At Cherry Crypto we work at the earliest stages with founders and often come to the discussion of how to structure their first financing round. I wanted to share our thoughts with the hope that others find it helpful and to help sharpen our own thinking.
The main and obvious difference between crypto and non-crypto financing rounds is that in addition to equity, crypto rounds can also include tokens. Not every investment round in crypto includes tokens, as companies such as Coinbase, Opensea, Fireblocks are unlikely to issue tokens. In this post I’ll focus on investment rounds that do include tokens, and specifically the deal structure we’ve gravitated towards: equity + token warrants.
The equity + token warrants structure is suited for founders that estimate the chances of issuing a token at some point to be greater than 0. If you are absolutely sure that you will never issue a token, just stick to plain equity.
Equity + token warrant
Starting with equity, this part of the deal is standard and mirrors any other equity financing round. Companies and investors agree on a valuation, round size, and individual investment amounts. Every investor participating in the round is a shareholder in the company.
Sometimes a SAFE is preferred to a priced equity round in order to optimise for speed and reduce costs. We prefer a priced round as it establishes a price and shareholding up front. That said, SAFEs are perfectly fine as well.
The inclusion of tokens is the novel part of the deal. Whereas equity represents an investor’s ownership in a company, tokens represent ownership in a decentralised network. Founders decide what asset to issue based on whether they want to build a company or a network.
The difficulty is that in the early days it’s often not clear. A team might set out wanting to build a company only to realise later down the road that they want to build a network and vice versa. Once a team has issued tokens, it can't backtrack. Moving from equity to tokens is possible, moving from tokens to equity is not.
Token warrants are attractive because they give a company the option—but not the requirement—to issue tokens at a future date. With a token warrant founders are provided more time and thereby more certainty in what they want to build.
If founders decide they want to build a company, investors, by having invested in equity, already hold the value-accruing asset and can ignore the token warrant. If founders decide to build a network, the warrant, which defines a conversion from equity into tokens, will need to be exercised.
There are three main ways to structure a conversion from equity to tokens. For illustrative purposes, we’ll assume an investor purchased 10% of a company’s equity for $1m.
- Company allocation method. Ownership in company = ownership in network. This means that an investor holding 10% of a company’s equity will hold 10% of a network’s total token supply.
- Conversion rate method. Equity converts to tokens based on a pre-defined ratio. Let's assume an equity to tokens ratio of 2:1 . That means that 10% equity shareholding equates to a 5% token holding.
- Fully diluted supply method. Investors get a proportional share of the company’s token allocation. For this method, investors and founders need to agree on the share of the network’s token supply the company owns. Let’s assume 20%. If an investor holds 10% of a company, which owns 20% of a networks token supply, the investor gets 2% (0.1 * 0.2) of a network’s token supply. Sometimes we also see a multiplier added to this method. Continuing on the example above and assuming a multiplier of 1.5x, an investor holds 2% of the network’s token supply before the multiplier is applied, and 3% (0.02 * 1.5) after.
The equity to token conversion trigger is in most cases a subsequent financing round based on tokens. At that point new investors buy tokens directly and existing investors have their equity converted.
You'll notice that none of these conversion methods explicitly set a network valuation. There is of course the option to just set the network valuation up front. We prefer not to. Setting a valuation on a network that may or may not exist is very difficult, and we prefer to have valuations set during subsequent financing rounds by new investors coming in when the establishment of the network is clear.
Current investors can nonetheless still calculate an implied network valuation. The formula for doing so is:
Network Ownership = Investment Amount / Implied Network Valuation
Given that investors know both their investment amount and network ownership, they solve for the implied network valuation. The implied network valuation helps investors get a sense for their network ownership at certain valuations.
Using the same figures as above, one can calculate the implied network valuations for the different conversion methods.
Our preferred conversion method
From the three conversion methods, our preferred is the fully diluted supply method.
The company allocation method gives insiders (investors and founders) too much ownership of a network. Decentralised networks differ to companies in that ownership is far less concentrated. There is an inverse relationship between a network’s ownership concentration and resilience. While on the equity side we typically target 15% ownership, on the token side our target sits in the low-to-mid single digit percent.
The conversion rate and fully diluted supply method are similar in that they don't give insiders a disproportionate share of network tokens. What we like less about the conversion method is that the ratio of equity to tokens is too arbitrary of a number. Because at this stage we don't know what the network will look like or if it will even exist, it's difficult to say what the value of a token is in relation to equity.
The fully diluted supply method aligns on a percentage of the network that a company owns. Deciding on network ownership rather than making judgements on price is in our opinion more appropriate at this stage. Defining ownership up front also makes it easier to plan for the future and can ensure that investors don't get too much of the network in future financing rounds. Setting up a future network for long term success is the most important aspect to get right in the first financing round.