Token Warrants – How can you use them for crypto fundraising?
In this article, we will understand what token warrants are, how SAFTs vs token warrants perform, and how to allocate tokens to investors.
Equity term sheets are quite conventional. When investing in an early-stage firm nowadays, instruments like a convertible or a SAFE note, the SAFE note popularized by Y-Combinator, are often employed. However, investing in a web3 startup usually employs that startup’s native tokens rather than shares. There are 2 ways of securing funding with such tokens- SAFTs (secure agreement for future tokens) and token warrants. In this article, we will understand what token warrants are, how SAFTs vs token warrants perform, and how to allocate tokens to investors.
Token warrants and crypto fundraising
A token warrant is a broad instrument that protects investors’ rights to potential tokens that will be issued in the future. This document type is a pretty modern concept. Although the SAFE method is a well-known and well-recognized protocol in the investment business, many people may be unfamiliar with a token warrant.
What are token warrants or warrants in cryptocurrency?
The token side letter or token warrant conveys a right to acquire or buy future tokens but not a commitment to do so. The number of tokens available to the investor via token side letter or warrant is equivalent to the amount of equity provided through the SAFE. The tokens are not a substitute for getting firm shares as an investor; rather, they are utilized in conjunction with the standard equity agreement and cap table. While not identical, properly worded token side letters and warrants are meant to accomplish the same result.
Types of token warrants
Warrants are divided into two types- call warrants and put warrants. Let us understand each type in detail.
- Call warrants – When a trader chooses to bet on a rising token and acquires a call warrant, they get the right to purchase a specified number of the underlying asset at a predetermined price or strike price at any time between the purchase date and the expiration date. The value of the call warrant goes up when the value of the asset it is tied to goes up. And if the underlying asset’s value goes down, all you’ll lose is the premium you paid for a call warrant, even if the market goes down a lot. The break-even price is the value above which the call warrant starts to make money. It’s the point where the investor doesn’t make any money or lose any money.
- Call warrant break even = Strike price + (Premium paid / Ratio)
- Put warrants – If the investor anticipates the underlying asset’s price to decline, they must purchase a put warrant. As a result, they will get the power to sell a specified quantity of underlying securities at a predetermined price, or the strike price, at any time between the purchase date and the expiration date. The value of the put warrant goes up when the cost of the asset it is based on goes down. If, on the other hand, the underlying asset rose in price, the put warrant will indeed lose its value, but the loss would be limited to what was paid for the premium.
- Put warrant break even= Strike price – (Premium paid / Ratio)
Advantages and disadvantages of token warrants
There are several advantages of investing in token warrants, such as the potential for high returns, controllable risk, manageable operation, and can work with extreme market conditions. Let us look at each advantage in detail:
- Could produce high returns – Token warrants can be given out at a comparatively minimal cost in private markets to early entrepreneurs or early investors. Prior to purchasing the tokens underlying the warrant, investors can take their time. With time, there is a greater chance that a company’s native token price will rise beyond the warrant’s strike price if the open market behaves in accordance with its rules and fundamentals. Long-term earnings are usually greater for businesses.
- Risk is controlled with token warrants – With a warrant, even if the company tokens are dipping in price, the cost of the warrant or the fee is the maximum loss that remains unchanged by the actual value of the token.
- Manageable operation – Warrants provide flexible operation options as one can work with different strategies to hedge risks.
- Favorable in extreme market conditions – Investors can purchase put warrants when the tokens are at their highest bid and buy call warrants when the value of tokens is declining. In this manner, warrants provide minimal loss and decrease bottom fishing danger.
Despite all these advantages, one must consider the disadvantages before investing in token warrants during crypto fundraising, as mentioned below:
- Restrictions imposed on the strike price – This means that investors may only pick in a passive manner from a restricted range of token values.
- Restrictions due to expiry date – Because of the restrictions imposed by the expiration date, the value of the warrants reduces as the date draws closer.
- Complicated pricing – The price of the warrant is determined by a variety of variables, some of which include the inherent value, the temporal value, and the implied volatility. It is not easy to estimate the amount of profit that will be made.
- High risk – Warrants carry a degree of risk since it is impossible to forecast the value of tokens. If the tokens are unable to achieve the strike price, the investor will get no return on their investment.
Considerations to follow in the issuance of token warrants
When a token warrant is issued, the token warrants agreement comes with the strike price, entitlement ration, and the date of expiration. It is necessary to understand how each of them can play a role in the functionality of your warrant.
- Strike price – It is the fixed price at which the trade is carried out. When the price of the token hits the strike price, the warrant usually becomes valuable. The value of the call warrant increases with the lower the strike. This is because any logical trader would spend more for the right to purchase an asset at a cheaper price than for the right to purchase an asset at a higher cost.
- Entitlement ratio – The number of warrants necessary to convert into a single token at the strike price on the expiration date is referred to as the entitlement ratio. For example, if the entitlement ratio of a warrant connected to bitcoin is 10 to 1, it indicates that after expiration, every ten warrants can be exchanged into one BTC token at the strike price. So lower the ratio, the higher the value of the warrant.
- Expiry date – The greater the period to expiration, the more expensive is the warrant. For example, a call warrant with the strike of $200 can expire on March 30, whereas one with the same strike price expires on April 10; buyers pay a higher cost on call option investment opportunities with a considerable period of time until the expiration date since the underlying asset is more likely to hit or surpass the strike price.
