May 11, 2023

How to Structure a Token Incentive Scheme and Issue Token Options


The main purpose of this article and the free Token Incentive Scheme Template is to provide Web3 founders with a guide on how to structure token incentives for their teams. You can download the template for free by filling out the form on this page. This article will also serve as a legal guide to token compensation and will look at how best to structure a token incentive scheme for team members and contributors.

Everything contained in this article and in the Token Incentive Scheme Template is for informational purposes only and should not be treated as legal, financial, investment, or any other advice or legal opinion.

This article is brought to you by the Legal Nodes team. Legal Nodes is a legal platform that helps global businesses and Web3 projects create global legal structures and stay compliant with regulations as their businesses grow. We’ve helped many Web3 founders structure their Token matters, from issuance to token analysis and token opinion. Speak to us to learn more.

What are token incentive schemes?

Token incentive schemes do exactly what they say: they incentivise team members and advisors, who are the stakeholders of a particular Web3 project, to contribute to the project, with the incentive, or promise, or tokens as a reward for their efforts.

Important terminology relating to token incentive schemes

The Token Incentive Scheme Template contains a Contributor Token Warrant Template within it. To help make sense of how it all fits together, check out the following list: 

  • The Token Incentive Scheme Template. The overarching template, which includes the Contributor Token Warrant Template.
  • Contributor token incentive scheme (plan). This is a key policy that outlines how token incentives work with key terms.
  • Contributor token warrant. This is a document that outlines how many tokens a contributor will get for their contribution and on which terms they will receive their tokens.
  • Token option. In this context, a token option is a general term used to describe the combination of a contributor token warrant and a contributor token incentive scheme. Our use of the word “option” in this article is not to be confused with options that are financial instruments (derivatives).
  • Summary of the token option grant. This is a term from the template and the summary provides an overview of what’s inside the token incentive scheme and the token warrant.

Watch our video to get to know how to use the Token Incentive Scheme Template by Legal Nodes.

How can tokens motivate team members and advisors in a Web3 project?

Nowadays, token issuance doesn’t happen the moment that work on a Web3 project is begun. In fact, preparing for token issuance and protocol launch requires time and effort from the team. It also involves developing and testing the tokenomics, undertaking a vulnerability assessment of the protocol, and building a community around the project. Typically, this work can take 1-2 years. With token issuance taking so long, Web3 founders have to find a way to motivate their team to work on the project. They also need to find ways to attract early contributors and advisors who can bring critical expertise to the project.

This means that Web3 founders have an additional challenge alongside all their Web3 project goals and token issuance works: finding a way to keep the project stakeholders committed to the project. One of the best tools for incentivising a Web3 team is by giving them rights to receive tokens in the future, in exchange for their contribution. The contribution itself may be a certain number of hours worked, expertise provided, or other resources that team members can devote to the project.

This presents a fresh set of challenges. Web3 contributors will be asking particular questions about their rights to tokens, such as:

  • "Where is my right to receive tokens in the future for my early-stage contribution to the project recorded and regulated?”
  • “What guarantees this right?"

Answering these questions is also important for the Web3 founders, who have a portion of tokens allocated to them in their Token Cap Table. Web3 founders will need a legal framework that sets out how everyone who has a right to receive tokens will receive these tokens in the future.

Why legally formalizing token-based motivation systems for Web3 team is important

There are two main reasons why it is essential to legally formalize the right of the team and early contributors of a Web3 project to receive tokens in the future.

Contributors need legal guarantees

After the token issuance, each team member/contributor/advisor will independently control the tokens in their own wallet. However, BEFORE the token issuance, merely recording the token pool in the whitepaper and token cap table for the team and contributors will not be enough for them to feel protected. They need legal guarantees of such rights, fixed in a legal document.

The origin / source of tokens should have documentary proof

In the early stages of the project, Web3 founders and team members usually don’t think about how they plan to manage tokens in the future. After the initial distribution of tokens and their value growth in the ecosystem, these early token holders start listing tokens on exchanges, converting tokens into other assets. It is at this point that regulated platforms where token holders plan to carry out operations will begin to ask questions like:

  • How were the tokens obtained?
  • What documentation proves the source of their origin?
  • Were taxes paid on the tokens?

The issue concerning taxes becomes particularly relevant when the token conversion is made into fiat money. This issue will be discussed in more detail below.

The best tools for legally formalizing the team's right to tokens in the future is via documents like the contributor token incentive plan and the contributor token warrant.

What is a contributor token incentive plan?

At the core of the Web3 team's incentive program is the right to receive tokens in the future. The process of obtaining this right and its realization is regulated by the contributor token incentive plan (CTIP), which is a “unified policy” (aka, a summary of rules) for motivating the team and advisors of the Web3 project.

What is a contributor token warrant?

