We have partnered with OC Advisory - a crypto focused boutique law firm founded by Orlando Cosme - on this blog post and also to provide a sample token warrant drafted by OC Advisory that founders can use to understand what a typical token warrant looks like and how its terms are defined. You can find the sample token warrant here.
When raising capital, crypto founders planning to issue a token have a few major ways to incorporate it into the structure of their raise:
- A token sale - an outright purchase of tokens;
- A SAFT (Simple Agreement for Future Tokens) - an investment in exchange for tokens in the future; and
- An equity investment with token rights - an investment in exchange for company equity + certain rights to tokens launched in the future.
Token sales and SAFTs face many legal hurdles in the United States. Additionally, for many projects, it is unclear whether more value will accrue to a project’s token or the developer company’s equity. Thus, investors will usually request that crypto companies in the US who haven’t launched a token yet structure their fundraise with an equity component and token rights component. These token rights are often granted in the form of a token warrant.
In this blog post we’ll discuss:
- What is a token warrant?
- When does a token warrant have to be exercised?
- How are allocations determined in a token warrant?
- How does a token warrant relate to the valuation of the token?
- What restrictions are placed on tokens in a token warrant?
- What else is often defined in a token warrant?
- What are alternatives to token warrants?
This article is provided for informational purposes only and is not intended to be construed as legal, financial, or tax advice. Readers should not rely solely on the information presented herein and should consult with their own legal, financial, or tax professionals regarding their specific situations. The author(s) and publisher make no representations or warranties concerning the accuracy or completeness of the information contained in this article. Reliance on any information provided in this article is solely at your own risk.
What is a Token Warrant?
A token warrant is a legal document that gives the holder the right, but not the obligation, to buy tokens of a cryptocurrency at a predetermined price, before a specified expiration date. The total purchase cost is typically considered de minimis, in the $500-$1,000 range.
When does a token warrant have to be exercised?
Token warrants typically have an expiration date of 10 years after the effective date; however, expiration may be accelerated once the token is launched, triggering a window during which the warrant must be exercised before it expires. In the case of the sample token warrant, the expiration date is the earlier of 10 years from the date of issuance, or 60 days following the notice of a TGE (Token Generation Event). By accelerating the expiration following a TGE, unexercised token warrants don’t loom over the token issuer as an outstanding liability.
How are allocations determined in a token warrant?
One of the key aspects of a token warrant revolves around exactly how many tokens the investor will be allocated after exercising their warrant. After the investment amount and company valuation, this is probably the most critical and negotiated term between the company and investor, and can set an important precedent for how token allocations are defined for future investors.
At a high-level, there are three very different methods for defining investor allocation in a token warrant:
- As a pro rata portion of the Company Reserve
- As a fixed percentage of the total supply of tokens
- As a fraction of their ownership of the total supply of tokens
We’ll describe these using the example of an Investor X that invests $1,000,000 in the company in exchange for 10% of equity ownership. You can refer to the “Portion” paragraph in the example token warrant link to see how the investor’s allocation (“Holder’s Portion”) is defined for the below methods.
Method 1: Token allocation defined as a pro rata portion of the Company Reserve
The investor's ownership is, roughly, the "numerator" divided by the denominator.
In this instance, the company defines the denominator to be a “Company Reserve” – a percent of the total token supply set aside for the company and insiders (typically, all preferred and common shareholders, investors, employees, and service providers that are promised tokens). The non-Company Reserve tokens are typically set aside for things like community airdrops, ecosystem incentives, market making, foundation grants to build public goods, developer grants, and more.
Of the total Company Reserve tokens, the investor would then receive tokens proportional to their ownership in the company’s equity at the time of the TGE. This is the numerator.
As an example, if the Company Reserve is set to 40%, and the investor owns 10% of the company’s equity at the time of the TGE, then the investor would have a right to 4% of the total token supply at the time of the TGE – the pro rata ownership (in number of tokens) divided by the company reserve (in number of tokens).
Typically, when the investor's ownership is defined as their pro rata percentage, that ownership can be diluted as their equity ownership is diluted. This is often seen as a fair way to structure the distribution, so that all stakeholders, investors, founders, and employees alike, are diluted by future investments.
A few notes:
- This is the most project-friendly and decentralization-friendly option. Projects that aim to decentralize ownership may not want the insiders’ portion of tokens to be 50% or greater.
- The investor could be diluted by subsequent fundraising rounds after their initial investment and before the TGE, affecting their percentage allocation at the time of TGE.
- The company reserve can be defined by a company upfront. It is often defined as a lower bound (“the company reserve will be no less than 30%”) or range (“the company reserve will be no less than 30% and no more than 50%”).