SAFT vs SAFE vs Token warrants
SAFTs or secure agreements for future tokens are security given to investors for the future transfer of tokens from web3 companies. A SAFT differs from a Simple Agreement for Future Equity (SAFE), which enables cash investors to convert their ownership in a firm into equity at a later date. Developers utilize the proceeds from the sale of SAFT to build the network and technology needed to produce a functioning token, and then they sell these tokens to investors with the hope that there will be a market for these tokens.
Furthermore, SAFT is a non-debt financial product. Investors who acquire one risk losing their money and having no remedy if the enterprise fails. The document merely permits investors to acquire a financial interest in the endeavor, exposing them to the same enterprise risk as if they had bought a SAFE. However, this is unlike the token warrants in which the maximum loss during the failure of the tokens or venture is simply the cost of the warrant.
Token side letter/token warrant for fundraising
Each investment document’s job is critical. It must strike a balance between the interests of founders and investors. The primary goal for founders is to get funding while maintaining control of the firm and avoiding undue dilution of their shares. The aim for enterprise investors is somewhat different- to maximize their chances of earning a return on their investment. Let us understand how a token side letter/token warrant can be used for fundraising.
Consult with your legal advisers to determine if a token side letter or token warrant is appropriate. Based on the legal language, there are distinctions between token side letters and token warrants.
Token warrants with SAFE
When the company founders have assembled their dedicated team and progressed their project to the “Proof of Concept” phase, they should proceed to seek their initial investors, add more employees, and produce a complete product. The founders often do not have a full White Paper with established tokenomics and a token distribution strategy at this level; however, these stages may still be sketched out in the startup’s Web3 roadmap. As a result, many investors recommend that startup companies structure their investment by signing a SAFE or another regular convertible instrument with a Token Warrant, which promises the investor the right to obtain tokens in the years ahead if they are released.
How to use token warrants for fundraising
The Token Warrant or Token side letter is a document that assures the shareholder of its privileges to tokens that will be issued in the years ahead. It does not specify the quantity of the issued asset, the investor’s sharing, the value, or any other important terms; rather, it only promises the investor’s entitlement to receive these tokens in ratio to its investment.
- Take legal advice – When fundraising with token warrants, it is necessary to consult with experts. Every creator must address the legal issue of funding. It is complicated, highly leveraged, and always entails balancing many parties. Founders prefer to keep costs as low as possible; however, investors are more worried about legal risk. Consult with your legal counsel to develop the best plan for your case and fundraising needs.
- Develop a potential token allocation plan – Create probable token allocations considering recent token launches and standards. Keep in mind that this might alter substantially in the future. As an early-stage firm lacks product-market fit or a strong user base, determining the future tokenomics or token utility model could be difficult. Since your token approach and business strategies are sensitive to changes, keep as much flexibility as possible for future token distribution and as little token dilution as possible.
- Use the right pro-rata right method – Compare the results of the token allocation with the three different kinds of token pro-rata right approach: company allocation method, fully diluted supply method, and conversion rate method to determine which token pro-rata right method to apply.
- Understand negotiation leverage – When it comes to fundraising, it is important to have a clear understanding of how much bargaining power you have, as well as whether you need investor-preferred conditions or founder-friendly terms for the token side letter in order to successfully seal the transaction.
- Draft an agreement – Before you begin the fundraising process, ensure that the documents for your token side letter are ready to go and include the parameters you desire. The drafting and negotiation of token side letters may take several days to several weeks, which might delay the closure of a crucial investment agreement.
How to negotiate equity and token valuation with investors?
In the negotiation process during crypto fundraising, several investors emphasize signing a Token Warrant as an annexure to the SAFE due to the reasons listed below:
- Investors want assurances during crypto fundraising that if for whatever reason tokens cannot be issued in the coming years, they will at least obtain the company’s shares. This is especially important at the initial stages of Web3 growth of the venture when the venture hasn’t issued tokens, the tokenomics are not finalized, and the founders themselves are unsure if they will even issue tokens. These stocks serve as a kind of “insurance” or “guarantee” that the investment company will get their portion of the business, protecting their entitlement to a return on their capital.
- Early on, the investor may be aware that the kind of token the founders may create may need specific legislation, and as a result, the emerging company’s jurisdiction may not be appropriate for the token’s issuance and distribution. The Token Warrant, in this instance, will enable the project to establish a separate business later on, to distribute and transfer tokens to the investor in a legal manner.
The founder should convey the essence of the company and how value can flow into tokens, equities, or both tokens and equity. Based on this information, investors will arrive at a value for both the shares and the tokens. As part of this procedure, investors price the equity value in the event of no token launch to ensure that their investment is safeguarded.
You want to establish a value reference while fundraising by looking at similar firms with recent funding. Your current momentum, staff, approach, and sector could all produce different values, and similar firms in your unique sector may be leveraged to help you negotiate. Ensure the business, and the investors agree on the price of the shares and the tokens together to avoid incorrect token side letter conditions, which can lead to postponing completing the transaction due to valuation mismatch.
Get your crypto asset valuation with the expert team of Eqvista!
Eqvista can assist you if you need legal assistance with the funding procedure for a Web3 firm. You may find out how much your company is worth with Eqvista by doing a professional business valuation, which is a technique for determining a firm’s economic value. A business valuation can help you determine the worth of your firm, assets, revenue, and other elements. Eqvista’s highly qualified valuation team can help you establish the value of your tokens as well as the reasonable conditions for token side letters and warrants. Please contact us to learn more about our valuation services.