Important Web3 Fundraising Documents to Know
In this article, we will discuss different types of investment documents for web3 startups and how to choose the best fundraising document.
For web3 entrepreneurs to raise money, they need web3 fundraising documents that will help in getting funding without ceding too much control of the business or diluting their ownership too much. For venture capitalists, the objective is somewhat different; to offer themselves the best possibility of profiting from their investment. The token is the asset in Web3 businesses that gives the potential for a return on investment. Every Web3 investor thus wants to ensure and legally safeguard their token rights when selecting an investment instrument. In this article, we will discuss different types of investment documents for web3 startups and how to choose the best fundraising document for a web3 startup.
Web3 fundraising documents
The web3 fundraising documents that are used by investors and founders must represent and safeguard the many goals that they want to accomplish. There are a few possibilities for various legal instruments that both parties can select from in financing for Web3 startups depending on their respective objectives and the stage of growth that the Web3 business is at when the fundraising occurs. But before we dive into that, let us understand the basics of web3 and web3 startups.
Understanding web3 and web3 startups
Web3 is a special kind of decentralized Internet environment built on blockchain technology. It incorporates concepts like decentralization, blockchain technology, and token-based economies and is sometimes referred to as Web 3.0. Data ownership changes with Web3, transferring it to the users, making it a profitable business platform for start-up enterprises. Users can invest in crypto tokens, commercialize their data, and create financial assets owing to Web3 businesses.
A Web3 startup is a business that uses Web3 technology to operate its functions and is still in the early phases of development. Blockchain technology, on which Web3 is built, is more affordable, promotes a decentralized structure, increases user safety, and makes ownership easier. Decentralization increases the availability and transparency of the blockchain platform and affects everything from commercial payments and interactions to data security, giving businesses a competitive edge.
The need for funding for web3 startups
Like any traditional web2 startup, web3 startups need funding to develop their project, grow in the market, and enhance their operations to scale the business. Investors also offer their expertise and network to grow further and find success. Recently, some crypto businesses received money from well-known venture capitalists, and over $100 million flooded into the industry.
As per Eric Chen, the CEO of Injective Labs, businesses need the funds to create the ideal setting for decentralized finance (DeFi) apps. Additionally, they streamline the funds to equip themselves with talented employees and focus on business development and rolling out their products to the public. Additionally, funds have been invested in Web3 businesses that are creating tools for the creative economy.
Chen also explains the funding helps Injective Labs to move in the direction of a general-purpose [layer-1] blockchain with decentralized financial applications that are sector-specific. Investments help developers that wish to create a feature that only the core modules or core stack of the company can provide.
What do investors look for to fund Web3 startups?
Traditional venture capitalists have established a decision-making framework to swiftly pre-screen firms before beginning a formal evaluation procedure. Each year, they typically screen hundreds of investment proposals. Although there will be variances in the specifics, Web3 startups can usually comply with the same parameters. The deal flow pipeline for a hypothetical venture capital company is shown in the graphic below, along with the parameters that are used to sort possibilities at each level of review.
Many of the requirements are evident and don’t significantly differ for Web3. For instance, characteristics like the track record of the founders, the potency of the product, or the go-to-market (GTM) strategy are equally crucial for Web2 and Web3 firms. Defensibility and transaction structure, however, have a distinct dynamic in Web3.
Fundraising documents web3 startups need
When investors fund web3 startups, they need web3 fundraising documents to ensure their legal rights to the tokens are secured and guaranteed. There are a few possibilities for various legal web3 fundraising documents that both parties can select from depending on their respective objectives and the stage of growth that the Web3 business is at during the fundraising:
Token warrants are standardized investment documents that ensure investors’ rights to tokens that will (or could) be created in the future. Token warrants are a recent concept of investment documents and are less known compared to SAFE. However, they work similarly in function and allocate future tokens instead of equity rights.
How does it work?
Token warrants grant the holder the right but not the obligation to purchase tokens in the future. It just establishes the investor’s entitlement to receive these tokens proportionate to their investment; it makes no mention of the issue’s amount, the investor’s allocation, the price, or any other essential terms. The tokens are used in addition to the typical equity agreement and cap table, not as a replacement for purchasing business shares as an investor. While not identical, correctly written token warrants are intended to achieve the same goal as SAFE, which provides firm ownership in exchange for financing.
