Raising funds for a project via the combination of a SAFE and a Token Side Letter or Token Warrant has gained traction as an alternative fundraising approach to SAFTs. The SAFE instrument, pioneered by Y Combinator, is designed to simplify early-stage investments. It represents a promise of future equity in the project rather than a direct investment in tokens. When paired with a Token Side Letter or Token Warrant, this fundraising structure extends the offering beyond equity and provides investors with additional benefits related to the project's token and securing their right to receive future tokens if they are released.
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What is a SAFE
First let’s briefly look at the SAFE (Simple Agreement for Future Equity). A SAFE is a streamlined and standardized investment agreement used in startup fundraising, including in the blockchain industry. It represents a promise by the company to issue equity to the investor at a future triggering event. SAFEs simplify the fundraising process, they offer investor protections, and allow for customization. It is a standard and mirrors any other equity financing round in “conventional” companies where companies and investors agree on a valuation, round size, and individual investment amounts. For web3 projects the Developer Company (DevCo) which is set up at the early stage of a project's development by the founders operates as the shareholding company. It has an equity cap table which is a record of the ownership interests in the company, detailing the allocation and distribution of shares among the founders, investors, employees, and any other stakeholders. It provides transparency and clarity regarding the ownership percentages and rights associated with the shares. In order to fundraise via a SAFE the Equity Cap Table needs to be in place.
Please find the following two helpful links:
Convertible Note as an alternative to the SAFE
An alternative to raising via a SAFE is the Convertible Note. A convertible note is a financial instrument commonly used for start ups to raise capital from investors. It is a debt instrument that provides the investor with the right to convert their debt into equity at a future date or under specific conditions. It combines elements of both debt and equity financing. When a blockchain project or network seeks funding through a convertible note, investors provide capital in the form of a loan, which is documented in the convertible note agreement. The key feature of a convertible note is the conversion option, allowing the investor to convert their loan into equity of the issuing company or tokens of the network if a token is launched in the future.
Convertible notes are particularly useful in the early stages of a blockchain project when valuation and the corresponding equity terms may be uncertain or difficult to determine. By using convertible notes, companies can postpone the valuation discussion to a later stage when there is more clarity and information available. This provides flexibility for both the company and the investor in terms of setting the valuation and determining the conversion terms based on the project's progress and market conditions. As a result of this, convertible notes can expedite the fundraising process as they require less documentation and negotiation compared to a traditional equity financing round.
Convertible notes provide simplicity, flexibility, and a faster process compared to negotiating a priced equity round, which aligns with the preferences of many European investors. Therefore, if the team and company is based in Europe consider using a Convertible Note opposed to a SAFE. Convertibles are considered more suitable for European teams compared to US teams due to differences in investment and regulatory practices including stricter regulations when it comes to securities laws and the association with tokens by the US DevCo as a Convertible instrument in the context of blockchain networks is usually converted into tokens by the company that signs the document in order to redeem the debt. This should be avoided by teams located in the US.
When to use SAFE/Convertible Note + Token Side Letter or Token Warrant
Whereas equity represents an investor’s ownership in a company, tokens represent ownership in a decentralized network. This is where the addon of the Token Side Letter or Token Warrant comes in. The combination of equity and token warrants is ideal for founders who believe there is a possibility, no matter how small, of issuing a token in the future. If a project is completely certain that it will not issue a token, it is advisable to solely rely on traditional equity.
The SAFE + Token Side Letter or Token Warrant are usually used during the early fundraising stages from Pre-Seed to Seed rounds starting up to two years prior to the network's launch (if a network is launched). At this stage it might not be clear whether there will even be a network token, neither are detailed white papers and tokenomics fully developed. In summary, the main reason to raise via equity (SAFE) + providing investors with right to receive future tokens if they are released (through the Token Warrant or Token Side Letter) is that it gives a lot of flexibility in the project’s future plans opposed to raising funds by pre-selling tokens via a SAFT. Because: Moving from equity to tokens is possible, moving from tokens to equity is not. Once a team has pre-sold tokens via a SAFT it can't backtrack, read more about how SAFTs are structured in the following article: Understanding SAFTs.
Which one should be used?