You can see how Company Reserve is defined and used in the example token warrant [link].
Method 2: Token allocation defined as a fixed percentage of total token supply
In this instance, the investor negotiates a fixed and explicit percentage of the total supply that they will be allocated. This is often set to be the same percentage as their equity ownership at the time of the investment round. The numerator and the denominator are both fixed.
For example, if the investor receives 10% equity ownership through the investment, they may define their token allocation as 10% of the total token supply at the time of TGE. This is irrespective of future fundraising rounds that might dilute that investor's equity ownership. In these cases, the token allocation is fixed to a specific number.
This is the most investor-friendly way to define the investor’s token ownership, and the most aggressive (From the investor’s perspectie) – resulting in the highest possible ownership for the investor. This method may give the Company’s investors a high degree of control over the supply of tokens, which may raise regulatory issues and impact decentralization efforts, and also sets a risky precedent for future investors that may demand the same treatment. Communities may also have a negative perception of a project with tokens heavily allocated to investors early on. Further, it can limit future fundraising opportunities – future investos may see earlier investors as owning too much to make a company worth investing in.
Method 3: Token allocation defined as a fraction of their ownership of the total supply of tokens
This is often considered the middle ground between the two aforementioned options. In this case, the investor’s token ownership (out of the total supply) is still set to be specific percentage of the total supply, but that percentage is defined as a fraction or ratio of their equity ownership, often 2:1 or 3:1 (often referred verbally to as “2-to-1 ratio” or “3-to-1 ratio”, etc.).
In the above example of the investor that owns 10% of the company and sets the equity-to-token ownership ratio at 2:1 would be allocated 5% of the total token supply (their 10% equity ownership divided by two); if the fraction is set at 3:1, they would be allocated 3.33% of the total token supply. Investors can also often negotiate other ratios, such as 1.5:1. When the ratio is 1:1, it is effectively Method 2 above.
This ratio option is often used when the project is negotiating a higher token valuation than their equity valuation (e.g. founders will usually push for investors to have less overall ownership of the token supply than of the equity). This is for many reasons – tokens often get liquidity earlier, founders will argue that the networks will be worth more than the equity, a protocol or product may be structured so that value accrues to the token rather than the company, etc.
In the case of an investor that invests $1M at a $10M equity valuation with a 2:1 ratio token warrant, they would own 5% of the total supply, which could be seen as implicitly valuing the token at $20M on a fully-diluted basis.
Should the investor's token ownership be dilutable? Method 4: A pro rata percentage of the total supply.
With Method 1 (investor ownership defined as the investor's pro rata ownership divided by the company reserve), the pro rata ownership percentage may change as the company raises future fundraising rounds. Let's say an investor owns 10% of the equity at the time of investment. Subsequent fundraising rounds by the company may dilute that original investor down to 5%, which would reduce their token ownership by a similar amount, unless they participate in those rounds on a pro rata basis to maintain their stake.
However, with Methods 2 and 3, the token ownership is fixed and explicitly defined at the time of investment. The token ownership in these cases is typically not diluted by future fundraising rounds since it is explicitly defined up front. This can be problematic because founders can't always predict future fundraising needs. They may end up needing to raise more rounds in the future, only to realize that they gave up too many tokens too early and now have more limited fundraising options. This also removes the incentive for an existing investor to participate in future rounds if they do not need to do so to maintain their stake.
One option in these cases, where the investor insists on owning a specific percentage of the total supply (instead of the company reserve) is to peg that percentage to the investor's pro rata ownership or a multiple/fraction thereof. So if they own 10% of equity at the time of investment, they would be allocated 10% of the total token supply. But if they are diluted down to 5% equity ownership by the time of the token launch, their token allocation would be similarly reduced.
For example, let's say an investor invests $1M at a $10M equity valuation (10% equity ownership) in a Seed Round. with a token warrant for 10% of the total supply. The founder may negotiate with the investor– instead of fixing the ownership at 10%, to define it as equal to the investor's pro rata ownership. If the founder then raises a Series A from a new investor that takes 20% equity ownership (with a token warrant for 20% of the total supply of the token), the original investor would be diluted to 8% equity ownership and consequently 8% of the ownership of the total supply.
How to decide between the above methods?
While there is no hard-and-fast rule about what is “standard”, it is widely considered that the most founder-friendly and decentralization friendly approach is the pro-rata company-reserve method, while the most investor-friendly option is the fixed supply method; the fraction method is often a compromise between the two.
While some investors will push for maximum ownership at the time of investment, many are open to considering the adverse effects that may have on the project’s ability to decentralize ownership in the future, as well as the community’s perception of the token.
