Web3 Fundraising Mechanisms
Investing in the Crypto Bear Market
During the most recent crypto bull run, top VC firms raised unprecedented sums of money to invest in web3 companies: crypto-native firm Paradigm raised $2.5 billion in early 2022 just weeks before a16z announced its $4.5 billion web3 fund.
While we’re currently in a crypto winter, firms still have tons of capital to deploy. It will likely take a few months for investors to dole out checks at a more regular cadence as markets reset. But with crypto hype dying down, startups have the opportunity to go heads down and create the products and infrastructure that will propel the next bear market forward. Bear markets are the best forcing function to separate signal from noise, making now a better time than ever to invest in crypto startups creating real value.
There are 3 basic ways that traditional (i.e. accredited and institutional) investors gain exposure to web3 companies: pure equity, pure tokens, or a mix of both. The most common web3 investing strategy is to buy both equity and tokens: this offers investors comfort given their familiarity with equity and upside in new incentive structures.
Early Stage: SAFEs, Side Letters + Warrants
SAFEs
Most early-stage businesses raise pre-seed and seed rounds using SAFEs (Simple Agreements for Future Equity), an investment option popularized by Y Combinator. A SAFE is an agreement for investors to purchase stock in the future and is used before companies set a share price. Founders raise these unpriced rounds when they need capital to grow their business but want to achieve certain milestones (i.e. revenue or user targets) before putting a price tag on their company. Future equity agreed to in a SAFE “converts” to shares with a defined price when a company raises its first priced round. This article walks through a helpful example of a conversion to priced shares (note: they refer to SAFEs as convertible notes).
In return for their commitment to a company under such ambiguous terms, investors get access to between ~15% and ~30% of a business in pre-seed and seed SAFE rounds; this number is closer to 10% in Series A and beyond. These terms give investors the potential for massive returns. For instance, if we assume YC’s original $150,000 investment for 7% ownership in Coinbase diluted down to 0.05% at IPO ($100 billion market cap in April 2021), that would mean a $50 million (or > 300x) return!
Token Side Letters
💡 As a quick reminder, tokens are a core feature of many web3 companies. They offer a way for users, community members, creators, and investors to feel true ownership over a product, service, or protocol. See this article for more context on how tokens align incentives between these stakeholders.
Token side letters are the most common mechanisms founders use to offer tokens in an early-stage funding round. Token side letters “represent a right, but not the obligation, to receive future tokens” (Liquifi Twitter). According to this thread,
These warrants are not SEC-registered and they do not provide any guarantees for future tokens. They are an optional ‘side letter’ that give both parties the optionality: for teams to issue tokens down the road, and for early backers to be rewarded for their contributions.
Side letters are generally agreed to before a company decides if they will launch a token, hence the ambiguous language: given that there are no live tokens or defined tokenomics, you can’t agree on much more than future rights to an asset that might exist one day.
Later Stage: Priced Rounds + Token Awards
Priced Rounds
Once a company has sufficient traction they raise a priced round: an equity investment based on a negotiated valuation of a company. Investors write checks in exchange for preferred stock at a price per share determined by the valuation. Let’s look at a quick example:
Imagine that Kristen’s Cool Crypto Company is raising a Series A:
She is raising $10 million in exchange for 10% of the company
There are 50 million outstanding shares (the total number of shares held by all stakeholders – investors, founders, etc.)
First, it’s worth noting that the total % of the company is 100%
Next, let’s find the valuation of the company. $10 million for 10% of the company means 100% of the company is worth $100 million ($10 million / 0.1)
Now that we have the valuation (and we’re given # of total shares), we can calculate the share price: $100 million / 50 million shares = $2.00 / share
Finally, 10% of 50 million outstanding shares is 5 million shares. This is the amount of shares investors are buying for $10 million.
Note that a priced round details a company’s valuation, a share price, and number of shares per investor, parameters that are unknown in unpriced rounds. This is also when companies start to offer board seats, usually to lead investors.
Token Awards
There is a parallel way to offer tokens at this stage. Companies issue token awards when they have already launched a token. If token side letters are the crypto-native version of SAFEs, then token awards are the crypto-native version of priced rounds: where priced rounds offer a share price, token awards define details like total token supply and lockup periods. Similar to board seats, when investors receive tokens, this often comes with governance power proportional to their token share.
So at this stage, there are details on token supply. But, how is it determined how many tokens an investor gets? We can look back to our example to figure this out.
A token warrant indicates that investors will have a proportional ownership stake in the form of tokens – that is, they will also own 10% of the token supply.
If the token supply is 10 million tokens, Series A investors will own 1 million tokens
Full Money Value
Finally, an investment’s “full money value” is the combination of equity and token stakes. If we assume tokens are worth $1.50 each, the FMV of the equity and token deal is $10 million + ($1.50/token * 1 million tokens) = $11.5 million.
Balancing Short and Long Term Liquidity
Taking a step back (and drawing from a previous Coinsights article), for each equity investing mechanism that exists in web2, there is a parallel for issuing tokens in web3:
Now that we understand the details of investing in tokens, we can look at the implications of taking tokens in addition to equity. In short, the combination of these investment assets aligns founder and investor incentives in both the short and long terms: long-term equity bets take an average of 10 years to reach liquidity, while tokens can reach liquidity in 3-5 years.
There’s a few things this can lead to:
Investors and founders will be more willing to let employees sell shares on secondary markets to keep up with faster liquidity cycles that web3 offers
Investors will manage funds differently. This might look like either of these scenarios or a combination of the two:
Setup separate funds to manage equity and token investments because of the legal implications and regulations on the different assets types
Reinvest profits from token sales as part of the same fund to take advantage of compounding interest (before sharing profits with LPs)
There are still so many unknowns with how token sales will affect both web2 and web3 fundraising landscapes: for example, how do we calculate internal rates of return on token sales if tokens are included in side letters? That is, if tokens have a price of 0, is the rate of return infinity?
Have thoughts on these questions? Drop a comment below or reach out on Twitter (@kmashiki).
Thanks to Yash, Grace, and Henri for their cointributions!