I’ve previously written on the deal structure we gravitate towards when making a first investment into a crypto company: equity + token warrants. In this post I’ll dive into the token warrant itself and highlight some key points.
A warrant is similar to an option. Warrants give their holders the right, but not the obligation, to purchase an asset at a certain price and quantity before an expiration date. Historically, warrants have mostly been used for equities. Token warrants, however, as the name implies, give holders the right to purchase tokens.
The reason early stage crypto companies issue token warrants to investors is that they aren’t entirely sure yet whether they will build a centralised company or a decentralised network. Token warrants give founders optionality and ensure that investors have a claim on either of the value accruing assets: equity for companies or tokens for networks.
All token warrants have a purchase price, which is the price to acquire the warrant itself. Since a warrant is a separate security from the underlying token, it requires a purchase price. This is usually a nominal amount and paid for right after the warrant is signed.
The number of tokens sold to investors is defined by the equity to token conversion method. Let’s assume the fully diluted supply method, which is our preferred method. This method defines in advance what percentage of network tokens “insiders” (founders, employees, investors and advisors) receive, which is referred to as the company reserve in the warrant. The portion defines how many tokens an individual investor receives. According to the fully diluted supply method, an investor's portion is equal to their equity shareholding in the company multiplied by the company reserve. If an investor owns 10% of a company’s equity and the company reserve is 40%, then that investor would own 4% (10% * 40%) of the network’s token supply.
Token warrants are valid until an expiration date, which is typically defined as the earliest of one of the following three dates: 1) 10 years into the future 2) day the company decides not to issue tokens and 3) a period of time after the day the company decides to issue tokens.
The first date simply caps the time period during which the warrant is outstanding. It usually never comes into effect, as companies will have decided before whether to issue tokens or not. If a company decides not to issue tokens, the warrant expires and investors will be left holding equity, the designated value accruing asset.
If founders decide to build a network and issue a token, a token generating event (usually called token structuring event in the warrant) can be triggered. At this point tokens are minted and existing investors have the right to exercise the warrant. While the company can decide the timing of a token generating event, it usually occurs in the context of a subsequent financing round when new investors purchase tokens directly. This can be both a private token round or a public sale. Existing investors exercise the warrant and purchase their allocated tokens at the warrant exercise price, which is the agreed upon price of the underlying tokens. This is something that’s negotiated between investors and founders when the warrant is initially drafted and is typically a nominal amount.
Once existing investors have exercised their warrant, they can claim their tokens and start vesting.
While we've seen a lot of variation over the past few years in how crypto deals are structured, the token warrant has emerged as the standard. There are always other approaches, but what we like about token warrants is that they are lightweight in their construction and give both founders and investors optionality.