Author of the original article: Miles Jennings, Joseph Burleson, Zachary Gray

Translated by: DeepFlow Tech

The successful issuance of tokens is a complex process that requires a lot of strategic planning and a certain amount of luck. However, before a project launches its tokens, an incorrect token rights structure may jeopardize its future prospects. The structuring of token-related legal rights in the early financing rounds is very complex, and some investors may take advantage of the lack of clearly defined market standards to exploit unsuspecting entrepreneurs.

To help entrepreneurs better understand the market and ensure fair and sustainable trading structures, here are the basic principles that define the scope of token rights and restrictions. We also highlight some predatory behaviors of investors, discuss how these behaviors can harm projects, and provide explanations of the terms we use.

Alignment of Incentives: Key to Success

The alignment of incentives between founders and investors is key to the success of any business. Misaligned incentives can lead to distrust and inefficient work, and limit the choices of a project. Incentive alignment—by definition—helps ensure that everyone is working in the same direction.

In traditional equity structures, incentive alignment is straightforward. If the company becomes more valuable, both investors and founders benefit. However, with the introduction of tokens in Web3, incentive alignment becomes more complex. The blockchain systems deployed by Web3 projects are open-source, decentralized, and often designed to accumulate value in the tokens of the system, rather than in the company developing the technology—this is a subtle but important distinction. This design shifts value away from equity, resulting in misaligned incentives between token holders and equity holders.

This misalignment of incentives is most common in early projects that raise funds by selling tokens directly to institutional investors and angel investors, which can lead to the following two issues:

• Investors focused solely on the tokens often have shorter investment horizons and typically pressure projects to launch tokens quickly for faster returns. This unnecessary pressure may limit the potential of projects, leading them to take actions that harm their ecosystem—such as premature token launches.

• Selling token rights reduces the overall flexibility of the project's design. When investors' expectations can only be met through tokens, projects often prioritize the launch of tokens and the accumulation of token value. However, tokens may not be the best path for every project, and some projects need more time to ensure their economic balance. Losing the flexibility to choose alternative paths may harm the long-term success of the project.

Therefore, early projects are best served by adopting a balanced trading structure that allows all stakeholders to access both equity and tokens. By maintaining alignment between investors and entrepreneurs, projects can maintain flexibility to design their systems in the best way and allow value to accumulate in tokens, equity, or both. By aligning interests, both parties can focus on sustainable growth and long-term success.

Even in cases where early projects use a balanced trading structure, misaligned incentives may still arise after the public issuance of tokens: some people may hold tokens, while others hold both tokens and equity. Due to this potential misalignment of incentives, projects must guard against conflicts of interest. In some cases, it may be beneficial for the project to close the development company, meaning that every stakeholder becomes a token holder. In other cases, it may be advantageous for many companies to actively use the project's technology for building and competing. In such cases, the project should prioritize creating a fair competitive environment, establish procedural incentives, and even consider imposing strict and milestone-based token sale restrictions on employees, investors, and other insiders of the original development company to protect token holders. In most cases, the project's intellectual property should be controlled and owned by token holders.

Predatory Behavior and How to Avoid It (with Example Clauses)

The following are several clauses used by a16z Crypto and other large crypto venture capital firms to maintain incentive alignment with entrepreneurs.

Token Rights

Founders should be cautious about granting investors fixed, undilutable token rights or unsustainable network percentages. These predatory clauses limit the flexibility of the project and its future growth potential. If a development company has granted existing investors a non-dilutable right to a certain percentage of the total token supply, for example X%, they may find it difficult to raise additional funds without offering the same undilutable terms to future investors. These clauses may limit the project's financing options or ultimately reserve an excessively high proportion of the token network for investors. When investors hold a disproportionately large share of the tokens, it ultimately forces founders to sacrifice builder token incentives—whether from the community, the development team, or both.

Founders should also be wary of venture capital firms that require them to pay tokens for assistance in token issuance. In this case, there are usually two facts: first, you do not want their help; second, they are likely to be "value extractive" and will attempt to sell their tokens early.

