Token Warrants: Insights & Legal Considerations
As Web3 ecosystems and decentralized finance (DeFi) projects continue to grow, the demand for innovative Web3 fundraising tools is now higher than ever. One of the most used tools – Token warrant – has become a standard form of legal agreements for projects seeking to attract investors while ensuring flexibility in token issuance. This guide will explain what token warrants are, how they work, their uses, and why they offer benefits to both Web3 projects and investors in the Web3 space.
What Are Token Warrants?
At its core, token warrant is a financial agreement that gives the investor the right—but not the obligation—to purchase a specific number of tokens at a predetermined price on a future date. Token warrants operate similarly to traditional stock warrants, where investors have the option to buy company shares in the future at an agreed-upon price. However, token warrants specifically apply to blockchain-based projects and tokens rather than stocks.
Token warrants are often issued to early-stage investors in blockchain projects as part of raising funds, such as Initial Coin Offerings (ICOs), grant programs, and venture capital deals.
The tokens tied to the token warrants can represent various forms of value within the project, such as governance rights, access to a platform’s utility, or ownership stakes in a decentralized protocol.
The flexibility and future orientation of token warrants make them an appealing option for projects looking to secure financing prior to the token issuance and for investors wishing to secure their position with a promising project at an early stage.
Token warrants are often used together with an agreement for future equity (SAFE) or a convertible loan. This combination is commonly used in the situation where the investor shall have the right to choose in the future whether they want to have an equity in the project or the tokens. Such combination can increase project’s attractiveness for the early-stage investors in the volatile and rapidly changing crypto space.
How Do Token Warrants Work?
How token warrants work is similar to stock warrants, but with some distinct differences relevant to the blockchain space. When a company issues token warrants, it typically grants the recipient the right to buy a predetermined number of tokens at a set price within a specified time frame. The investor is not obligated to purchase the tokens, but they have the option to do so. This right – rather than an obligation – is one of the key differences between the token warrant and a simple agreement for future tokens (SAFT) which normally includes an obligation of the contribute to purchase tokens under the terms of the SAFT.
Consider a scenario where a Web3 project issues token warrants to an early investor. The company may set the warrant price at $1 per token, with the right to exercise the warrant within three years. During this period, the investor monitors the token’s market performance. If, after three years, the token’s price has risen to $5, the investor can exercise the warrant, purchasing tokens at the original $1 price and potentially profiting by selling them at the market price.
Another common use case is when the entity that shall issue the token is not incorporated yet or when the tokenomics are not finalised yet. In this scenario the investors are uncertain whether the genesis event (token generation event) will ever occur and what the functionality of the token will be. They therefore might want to monitor the development of the project first. A simultaneous convertible loan might at the same time secure the investor’s equity rights there by increasing investor’s interest in the project overall.
In addition, smart contracts are often utilized to automate the execution of token warrants, ensuring that the terms of the agreement are followed securely and without the need for intermediaries. This allows for a seamless and efficient exercise of warrants when the conditions are met, aligning with the decentralized ethos of blockchain technology.
The Use of Token Warrants in Web3 Fundraising
Token warrants have become a common feature in blockchain fundraising strategies due to their unique advantages. They are often used in:
1. Venture Capital Deals
In venture capital deals, token warrants are frequently issued to incentivize early-stage investment. Many blockchain startups seek funding from venture capitalists or angel investors to get their projects off the ground. By offering token warrants instead of immediate token ownership, startups can get the necessary funding during the development stage of the tokenomics. This allows projects to bridge the development phase and prepare a stronger launch.
2. Initial Coin Offerings (ICOs)
Token warrants are also used during token sales, such as ICOs. Instead of immediately selling tokens to investors, a project might issue token warrants, giving investors the right to buy tokens at a future date once the platform is more developed. This ensures that tokens to investors are only distributed when they are most likely to have utility or value, rather than receiving them during the early, speculative stages of the project.
3. SAFE Agreements
Token warrants are often paired with SAFE (Simple Agreement for Future Equity) agreements, particularly in Web3 fundraising. In these agreements, instead of receiving equity, investors receive the right to purchase tokens at a future date through a token warrant agreement. This is beneficial for startups because it avoids initial dilution of token supply and gives them more control over their token issuance strategy.
Why Are Token Warrants Beneficial?