A Simple Agreement for Future Tokens or SAFT is a contract that is typically signed by a startup that has already made a decision regarding the kind of tokens it intends to issue, has described the tokenomics, and has developed a token distribution plan, which includes prices and phases of allocation. A SAFT agreement is only made after a White Paper that explains the aforementioned is released.
How does it work?
To construct a full-fledged SAFT, a thorough White Paper with descriptions of tokenomics, token distribution strategies, and token use cases is required. When SAFT is utilized as a tool to solicit funding for a Web3 company, it should be combined with the following three other tools:
- A complete White Paper with full tokenomics that is useful or almost finished.
- A fully prepared Token Distribution Company, on whose behalf the signing of SAFT will take place and which will distribute tokens to the investors in accordance with the outcome of the conversion of the SAFT.
- A specific event or period that will serve as a trigger in the SAFT for the issue of tokens and transfer rights to investors.
Token sale agreement
Except for the absence of a specification of the conversion event and the inclusion of a specific date for the distribution of tokens to investors, the Token sale agreement’s essential provisions are almost identical to those of the SAFT. The token sale agreement is made at a more advanced stage of a Web3 project’s development, and the investment sums are rather substantial.
How does it work?
The issue of token issuance will be the main factor used by the Web3 founders to decide whether it is preferable to sign a SAFT or a Token Sale Agreement (TSA). For the aim of fundraising for Web3, founders should take into account the Private Token Sale Agreement if the tokens are already created, and the distribution process via a private or public sale, airdrops, the release of token options, etc., is underway. When signing a Token Sale Agreement, investors often inquire about gaining ownership of the business and getting tokens. Therefore, there are two approaches to it.
- Startups with no plan of establishing a DAO after distributing tokens – If Web3’s creators want to centralize token issuance and distribution without a decentralized autonomous organization (DAO), investors can seek ownership over the Token Distribution firm at later levels of investment. Investors arrange these powers as a veto on specific corporate actions or a list of reserved topics requiring investor assent. Investors can also claim Token Distribution shares to retain control. In such circumstances, the Subscription (Share Purchase) Agreement and Shareholders Agreement are also signed together with the Token Sale Agreement.
- Startups distributing tokens to establish a DAO – If the Web3 startup wants to “decentralize” the governance by forming a DAO later, it will be crucial for an investor to know how DAO members will be chosen and how their governance rights will be organized. If the rules permit the issuing of administration tokens for DAO members or the reception of Liquidity Provider (LP) tokens by current stakeholders, investors will seek to retain the rights to such tokens to become DAO participants and engage in its governance. This could be expressed in the Token Sale Agreement or the constitution of DAO.
How can web3 startups approach fundraising?
There are a variety of tactics web3 startups can and should adopt in order to get funding offers on the table. In the end, it comes down to striking a fine balance between weighing the numerous fundraising alternatives accessible and understanding which methods to use or disregard along the route.
- Be open to all investment sources – Starting small and working your way up is a good strategy when looking for financing. Speak with individual authorized investors in the cryptocurrency industry. Also, keep incubators and accelerators in mind. In the past, accelerators like Y Combinator had a more preparatory function by offering courses to enhance entrepreneurs’ business knowledge. However, in more recent years, they have evolved into a vital tool for linking entrepreneurs with a network of investors.
- Show balanced skills in business – Investors want a skilled founder who can bridge the gap between generalist and sector-specific talents while also effectively representing the firm. Entrepreneurs in the web3 field must be knowledgeable about business in general as well as cryptocurrency, blockchains, NFTs, or whatever their specific technology is. Potential investors may be turned off by an imbalanced listing.
- Pitch everyone – The more you pitch, the better your possibilities. When you cast, you never know who is going to bite. Don’t rely only on cryptocurrency investors who made their money from coins. Traditional VCs often possess the tenacity to remain on board through any type of challenging market. Investors in traditional finance are hard to frighten; they will always increase fiat. They are far less susceptible to the anxiety of a downturn than some DeFi investors are since they do not individually choose which currency to purchase. Don’t rule them out as potential sources of funding and connections.