Fixed token allocations are harmful. They can lock early-stage projects into allocations that are no longer reasonable at the time of issuance, and when these projects run out of allocatable tokens, they may find it difficult to raise funds in future rounds. Token rights should be proportional to equity ownership and subject to dilution. This ensures flexibility in token allocation and aligns with the long-term development of the project. This way, projects can raise additional rounds of funding as needed to continue development, rather than rushing to launch tokens because other options have been exhausted.

a16z Crypto's transaction documents are designed in two ways.

• Granting investors a portion of the total token supply equal to their percentage ownership in the company at the time of token creation. This option sets clear expectations for investor token allocation from the start.

• Granting investors the right to a proportionate share of the tokens allocated to the development company and its employees, advisors, investors, and other shareholders, provided that the allocation meets a minimum percentage of the total token supply. This option sacrifices clarity for flexibility, allowing the project to determine shareholder allocation (i.e., how many tokens will be allocated to employees, advisors, and investors) and community allocation (i.e., how many tokens will be airdropped, reserved for community project funds, etc.) before issuance.

Example Clauses

• Option 1: If the company (or any of its affiliates, foundations, or nominees) creates any cryptographic tokens, investors will have the right to a proportionate share of the total potential supply of those cryptographic tokens, representing half of their fully diluted ownership at the time of token creation (e.g., representing [X]% post-planned financing).

• Option 2: If the company (or any of its affiliates, foundations, or nominees) creates any cryptographic tokens, investors will have the right to a proportionate share of the cryptographic tokens allocated to the company and its executives, directors, employees, shareholders, and other investors (collectively referred to as "insiders"). The amount allocated to the company and insiders shall not be less than [X]% of the total cryptographic token supply.

Lock-Up Period

Founders should be wary of short lock-up periods. Investors may push for their tokens to be unlocked as soon as possible for early sales, which can disrupt the stability and growth of the project, bring irreversible reputational damage to the project, and introduce legal and regulatory risks. Pushing for shortened lock-up periods is both dangerous and irresponsible.

Lock-up plans should be consistent among investors, founders, employees, and other shareholders of the original development company. This ensures that all parties are equally concerned about the long-term success of the project.

The table clause structure of a16z Crypto stipulates that all internally held tokens are subject to a lock-up period of at least one year after the public token issuance or the date when the tokens become transferable (if the tokens are non-transferable at issuance). Generally, a16z Crypto pushes for a four-year lock-up plan for internally held tokens, where all of these tokens are fully locked up for one year, followed by a three-year staggered unlock. This helps maintain stability of the token network in the initial days after token issuance and ensures that all insiders bear significant market risk for at least one year after token issuance.

Such lock-up periods can also strengthen the project's regulatory position to apply to securities laws specific to the tokens. The table clause also ensures that all internally held tokens are unlocked on the same schedule, further reinforcing the alignment of incentives between entrepreneurs and investors.

Example Clause

• Any lock-up plan for these tokens should be consistent, provided that the lock-up period shall be (1) no less than one year from the date of issuance of the cryptographic tokens, (2) no more than four years from the date of issuance of the cryptographic tokens, and (3) no more stringent than the schedule applicable to the tokens of the company or any executives, directors, employees, shareholders, or other investors of the company.

Protective Clauses

Founders should be cautious of unconditional approval rights for token issuance. These predatory clauses may allow investors to delay token issuance to renegotiate better deals, causing unnecessary delays and strategic misalignment.

Investors generally should not have approval rights for the timing of token issuance for a project. Token issuance may involve significant risks, and the timing of issuance is fundamentally a business decision that founders are better suited to make. They are better positioned to decide when and how to structure token issuance best. Approval rights may allow investors to exert undue influence on these decisions to maximize their anticipated economic outcomes (e.g., delaying token issuance, forcing the project to collaborate with other portfolio companies of the investors), which may have adverse effects on the project's development.

The table clause structure of a16z Crypto allows projects to issue tokens without requiring investor approval, as long as the issuance does not circumvent any investor's token rights. Generally, if each investor receives their agreed-upon token allocation, investor approval is not required. This provides operators with maximum flexibility while maintaining alignment of incentives with investors.