When choosing either of the two instruments in addition to the SAFE, a few factors play in, preliminary it depends on the jurisdiction of the Developer Company which is the shareholding company that signs the SAFE + Token Warrant or Token Side Letter agreements with the investors during the fundraising.
The DevCo is usually registered in the country where the founders are located or an IT/IP-friendly country such as the USA (Delaware), the UK, UAE, Singapore, or Estonia. The jurisdiction of registration plays a crucial role in determining choosing between the Token Side Letter or Token Warrant. It comes down to two routes:
1. DevLabs registered in the U.S. (usually registered as a Delaware C-Corp)
2. DevLabs registered in other jurisdictions outside of the US (UK, Singapore, Hong Kong, or one of a handful of European countries)
Route 1: Dev Co Registered in the US:
If the DevLab is registered in the U.S. a founder should strongly consider using a standard SAFE document together with a Token Warrant and not Token Side Letter because of regulatory uncertainty, particularly concerning the legal status of tokens in the U.S., as well as the high risk of tokens being considered as securities. Due to these risks American companies such as Delaware C-Corps should be very careful about how they participate in the distribution and sale of tokens. Using a token warrant alongside the SAFE reduces the chances of falling into a regulatory pitfall.
How does a Token Warrant solve this?
The token warrant provides investors with a right to purchase tokens in the future at a predetermined price or with a predetermined discount. Due to the nature of the purchase agreement, where there will be an additional payment needed for investors to be able to receive the tokens when they are launched, the Token Warrant can be assigned to a separate company, typically a Token Issuer Company (Token SPV) that takes care of the token distribution and exercising the warrant. When the token warrant is executed during the token launch, the investors will be making a transaction with the Token SPV (not the Developer Company) which will then issue the tokens to the investor. As a result, this process completely excludes the American company from the token distribution process and the Token SPV will be solely responsible for the distribution of tokens.
A Token Side Letter on the other hand cannot be assigned to another company as there is no additional purchase. Token Side letters convert equity into tokens without additional payment. The reason that a Token Side Letter cannot be transferred is because without requiring further payment for the token results in a legally impermissible flow of value from one side without any consideration for it from another side. It therefore is not possible to transfer a Token Side letter to a Token Issuer Company and the company signing the Token Side Letter will be responsible for distributing the tokens to investors. More on this in the next section.
Route 2: DevLabs registered in other jurisdictions outside of the US
If the DevLab is registered in a non-US jurisdiction (in Hong Kong, the UK, and some European countries) and the DecCo will have more flexibility in choosing between the Token Warrant and a Token Side Letter because outside of the U.S. the applicable laws are more flexible and more certain. This means Dev Cos located outside of the U.S. can be partially involved in the distribution of tokens as follows:
- The Dev Co can receive and hold the token pool that is reserved for the founders, advisor and teams and can distribute them by converting token options
- The Dev Co converts token options into tokens for founders, advisors, and team members
- The Dev Co can convert Token Side Letters and distribute tokens to investors
The Token Side Letter does not involve any purchase or sale and therefore the DevLab is not involved in a token sale (the paid token transfer) but instead it covers only the conversion of the fundraising instrument. As mentioned, due to “lighter” regulations opposed to the US, the distribution of tokens for team and investor pools it receives via the genesis distribution. In this scenario, the set up of a Token Issuer Company might not be required which can save the project significant legal cost in setting up a Token Issuer Company and acquiring all the needed documents to fulfill a compliant token sale to the investors.
In summary, if a DevLab is registered in the US, then it's best to use a token warrant along with SAFE. If founders have registered the DevLab outside of the US (i.e. in Europe or elsewhere), then they have more flexibility in choosing between the token side letter and the token warrant to sign along with SAFE. To take a deeper dive into the specifications of the Token Warrant and the Token side Letter, please view the following article: Token Warrant vs. Token Side Letter: Understanding the Key Differences
As a result of these distinctions, US teams and non-US teams go separate routes in their incorporation roadmap due to the fact that non-US teams don’t need to set up a Token Issuer Company (Token SPV). Please view more about this topic here: Incorporation Structures for Cosmos SDK Chains and dApps with tokens