Ultimately, each token-based project is different. Founders should deeply consider the circumstances of their project and to what extent token decentralization, and thus a lower allocation of tokens to investors or a Company Reserve, is important to the long-term goals of the project. Founders should also consider future fundraising needs in order to estimate the total supply that may be allocated to investors prior to a TGE.
The thing to remember is: What is the "numerator" and what is the "denominator"?
Method 1: Pro rata %ownership out of the company reserve.
Method 2: Fixed % ownership (equal to equity ownership) out of the total supply
Method 3: Fixed % ownership (fraction/multiple of equity ownership) out of the total supply.
Methods 4: Pro rata % ownership out of the total supply.
How does a token warrant relate to the valuation of the token?
For the purposes of the investment, the token’s valuation is either implicitly or explicitly defined in the token warrant, and commonly used by investors to track the value of their investments.
In the above examples, if an investor invests $1M at a $10M equity valuation, and receives the rights to 5% of the future token supply (a 2:1 ratio of equity ownership to token allocation), the investor may view this as valuing the fully diluted token supply at $20M.
This is separate from the token’s Fair Market Value (FMV) – the FMV is often determined by a professional 3rd party valuation firm. In the eyes of these firms, token warrants are seen only as a single data point in their FMV calculation, which will also take into account a number of discounting factors including the token’s lack of marketability or liquidity, a lack of open market transactions, trading or custody restrictions, among other factors. This is similar to how a company’s 409A equity valuation is often much lower than their preferred equity valuation (the valuation seen in fundraising headlines).
What restrictions are placed on tokens in a token warrant?
When tokens are launched, a project will often define unlock schedules- a timeline on which tokens will be received by the stakeholders. Token warrants refer to these as a type (among others) of “Transfer Restriction”.
For example, team tokens may be on a four-year monthly unlock with a 1-year cliff, while investor tokens may be on a 3-year monthly unlock with a 1-year cliff. Transfer restrictions usually start at the time of the token launch or TGE.
The process of defining the exact unlock schedules and transfer restrictions is an often complex part of the project’s tokenomics planning, which is conducted in collaboration with their investor base, advisors, community, and possibly a tokenomics firm. For this reason, token warrants will typically not define an exact unlock schedule at the time of investment, but instead specify that the investor will not have an unlock schedule more restrictive than any other insider. Token warrants may also impose a ceiling on investor unlock schedules (e.g., the unlock schedule shall not exceed a period of 4 years).
- Some lead investors may seek that unlock schedules must also be approved by a majority of holders including themselves.
- Many projects impose a 1-year “cliff” as a minimum lockup on investors and team members. In some cases, this is also done as a safe harbor to stay within the bounds of U.S. securities laws—specifically, Rule 144’s resale restrictions and Regulation S for non-U.S. offerings.
A token warrant may also further specify:
- Custody restrictions – Describing where tokens must be custodied (e.g. with a Qualified Custodian, in a multisig, in an MPC wallet, etc.)
- Token limitations– Specifying exactly which tokens the investors have rights to – for example, the warrant may exclude test tokens, testnet tokens, promotional NFTs issued by the project, etc.
What are alternatives to token warrants?
Token warrants are often used alongside equity investments because they are widely used and understood by investors, and also allow the token language to be kept separate from the equity instrument (particularly when raising on a SAFE, where a standard SAFE is typically used and the parties involved would not want to modify the SAFE with token language).
There are other types of ways that investors can be granted token rights. One type of commonly-seen agreement is a “Token Side Letter”. This is often a much simpler agreement that often does not contain elements like an expiration date or a specific price, but instead generally grants the investor rights to future tokens (often using one of the three methods above to define investor ownership). However, unlike a token warrant which is its own unique and separate instrument, a side letter is a part of the equity investment instrument. Accordingly, a company may not be able to assign a token side letter to another entity, such as a nonprofit foundation or offshore token issuer company.
If a company is raising a priced equity round, the documents involved are much more custom and the token rights can be written into the share purchase agreement or investor rights agreement of that fundraising round.
To recap, this blog post provided an overview of token warrants in crypto fundraising, explaining their role, exercise conditions, and allocation methods. We also discussed the three major ways that allocations are determined – as a pro rata percent of the Company Reserve, as a fixed percent of the total supply, or a ratio of the equity ownership out of the total supply.
You can view a sample Token Warrant here.
If you have further questions about token warrants, token fundraising, token issuance, or your specific situation, contact Orlando Cosme of OC Advisory at firstname.lastname@example.org or on X (Twitter) @orlando_btc. If you are looking for help tracking your token warrant allocations, token vesting, or token unlocks, book a demo today.