Example Clause

• Prior approval of a majority of preferred stockholders shall be required before creating, reserving, selling, distributing, issuing, or otherwise disposing of cryptographic tokens, coins, crypto assets, virtual currencies, or other assets ("cryptographic tokens") built on blockchain technology, provided that these restrictions do not apply to (i) sales, distributions, issuances, or other dispositions conducted in a manner not conflicting with the "Token Rights" clause below, or (ii) sales, distributions, issuances, or other dispositions conducted pursuant to certain customary exceptions.

Network Utilization

Founders should be wary of transactions that do not impose restrictions on how investors and founders can use the company's technology. The lack of any restrictions may allow some investors to exploit loopholes to control the network, undermining the founders' intentions and the project's objectives. Conversely, unconditional restrictions may inhibit collaborative development and decentralized value creation.

For example, investors and founders should be restricted from using the company's developed technology to launch competing platforms. This protects the interests of investors and founders and ensures the integrity of the project. Any restrictions should be balanced enough to ensure they do not hinder the necessary partnerships and integrations for the project.

We recently revised the table clause structure of a16z Crypto to limit investors and founders from using the company's developed technology for personal gain or in a manner that competes with the company's objectives, provided that customary exceptions allowing non-commercial and non-competitive use of the company's technology are permitted. These exceptions may include personal use by founders as ordinary end-users of protocols developed by the company, use related to university-led research, advisory roles for other blockchain protocols, or collaboration with services compatible with the company's developed protocols. These exceptions allow founders to contribute to the industry in a manner consistent with the open-source and collaborative spirit of Web3, while ensuring they can develop the company's technology in a manner that does not impede their obligations to investors and alignment with the community.

Example Clause

• The company, founders, and investors shall agree that they will not utilize or exploit the company's network or protocols for commercial purposes, unless directly through the company, provided that certain customary exceptions are followed.

Compliance

Investors who do not prioritize compliance are not suitable partners for Web3 projects. Some investors may lack interest in the legal and regulatory requirements applicable to blockchain networks and the products built on them, or may prefer to remain ignorant of them. Avoid working with them. Given the significant regulatory uncertainty in the industry and the survival risks it brings, compliance obligations must not only be addressed but must be prioritized.

In theory, founders and investors should both want the token network to comply with applicable laws, thereby reducing risks and achieving sustainable long-term growth. However, in practice, not all Web3 stakeholders hold this view. Short-sighted predatory investors may prioritize profit through regulatory arbitrage rather than compliant development, sacrificing the stability of the project in the process.

The transaction documents of a16z Crypto include multiple clauses to ensure that projects take appropriate caution in network design, product development, and token issuance, and that investors support this process. These clauses include requirements for the company to (i) develop comprehensive compliance policies, (ii) reasonably endeavor to inform investors of any legal or regulatory requirements that may apply to their blockchain products or services and the adverse impacts these requirements may have, and (iii) engage lawyers specifically to assess the legal and regulatory risks of these products and services and take appropriate protective measures. These contracts further enable investors to support each of these processes.

Example Clause

• Before the public issuance of new blockchain products or services, including the distribution of tokens (if any), the company shall engage lawyers to assess and analyze the form, mechanism, and structure of such products or services and the distribution of tokens (if applicable) for the company's risks (considering security holders, including investors). When the company requests advice on the planning or design of any such blockchain products or services, including any digital tokens, cryptocurrencies, or other blockchain assets related to them, the company shall engage additional external lawyers approved by the board of directors to review the risk assessment and analysis related to any such products or services and make reasonable efforts to ensure that any such products or services are provided only in accordance with all applicable laws.

Correctly defining token rights in the early stages of a project is crucial for the project's future success. However, many projects—through no fault of their own—may find themselves constrained by predatory clauses, which may be difficult or even impossible to remove in later stages. By following the guidance and example clauses outlined here, founders and investors can create a balanced framework that promotes alignment, innovation, and stability among stakeholders. This approach not only mitigates many of the inherent risks of venture capital and Web3 transactions but also enables projects to thrive in the ever-evolving Web3 ecosystem.

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