The contributor token warrant contains the specific conditions regarding the number of tokens that a team member can claim. This agreement is signed between the company issuing / distributing the tokens and the team member who will receive the tokens. The CTIP is attached as the company's general policy regarding team motivation through tokens.

This approach allows Web3 founders to have a single unified policy for issuing token incentives to team members and advisors (approved at a company level) and avoid situations where individual conditions for issuing token options have to be negotiated with each new team member. This would take a lot of time and hinder attempts to rapidly scale the Web3 team.

How does a contributor token incentive plan differ from an employee stock option plan (ESOP)?

In parallel with the token-based motivation system for the Web3 team, DevLab, the company registered first in the legal structure of the Web3 project, can also have an ESOP. The ESOP provides the right for team members to receive shares in the future. Just like in a traditional ESOP, the CTIP provides a percentage of tokens from the pool for investors and contributors to be distributed among team members and early contributors.

However, unlike a traditional ESOP, the CTIP has several differences.

In a traditional ESOP, a specific number of shares is allocated to the option pool. This allocation is achievable because the company's capitalization is known at the time of ESOP approval. In comparison with the CTIP, only the size of the share (a percentage) in the pool for investors and contributors is fixed. This share will be distributed among team members and early contributors, as at such an early stage of the Web3 project, neither the hard cap nor the initial token price is known.

In a traditional ESOP, vesting is linear, while in the CTIP, vesting is divided into two segments, and each of these segments is regulated differently, specifically as either “on-chain” or “off-chain” vesting:

  • “off-chain” vesting takes place during the period BEFORE the issuance of tokens (the rules for this vesting are fixed and regulated in legal documents (CTIP and contributor token warrant)
  • “on-chain” vesting takes place AFTER the issuance of tokens. This vesting is controlled by autonomous smart contracts that impose a lockup on tokens at the time of issuance and gradually unlock them.

In the case of “on-chain” vesting, the role of the CTIP is to describe the rules of operation for smart contracts that will impose a lockup on the tokens of team members, namely:

  • How team members should submit their wallet addresses to receive locked tokens at the time of token option conversion, and
  • Which moments/events token unlocks will be tied to, for example, to time intervals, to epochs of the blockchain network, or to the results of DAO voting.

What does a contributor token incentive plan regulate?

The “on-chain” vesting part of the CTIP plays a more “descriptive” role, as the purpose of the CTIP in this part of the token incentive plan is to describe the rules of operation for smart contracts that will “control” the locked tokens of team members. The company's obligations, which approve the CTIP / issue token options, are to ensure that the rules of operation for option smart contracts provided in the CTIP are properly incorporated into the smart contracts themselves.

As for the “off-chain” vesting, the CTIP plays a legally binding role here, as it regulates the following provisions:

  • The order of “off-chain” vesting (including the vesting schedule and the time intervals through which additional a percentage of tokens are “accrued”)
  • The acceleration moment of the “off-chain” vesting (usually the moment tokens are issued)
  • The list of grounds that interrupt the “accrual” of an additional percentage of tokens (usually, these are “good leaver” grounds, i.e., a team member leaving the project by mutual agreement or termination of project advising)
  • The list of grounds on which the token option is annulled or burnt (the “bad leaver” grounds, such as when a team member leaves after having disclosed trade secrets or is working for a competitor, etc.)

What does a contributor token warrant regulate?

As mentioned above, the CTIP is a company-approved policy for incentivizing team members using tokens, while the contributor token warrant is a bilateral document between the company and the team member, specifying the size of the token option for that team member. The CTIP itself is signed as an appendix to the contributor token warrant, as it contains general terms & conditions for the token incentive scheme, to which the contributor token warrant refers.

The essence of the token option is to provide and legally fix the right for a team member to receive tokens in the future. This right can be realized either free of charge (when the team member does not need to pay anything extra to receive tokens in the future) or for a fee (where the team member will need to pay a significantly discounted price for the tokens). The type of this right depends on where the company issuing / distributing the token option is registered. Typically, the first route described above is more common for non-US entities, whilst the second route is for US-based entities).

In this article, as well as in the template document available for download, we will consider the second option (paid realization of the token option). This is where the contributor token warrant is structured as a token purchase right with a substantial discount (usually 99.95%), applied to the primary token price at the time of token option conversion. The only figure entered into the contributor token warrant when signing with a team member is the percentage of tokens from the pool of tokens for investors and contributors, which will be calculated as an absolute figure at the time of token option conversion. This is also provided for in the token cap table of the project.

The difference between a token warrant for investors and a contributor token warrant

At first glance, it may seem that both the investor token warrant and the contributor token warrant cover the same subject matter: the token purchase right. However, unlike the token purchase right provided in the investor's token warrant, in the token option for contributors and advisors, the token purchase right is tied to the time during which the contributor/advisor commits their resources (knowledge, consultations, code) to the project.

