Web3 founders who are undergoing a pre-seed round for their Web3 project will have to take several necessary steps to give themselves the highest chances of success. This article covers the importance of investor due diligence, managing expectations of different parties, and sourcing and signing the most suitable documents, including a Token Side Letter. To get a free token side letter template from Legal Nodes, fill out the form on this page.
Looking for a token warrant template? Check out this guide to token warrants and get a free token warrant template.
What is the pre-seed round?
This is a period of fundraising where, in the world of Web3, Web3 founders will ask friends, family members, and business angels to invest in their Web3 project. At this stage, the Web3 founder is looking for up to half a million dollars in investment (though this amount can vary) and may need to have specific legal entities established to ensure that investors will recognise the startup’s legal structure as "fundable" and will be ready to invest in it. For example, investors might want to check that the company they’re investing in is the owner of the IP rights.
Investors’ due diligence in Web3 fundraising
Each fundraising stage, including pre-seed fundraising, can be performed in a two-part process. The first step is for the investor to undertake due diligence of the Web3 startup. The investor analyzes current successes and prospects of the startup. This step of due diligence is vital for the investor; it gives them the opportunity to run a risk assessment of sorts on the startup that they plan to invest in. If due diligence is completed successfully and all parties are satisfied, then fundraising may proceed to the second part of the process; the signing of investment documents and payment of investments.
Investor due diligence in the pre-seed round of Web3 fundraising
At the pre-seed Web3 stage, investors usually analyze the following:
- Whether there is an MVP of the product that can be tested
- Whether the founders can demonstrate the PoC of their MVP (investors may look for customer reviews or successful pilot launches as evidence of the MVP actually working to some degree, for example)
- What the initial version of the tokenomics looks like including how detailed the token utilities are (ultimately, helping the investor to understand whether the tokenomics has the potential to grow)
- Where the legal entity for product/protocol development (DevCo) is registered
- Whether the founders have worked out a legal strategy for the project that will help them avoid legal obstacles for global scaling in the future.
The “checklist” above helps the investor identify risks associated with the project, as well as figure out the potential of the project. By seeking answers to these questions, the investor can try to determine the project’s possible valuation.
Investors’ expectations at the pre-seed round
So, what can the investors expect if they were to back the Web3 project at this pre-seed stage? Ultimately, by making an investment in this round, Web3 investors will expect to receive two types of project assets:
- Actual shares or the right to receive shares of the company that owns the IP rights to the product (the DevCo)
- The right to receive tokens in the future after the launch of the mainnet when the tokens become liquid
Founders’ expectations and the pre-seed round
Web3 founders, in turn, attract investments to raise funds to further develop their product and help it reach the next development stage. Their product is usually only at an MVP stage, and in order to attract future investors and grow their product into a working, scalable, commercially-viable money maker, most founders must get investment to do this.
Investment at the pre-seed stage will allow founders to:
- Transition their product out of the MVP stage to the public launch stage
- Attract the first real users of the product
- Finalize the tokenomics and launch the token or protocol testnet
Once the product has transitioned to this new stage of development (product upgrade complete) and garnered some real-world users, the founders will be able to open a new fundraising round, the Seed Round, where they can approach different kinds of investors and ask for more money.
Web3 pre-seed round investment documents
Every investment round will require investment documentation. The purpose of investment documents is to stipulate and protect the rights and interests of both investors and founders in a balanced way.
At the pre-seed stage, it is important for founders to maintain flexibility in the company’s management and operational decision-making, including pivots and iterations, as well as not to spend months on investments’ complex corporate structuring. Convertible investment documents such as SAFEs, Convertible Notes, and Advanced Subscription Agreements work well to achieve these goals.
At the same time, investors need to protect their rights to receive shares in the company that owns the IP (DevCo), as well as to protect themselves from situations where intellectual property can be withdrawn from the company without the investor's consent. These guarantees are usually specified in the convertible equity investment documents mentioned above, which are signed by the founders on behalf of their DevCo.
Additionally, investors need to formalize the right to receive tokens in the future, in case the founders decide to issue tokens. To help with that, both parties may wish to use a “token side letter”. This is signed as an annex to the main convertible instrument and guarantees the investor's right to receive tokens in the future.
What is a token side letter?
A token side letter is a document that represents a right (not an obligation!) to receive or purchase future tokens and is signed together with a convertible investment document like SAFE.
Crucially, the token side letter:
- Does not specify the exact date when it converts into tokens
- Does not fix the price of the token
- Does not foresee token capitalization
- Does not define the utilities of the token
In addition, the token side letter helps protect the DevCo from any risks related to the regulatory uncertainty surrounding the status of specific tokens in individual countries. The token side letter does so by stipulating that the issuance of tokens will take place from a separate TokenCo in the future.
All in all, the token side letter allows the founders to avoid making concrete commitments for their tokenomics at an early development stage. As a result, it lets them be flexible in their experiments with tokenomics and simultaneously serves as a guarantee for investors to receive tokens in the future.
How token side letter differs from token warrant
Although often used interchangeably, these two documents are quite different.
A token side letter is a very simplified version of a token warrant. If a token price–a price at which the investor will have the right to purchase tokens in the future–and a deadline by which the investor must exercise this right, are added to the token side letter, then the token side letter will turn into a token warrant and become a separate contract with its own subject matter. It is important to note that the right to redeem tokens at a pre-fixed price cannot be granted free of charge. Therefore, the token warrant provides for its own consideration (the investor must separately purchase the right to purchase tokens in the future at a pre-fixed price).
Unlike the token warrant, the token side letter does not provide for a fixed price of tokens or a deadline for the issuance of tokens (and, accordingly, it does not provide for the exercise of the right to receive tokens). This document gives founders much more flexibility in deciding whether to issue tokens or not, as well as deciding on the pricing of tokens.
The key characteristics of a token side letter are:
- Cannot be signed as a standalone document. Annex to Convertible Equity Investment Agreements (e.g. SAFE); cannot be signed without the main Convertible Equity Agreement (e.g. SAFE);
- No separate subject matter. Document reserves the additional right for SAFE investor (in addition to the main right to receive equity in the future according to SAFE) to receive project’s tokens in the future should the founders decide to issue tokens (like the pro-rata right in Web2 venture deals which might be exercised by investors in situations where the founders decide to raise a new investment round);
- Consideration for tokens is covered by Convertible Equity Agreement (e.g. by the sum of equity investments).
The key characteristics of a token warrant are as follows:
- Self-sufficient (separate) document with its own subject matter and consideration (can be signed without any additional agreements/annexes);
- Subject matter of the document is related to the right to purchase tokens in the future at the fixed price. To receive this right, the investor has to make a consideration (they have to purchase the right). At the same time, when an investor decides to execute their Token Warrant, there will be a separate Token Purchase Agreement with the price which was fixed in the token warrant and according to which the investor will be able to purchase tokens;
- Two separate considerations will be required: 1st: for the right to buy tokens in the future with the fixed fee (token warrant) and 2nd: for the exact token (token sale agreement) using the price stated in token warrant.
Download the free token side letter template
Securing investment in pre-seed can be challenging. Many Web3 projects may still be trying to figure out the future of their tokenomics, their product, and which legal steps are necessary. Strong legal frameworks are vital to not only build a Web3 project with the highest chance of success; they’re also a green flag for investors too.
Web3 founders will need to consider their due diligence requirements, as well as which legal documents are most suitable for their fundraising stage. For pre-seed round fundraising, a token warrant or token side letter may be critical to securing investment that has a degree of flexibility yet still comes from an accredited source.
Get started with a free token side letter template from Legal Nodes, which you can download by filling out a form on this page.
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.