The terms Token Side Letter and Token Warrant are often used interchangeably or separated with a slash, suggesting that they are more or less the same. However, these two instruments have some fundamental differences, making it crucial to understand the distinctions to choose the right instrument and avoid potential pitfalls that come with selecting the wrong document. This is particularly true for projects at a very early stage.
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Understanding the Key Differences
In this article, we will highlight the differences between the two instruments and their implications for your fundraising strategy.
The article is structured into the following sections:
- When are Token Side Letters and Token Warrants being used?
- What do they have in common?
- What are the key differences?
- Key takeaways
When are Token Side Letters and Token Warrants being used?
Both documents are used during the early stages of fundraising, typically during a project's Pre-Seed and Seed rounds when the following conditions apply:
- The initial team has started the project's development in a centralized way, and it is essential for the founders to maintain flexibility regarding management, operations, and decision-making. This also applies to the usage of early funding needed for the project's development.
- An initial entity, the Developer Company, is set up where the initial team members and founders are employed, holding a FIAT bank account and signing agreements and making payments. Usually, this company is established in the jurisdiction where the founders are based and is a "conventional" limited liability company.
- At the same time, there is no entity in place yet that is compliant to sign more mature fundraising documents, such as SAFTs, or could sell or issue tokens.
- The launch of the blockchain's or dApp's mainnet and therefore the Token Generation Event / Token Issuance is still several months away. (This can be anywhere from 6 months to 2 years.)
- As the project is still in the early stages of development, the token design isn't fully fleshed out yet and still needs time to work on aspects such as token type / utilities, token distribution, token's economic and revenue model, lock-up and vesting schedules, etc.
What do Token Side Letters and Token Warrants have in common?
- Both the Token Side Letter and the Token Warrant are signed by the Developer Company, usually a conventional limited liability company in an on-shore jurisdiction such as the U.S., Germany, France, Hong Kong, the UK, Estonia, etc., that holds the IP of the protocol and where the initial team members are employed to develop the protocol.
- Both documents are connected to a SAFE/Convertible Instrument in the form of an annex or add-on, commonly used by early-stage projects to raise Pre-Seed or Seed funding by selling the Developer Company's equity.
- Raising funds via a SAFE/Convertible with a Token Side Letter or Token Warrant fulfills the following criteria for investors:
- The rights to receive shares in the company that develops the protocol and owns the Intellectual Property
- Protects the investor from situations where intellectual property can be withdrawn from the company without their consent
- Serves as due diligence on the legal setup, management, and team through an incorporated entity regarding how the protocol development is run and managed
- The right to receive tokens in the future if the protocol issues tokens
What Are The Key Differences Between Token Side Letters and Token Warrants?
Now that we've outlined the shared features of Token Side Letters and Token Warrants, it's time to focus on the key aspects that set them apart. In this section, we will discuss the three main differences, their implications, and essential factors to keep in mind:
- Exercising Rights and Considerations
- Token Issuance and Distribution
- Terms concerning the Tokens
1. Exercising Rights and Considerations
Token Side Letter
- The Token Side Letter offers SAFE investors the option (but not the obligation) to receive the project's tokens in the future, IF the protocol decides to launch a token.
- In the Token Side Letter, equity is converted into tokens without the need for the investor to buy tokens separately when they become available. Given that the cost is already factored into the convertible equity agreement, there's no need to outline additional payment details.
Consequences:
This approach gives founders more leeway when deciding if they should issue tokens and at what price. For investors, the Token Side Letter is generally seen as the more attractive option since no extra payment is needed for the tokens.
Token Warrant
- The Token Warrant, sometimes referred to as a "token purchase right," allows investors the option to buy a certain number of tokens at a predetermined fixed price or discount rate when the tokens are issued. This means that investors can only acquire future tokens by purchasing them separately (in addition to the SAFE agreement) at a pre-set price or (preferably) at a discount rate.
- The Token Warrant provides a right but not an obligation for investors to buy tokens, giving them the freedom to decide whether they want to proceed with the purchase. The warrant typically sets a time frame following the Token Generation event in which the investor must exercise this right.
Consequences:
Requiring an additional purchase and a deadline for buying tokens can make the Token Warrant seem less appealing for investors, although more often than not the actual discount percentage can be close to 99,95%, making the actual price mostly symbolic. It's crucial to notify investors well in advance about the exact date of the token generation event. They will then be given a specified period to exercise their right to acquire tokens. If they choose to move forward with the purchase, founders should include the investor in the Token Cap Table.
2. Token Issuance and Distribution
Token Side Letter
- The Token Side Letter states that token issuance will occur through a separate Token Issuer Company in the future, shielding the Developer Company from any risks associated with regulatory uncertainty surrounding the legal status of specific tokens in different countries.
- However, due to the Token Side Letter's nature—where equity is converted into tokens without additional payment—the document cannot be assigned to the Token Issuer Company. Transferring the document without requiring further payment for the token would result in a legally impermissible flow of value from one side without any consideration for it from another side.
Consequences:
In the case of Token Side Letters, the Developer Company that signed the document is responsible for converting the document into tokens and distributing them, while not being directly involved in the token issuance, the Developer Company IS responsible for the distribution and therefore associated with the tokens.