Important considerations web3 startups must follow to get funding
Many Web3 initiatives intend to attract venture financing to drive their development, and the venture market currently has an increasing number of Web3 funds. Each Web3 fund selects startups internally. Web3 entrepreneurs must consider the following activities if they want VC financing-
Due diligence of web3 startups is the negotiation and verification process of web3 fundraising documents to conclude an investment agreement. It includes:
- Examining the documentation for tokens
- A review of the authorizations and licensing that the business issuing the tokens must receive.
- Evaluation of the token issuer company’s statutory papers and proprietary information if investors plan to invest in tokens and company shares.
Token cap table
Tokenomics requires a Token Cap Table that discusses the total token emission, token pooling, and distribution techniques. The project’s Token Cap Table includes and clarifies the following:
- The number of tokens the project intends to issue and their estimated value.
- The number of tokens an investor can obtain for their contribution, as well as the creators’ proposed token distribution strategy inside the pools.
- The number of tokens founders allot to themselves and if they have a framework in place to motivate employees, such as a token incentive program.
The first two elements are critical for analyzing the project’s tokenomics since only a good tokenomics plan can assure consistent token demand and investment returns. The third factor tells the investor whether the Web3 company team is motivated and if the number of tokens earmarked for founders could become a cause of market manipulation.
Token legal status
Investors check the Token’s Legal Status after reviewing the Token Cap Table. Token Legal Opinions, written by a certified lawyer and including the legal qualification of the token, are often requested from the Web3 startup founders. Investors want to be confident the token’s legal status and legal repercussions won’t hinder its liquidity. Due to the token’s financial instrument qualities, crypto exchanges may agree to remove it. Investors seek assurances authorities won’t prohibit the token. Token Legal Opinion provides some legal protection for investors.
Assume the Web3 fund is ready to fund the Web3 startup by investing in tokens and shares or equity. In such an instance, the investor’s attorneys will also want an Equity Cap Table, which details how Token Issuer Stock holdings are split among founders and team members. They will also want supporting documentation proving that any intellectual property associated with the project has been awarded to the firm.
No investor likes to pay penalties. No investor wants their investments linked to laundering money or other financial law crimes. Improper regulatory compliance can result in the need to refund all collected money and cancel the project, as well as financial and criminal liabilities, thus, investment attorneys will pay special attention to these issues. Investors discuss three principles to prevent risks before finalizing their investment:
- The process through which the team selected the crypto-friendly jurisdiction for the startup.
- Whether the Company has met all of the regulator’s criteria before issuing tokens, including obtaining all applicable authorizations and licenses.
- If the Token Issuer Company has adopted KYC and AML rules and procedures to validate token holders and their transactions.
The founders and investors draft investment documents following conducting Due Diligence and finalizing the Term Sheet. The bundle of investment paperwork will vary depending on whether the investor wishes to invest just in tokens or in tokens plus shares and finalize between token warrants, SAFT, or token sale agreement.
For an investor interested in tokens and not shares, The investment agreement depends on if the tokens have already been released or whether the enterprise will issue them later. If the business has already issued tokens, a Private Token Sale Agreement outlines the number of tokens investors can redeem, their value, and lockup terms. SAFT is utilized if tokens aren’t issued at the moment of investment.
In traditional venture investing, a fund’s investment in a company is a monetary investment in the business’s capital or shares and is thus tax-free. The scenario is different when investing in a Web3 business since contributions are often made via token purchases, which, according to their legal status, can be either digital products or securities. Although there are no financial repercussions for the investor as a result of this transaction, the investor must ensure that:
- The team has performed the relevant tax analysis.
- They are aware of the taxes that could be owed on token sales.
- Obtain assurance from tax professionals that no tax liabilities would materialize.
How can founders choose the best fundraising document for their web3 startup?
When it comes to fundraising, there are three situations in which a Web3 project can find itself:
- You’re just getting started with your business; you do not yet have a licensed token issuer or any defined tokenomics. A SAFE/Convertible Note + Token Warrant will probably be the best choice in this situation.
- You are prepared to issue tokens since you have a finished white paper, a registered token distribution business, and an estimated issuance date. The SAFT could be the best course of action in this situation.
- A Token Sale Agreement (TSA) will be the best choice if you have already issued a token. Whether or not you intend to create a DAO may affect the conditions and related documentation.
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