks, investors clarify three points:
- how the team chose the crypto-friendly jurisdiction for the Token Issuer Company (also called Token SPV);
- whether the Token Issuer Company has fulfilled all the requirements of the regulator before issuing tokens (whether it has received the necessary authorisations and licenses); and
- whether the Token Issuer Company has implemented policies and processes to verify tokenholders and their transactions (KYC, AML).
The consequences of improper regulatory compliance can range from the obligation to return all raised funds and close the project to financial and even criminal liability, so the investor's lawyers will pay close attention to these matters of compliance.
📚 Read more: How to Legally Issue Tokens in the Cayman Islands
Suppose the Web3 fund is willing to invest in tokens AND shares (equity) of the Web3 startup. In that case, the investor's lawyers will also ask for an Equity Cap Table (information on how the Token Issuer Company shares are distributed between founders and team) and the supporting documents stating that all project's intellectual property has been assigned to the company.
In classic venture investing, the money that a fund invests in a startup is an investment in the startup's capital/shares (capital investment) and is not taxable. In the case of investing in a Web3 startup, the situation is different, as investments are often in the form of token purchases that can be both digital goods and securities, depending on their legal status.
Although this transaction does not create tax consequences for the investor, the investor needs to make sure that:
- the team has conducted the necessary tax analysis, AND
- they understand what taxes will need to be paid from the sale of tokens, OR
- have confirmation from tax advisors that tax obligations will not arise.
After completing Due Diligence and signing the Term Sheet, the founders and investors prepare investment documents. The package of investment documents will depend on what the investor is interested in investing in: only tokens or tokens and shares.
Suppose an investor is only interested in investing in tokens. In that case, the investment agreement will depend on whether the tokens have already been issued when receiving investments or if the project will issue them in the future. If the project has already issued tokens, such an investment is structured through a Private Token Sale Agreement that specifies the number of tokens the investor redeems, their value, and lockup conditions. Also, it includes the verification (KYC) documents for the investor. If tokens were not issued at the time of the investment, a simple agreement for future tokens (SAFT) is used.
In a case where the investor is interested in investing in both tokens and shares, then, in addition to preparing investment documents for tokens, the parties prepare investment documents on shares:
- a Share Sale and Purchase Agreement; and
- a Shareholders' Agreement.
Also, the statutory documents of the Token Issuer Company are checked. If the project's team plans to issue tokens and shares for the investor in the future, a SAFTE (simple agreement for future tokens and equity) is used.
📚 Read more: a Playbook to Choosing a Web3 Fundraising Document
Fundraising of a Web3 startup is significantly different from the fundraising of a Web2 startup in legal terms. On the one hand, having such a highly liquid asset as a token brings interest from venture funds, but, on the other hand, it requires founders to do their homework, and:
- define the legal status of such a token;
- choose the best model for its distribution, and
- obtain authorisations/licenses from the regulators.
In the face of these somewhat extensive requirements, founders of Web3 projects preparing for fundraising must carefully perform all necessary legal work and prepare legal documents to avoid any deal-breakers that may hinder negotiations with Web3 funds.
If you're preparing your Web3 project for fundraising, Legal Nodes can help you build the right legal structure no matter what stage you're at– from incorporation to due diligence document preparation, we can help.
Fill out a form on our website to get started. The call will cover everything from how our legal platform can help you, to how we build a detailed Legal Roadmap for your project.
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.
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.