Also, it is important to note that the contributor token warrant cannot exist as a standalone document. For contributors (team members) and advisors, it is tied to service/advisory agreements. For founders (core contributors), the token purchase right is provided in the SHA or fixed in the founders' token warrant (similar to investor warrants), which is signed as an appendix to the SPA during the registration of the DevLab and issuance of shares.

Thus, summarizing the above, there are the following differences between the token purchase right for an investor and the token purchase right for a team member:

  • consideration from the token recipient. In the case of an investor, it is investment; in the case of a team member, it is the performance of work/services/provision of advice for the project.
  • conversion formula. In the case of an investor, this formula depends on the size of the investment and the calculation of investor shares in the DevLab; in the case of a team member, it is fixed as a percentage of tokens from the pool of tokens for investors and contributors, which will be calculated in absolute numbers at the moment of the token option conversion.
  • discount. In the case of investors, the discount size will depend on the agreements between the parties, while for team members, the payment for tokens usually has a formal character, so the maximum possible discount, for example, 99%, is provided.
  • vesting. There is no vesting in the investor's token purchase right, while vesting is provided for team members.

Can a token option be issued without the option holder having to pay for it?

Yes. If the DevLab is registered in a non-US jurisdiction and if the pool of tokens allocated for investors and contributors will be transferred for further distribution to the DevLab, rather than a specially created Token SPV (as is usually the case when the DevLab is registered in the USA). For this purpose, a token side letter adapted for issuing tokens to founders and team members is typically used.

In this article, we will consider the option where the token purchase right model is used, and where the option holder pays a nominal amount for the realization of this right. It can be calculated using the Token Cap Table Template created by Legal Nodes.

How is the CTIP approved and who issues token options to team members?

At the early stage of a Web3 project, the legal structure usually only has the DevLab registered (a company that is engaged in the development of the project/protocol). Therefore, this company, at the board of directors' level, approves the CTIP. Often this approval takes place simultaneously with the approval of the ESOP. On behalf of this company, contributor token warrants are issued (signed) with team members.

Also, as mentioned earlier, an important aspect that affects the payment or nonpayment right to receive tokens in the future is the jurisdiction of the DevLab's registration. Depending on where the DevLab is registered, one of two routes are possible. Either the DevLab assigns the obligation to execute the option (fulfill the obligation to issue tokens) to the Token SPV, which is usually the case when the DevLab is registered in the USA. The second route is that the DevLab will convert the token options itself after receiving the contributors token incentive pool at the moment of the initial token issuance. This second route is typically followed when the DevLab is registered in Switzerland, Singapore, Liechtenstein, or other non-US jurisdictions. The reason for this approach is the high level of regulatory uncertainty in the US jurisdiction, which is why it is not recommended to take any actions regarding token distribution on behalf of American companies. We’ve previously explored how US regulatory uncertainty impacts Web3 projects in articles on how to choose a fundraising document and how to issue tokens.

How is the token option converted and how can a contributor receive tokens in the future?

Once the token generation event (TGE) has happened, the TGE optionees will have the right to exercise their option and provide the address to receive their tokens. After the transaction with locked tokens has taken place, all further rules and procedures for unlocking these tokens are fully decentralized and autonomously regulated by smart contracts and/or DAOs.

Tax aspects of token options realization

One of the reasons why it’s important to legally formalize the right to receive tokens in the future for founders/contributors/advisors is the importance of obtaining certain legal confirmations. These confirmations will outline what the tokens were received for, in what quantity, who issued them, their value at the time of issuance, and how much the team members paid for the conversion of token options.

This information will help founders/contributors/advisors to address the following issues in the future:

  1. Tax payment on tokens in the jurisdiction of the individual’s tax residence. When the financial year is coming to an end and they must prepare a personal tax return, these token legal confirmations will be critical in providing accurate documents as part of the tax return.
  2. Capital gains issues. When tokens increase or decrease in value, token owners need to reflect these gains/losses in their personal tax returns, as these situations already have tax implications in most jurisdictions today.
  3. Financial compliance issues. When token owners bring their tokens onto regulated platforms (for example CEXs or regulated custodians) for conversion of large amounts of tokens into other virtual assets or fiat currencies, these regulated platforms will request documentary evidence of the origin of these tokens and confirmation that taxes have been paid on them. In the absence of any confirmation, these assets may be frozen.

An additional question to think about that may be relevant for founders and core contributors of Web3 projects is the option of using their own holding companies to receive tokens, where corporate tax consequences may be more clear and predictable compared to personal ones.

Prepare the right legal documents for your tokens

Throughout this article, we’ve explored the many different routes for token options, token issuance, and the various implications and risks that contributors, founders, and advisors should be aware of. 

If you’re planning on using tokens in your Web3 project, Legal Nodes can help you understand the best legal strategy for you, including the best jurisdictions for registering important entities like DevLabs and TokenSPVs, and the best legal documents for creating a future-proof that will appeal to investors, 3rd party platforms, and Web3 project contributors. Speak to us to get started.

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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