Here's how it works: The Developer Company obtains the tokens reserved for investors so they can distribute them accordingly. The same process applies to the distribution of tokens to advisors and team members holding token options.
Token Warrant
- The Token Warrant specifies that the Developer Company, which signed the document, will assign the agreement to the Token Issuer Company once it is established and before tokens are issued. This transfer is possible due to the additional payment for the tokens, as it doesn't lead to one-way flow of value e.g. the flow of value without consideration from the other side which could make the qualification of such an agreement void.
- The Token Issuer Company then sells and distributes tokens directly to investors at the predetermined fixed price or discount rate outlined in the Token Warrant. The Token Issuer is fully responsible for the issuance and distribution of tokens.
Consequences:
By assigning the Token Warrant to the Token Issuer Company, the Developer Company is relieved from any responsibility related to the document's conversion, token issuance, or distribution. This action effectively removes the Developer Company from any association or participation in the token issuance and distribution processes. The Token Issuer Company alone will be held accountable for token sales and will have received the necessary regulatory approvals to organize the distribution.
Why does this matter?
The jurisdiction of the Developer Company plays a significant role in this decision.
For US-based Developer Companies, due to the risks and regulatory uncertainty surrounding the legal status of tokens and the potential for them to be considered securities, it is crucial to be cautious about their involvement in token issuance and distribution. Because using a Token Side Letter gives the Developer Company the responsibility to distribute the tokens, it is highly recommended to use a Token Warrant if you’re operating out of the U.S.
On the other hand, Developer Companies registered outside of the US (e.g., Europe, Asia, or Latin America) have more flexibility in choosing their preferred fundraising document, be it a Token Warrant or Token Side Letter.
3. Terms Concerning the Tokens
Token Side Letter
The Token Side Letter typically does not explicitly state:
- The precise conversion date from equity to tokens
- A fixed token price
- Token capitalization specifics
- Token utilities and their functions
Consequences:
This lack of specificity offers founders the benefit of flexibility during the early stages of their project. They can avoid making firm commitments about their tokenomics while they refine and develop their business model. Companies located outside the US generally prefer the Token Side Letter for this reason.
Token Warrant
In contrast, the Token Warrant often includes pre-defined terms, such as:
- The quantity of tokens allocated for the investor
- A fixed date or deadline for the Token Generation Event
- The purchase price or, preferably, discount rate for the investor's token acquisition
- Details about token transfers, including lock-up, cliff, and vesting periods
Consequences:
Navigating Token Warrants can be a challenge for early-stage projects during development and economic model refinement. For US-based projects using a Token Warrant, it is crucial to adjust and potentially negotiate the specifications with investors before signing to maintain as much flexibility as possible.
This is particularly important for the following reasons:
- Quantity of tokens allocated for the investor: Ideally, this is structured as a conversion formula based on the conversion formula of the SAFE or Convertible Instrument. In this case, founders don't need to define the exact numbers for token distribution. This approach is generally beneficial for projects at the Token Warrant signing stage because the token economics aren't finalized yet and no hard cap has been determined.
- Fixed date or deadline for the Token Generation Event: For projects more than six months away from launch, specifying a fixed date is often unfeasible. Most investors will understand this, so teams should opt for a deadline if necessary (e.g., no later than a year from now). If the investor allows it, it's best not to include any date or deadline.
- Purchase price or discount rate for investor token purchases: The predetermined price should be lower than the standard price during the token generation event, making this sale to the investor a "pre-sale." However, tokenomics are rarely finalized at such an early stage. It may take one to two years between initial fundraising and token issuance, during which market conditions can change significantly, even allowing for new tokenomic models' emergence and adoption. A discount rate is preferred because it requires minimal information about the token price. Assigning a price to the token can have some downsides, including:
- Tokens received with a set price at the Token Generation Event are taxable for founders, employees, and advisors. These taxes must be paid in fiat currency, which can be problematic if the tokens are locked or lack liquidity.
- When the project founders decide on a token price, the tokens may not be regarded as sufficiently decentralized, increasing the risk of being qualified as securities (as in the recent case of Tron).
Key Takeaways:
- Understanding the difference between Token Warrants and Token Side Letter is crucial for projects issuing tokens, as each has its own set of legal and regulatory implications.
- Token Warrants are generally used for projects based in the United States due to the SEC's regulatory framework, while Token Side Letter are typically used outside the U.S.
- Token Warrants require more detailed specifications, such as a fixed date or deadline for the Token Generation Event and the purchase price or discount rate for investor token purchases. These specifications can be challenging to determine for early-stage projects, as the economic model is still being developed and refined.
- It is crucial to negotiate and potentially adjust the specifications of a Token Warrant with investors before signing any agreements, especially regarding deadlines and purchase prices. This ensures flexibility and reduces the risk of complications down the line.
- When setting specifications, it is better to keep information to a minimum and avoid setting a specific token price or network launch date, as it can have downsides such as demonstrating control from a centralized entity, affecting the valuation, and creating tax implications for founders, employees, and advisors.