Token warrants provide several key advantages for both token issuers and investors. These benefits explain why this tool has become so prevalent among the Web3 investment instruments. Let’s look at the core token warrant benefits:
Benefits for Startups
- Attractive to Investors: Token warrants are an attractive proposition for investors, increasing their flexibility in investment. Offering the possibility of purchasing tokens in the future at a favorable price gives investors a reason to contribute early, even if the immediate risks of holding the tokens seem high. This can help startups raise capital without immediately distributing tokens.
- Better Control of Tokenomics & Reduced Dilution: token issuers can strategically control the timing of their token issuance by utilizing token warrants. Premature allocations of tokens can be disadvantageous as they might reduce the token supply to a higher extent than optimal. For the entrepreneurs, issuing token warrants helps avoiding immediate dilution of their token supply and (if any) governance rights. By the time the token launches, the startup’s token economy may be more stable, and the project might have proven its viability to investors and the market.
- Alignment of Long-Term Goals: Token warrants help ensure that investors remain aligned with the long-term goals of the project. Since the tokens aren’t issued right away, investors are incentivized to stay with the project until it reaches its next stage of development, ensuring their commitment to the project’s success.
Benefits for Investors
- Reduced Risk Exposure: For investors, token warrants provide an opportunity to secure their participation in a project’s success on more flexible terms. By securing the right to purchase tokens in the future, investors can wait to see how the project evolves before deciding whether to exercise their warrants. This reduces the risk of investing in early-stage Web3 projects.
- Potential for Higher Returns: The speculative nature of crypto assets (including digital currencies) means that token prices can fluctuate significantly over time. If the project achieves its development goals and the token’s market value rises, investors who hold token warrants can purchase the tokens at the previously agreed-upon price and potentially sell them for a substantial profit.
- Flexible Investment Strategy: Investors can negotiate the terms of the token warrant, such as vesting schedule, pricing and limitations on transferability) at an early stage of the project. By doing so, they secure that their interested and the investment strategy are adequately mirrored from the outset.
- Alignment with Project Growth: By holding token warrants, investors can benefit from the long-term growth of the project. The warrants are typically structured to align with project milestones, ensuring that investors only acquire tokens when the project has demonstrated the desired progress. This makes token warrants a useful tool for long-term investment opportunities in blockchain projects.
Token Warrants vs. SAFT Agreements
While both token warrants and SAFT agreements are used in blockchain fundraising, they serve different purposes. A SAFT agreement typically contains an obligation of the investor or contributor to purchase tokens at a future event, such as a financing round or token launch. In contrast, a token warrant grants the right to purchase tokens at a predetermined price in the future. Both instruments offer flexibility but are structured differently depending on the investor’s needs and the project’s goals. This difference can influence how a project’s fundraising is structured and how the investors are aligned with the project’s success.
Regulatory Considerations for Token Warrants
Despite their benefits, token warrants exist in a complex regulatory environment. Crypto regulations vary significantly by jurisdiction, and the web3 projects must ensure they comply with local laws when issuing token warrants. In some regions, token warrants may be classified as securities, subjecting them to stricter rules and reporting requirements. It’s important to remember that this blog post is for information purposes only, and legal advice should always be sought when navigating the regulatory landscape of token warrants.
While some countries, such as Switzerland, have embraced token-based fundraising and established clear regulatory frameworks, others remain cautious or uncertain. This regulatory uncertainty can create challenges for startups issuing token warrants, especially when dealing with international investors. It is essential for projects to understand the specific legal requirements in each jurisdiction where their investors are located, as compliance failures in one region could impact the project globally. Failing to comply with securities laws can result in significant penalties and could jeopardize the future of the project. This is why working with an experienced legal team at the beginning of the project is crucial for navigating the regulatory landscape and for the future success of the entire venture.
Conclusion
Token warrants have become an essential tool for fundraising and investment in the Web3 space.
They provide startups with a flexible tool for raising funds in the early stages of their project, enabling more powerful development capabilities and alignment with the investors on their long-term goals.
For investors, token warrant offers a unique opportunity to secure a future stake in promising blockchain projects while balancing the immediate risks associated with holding tokens during the early, volatile stages of development.
As the regulatory environment surrounding cryptocurrency continues to evolve, it is crucial for both startups and investors to stay informed about legal requirements associated with each particular project.
Token warrants, when used correctly, represent a powerful instrument for project’s growth, benefiting both sides of the investment equation. Always consider seeking legal advice before entering into a token warrant agreement or any related financial instrument.
