a16z: Token Rights in Investment Terms—How to Avoid Predatory Deals?
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a16z: Token Rights in Investment Terms—How to Avoid Predatory Deals?
Founders should avoid granting investors fixed, non-dilutable token rights or unsustainable percentages of the network.
Navigating Web3 tides with focused insightsAuthors: Miles Jennings, Joseph Burleson, Zachary Gray
Translation: TechFlow
Executing a successful token launch is a complex process that requires extensive strategic planning and some luck. However, before a project launches its token, an improper token rights structure can undermine its future prospects. Structuring legal rights related to tokens during early funding rounds is highly nuanced, and the lack of clearly defined market standards may allow certain investors to exploit unsuspecting founders.
To help founders better understand the market and ensure fair and sustainable deal structures, below are our foundational principles for defining token rights and limitations. We also highlight predatory behaviors by some investors, discuss how these actions harm projects, and provide explanations of the terms we use.
Incentive Alignment: The Key to Success
Incentive alignment between founders and investors is critical to any venture’s success. Misaligned incentives can lead to distrust, inefficiency, and constrained options for the project. Incentive alignment—by definition—helps ensure everyone moves in the same direction.
In traditional equity structures, incentive alignment is straightforward: if the company becomes more valuable, both investors and founders benefit. But in Web3, the introduction of tokens complicates this alignment. Web3 projects deploy blockchain systems that are open-source, decentralized, and often designed to accumulate value in the system’s token rather than in the company developing the technology—a subtle but important distinction. This design shifts value away from equity, creating misalignment between token holders and equity holders.
This misalignment most commonly arises when early-stage projects fundraise solely by directly selling tokens to institutional and angel investors, which can result in two key issues:
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Investors focused solely on tokens often have shorter investment horizons and typically pressure projects to launch tokens quickly for faster returns. This undue pressure can limit the project’s potential, leading them to take actions harmful to their ecosystem—such as launching a token prematurely.
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Selling token rights reduces flexibility in overall design. When investor expectations can only be met through tokens, projects tend to prioritize token launches and token value accrual. However, tokens may not be the optimal path for every project, and some require more time to ensure economic balance. Losing the flexibility to pursue alternative paths can damage long-term success.
Therefore, early-stage projects are best served by balanced deal structures that give all stakeholders exposure to both equity and tokens. By maintaining alignment between investors and founders, projects retain the flexibility to design their systems optimally and allow value to accrue to tokens, equity, or both. With aligned interests, both parties can focus on sustainable growth and long-term success.
Even when early-stage projects use balanced deal structures, incentive misalignment can still emerge after a public token launch: some may hold only tokens, while others hold both tokens and equity. Due to this potential misalignment, projects must guard against conflicts of interest. In some cases, projects might shut down the development company, meaning all stakeholders become token holders. In other cases, it may be beneficial for multiple companies to actively build and compete using the project’s technology; in such scenarios, the project should prioritize creating a level playing field, establish procedural incentives, and even consider imposing strict, milestone-based token sale restrictions on employees, investors, and other insiders of the original development company to protect token holders. In most cases, the project’s intellectual property should be controlled and owned by token holders.
Predatory Practices and How to Avoid Them (with Sample Terms)
Below are several provisions used by a16z Crypto and other major crypto venture firms to maintain incentive alignment with founders.
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Token Rights
Founders should avoid granting investors fixed, non-dilutable token stakes or unsustainable percentages of the network. These predatory terms restrict a project’s flexibility and future growth potential. If a development company has granted existing investors non-dilutable rights to X% of a token’s total supply, they may find it difficult to raise additional funds without offering identical non-dilutable terms to future investors. Such terms could constrain fundraising options or ultimately reserve an excessive share of the token network for investors—forcing founders to sacrifice builder incentives, whether for the community, development team, or both.
Founders should also be wary of venture firms demanding token payments in exchange for assistance with a token launch. In such cases, there are usually two truths: first, you don’t want their help; second, they are likely “value-extractive” actors who will attempt to dump their tokens early.
Fixed token allocations are harmful. They may lock early-stage projects into allocations that no longer make sense at launch, and may leave them under-resourced in future funding rounds when their allocatable token supply runs out. Token rights should be proportional to equity ownership and subject to dilution. This ensures flexibility in token distribution and aligns with long-term project development. As a result, projects can raise additional financing rounds as needed to continue building, rather than rushing to launch a token due to exhausted alternatives.
a16z Crypto structures its transaction documents in two ways:
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Granting investors a pro-rata portion of the total token supply equal to their percentage ownership in the company at the time the token is created. This option sets clear expectations for investor token allocation from the outset.
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Granting investors a pro-rata right to the portion of tokens allocated to the development company and its employees, advisors, investors, and other shareholders, provided this allocation meets a minimum percentage of the total token supply. This option trades clarity for flexibility, allowing the project to determine pre-launch how much of the token supply will go to shareholders (e.g., employees, advisors, investors) versus the community (e.g., airdrops, reserves for community grants).
Sample Terms
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Option 1: If the company (or any of its affiliates, foundations, or nominees) creates any crypto token, the investor shall have the right to receive a pro-rata portion of the total possible supply of such crypto token, representing half of their fully diluted ownership at the time of token generation (e.g., [X]% post-planned financing).
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Option 2: If the company (or any of its affiliates, foundations, or nominees) creates any crypto token, the investor shall have the right to receive a pro-rata portion of the crypto tokens allocated to the company and its officers, directors, employees, shareholders, and other investors (collectively, “insiders”). The amount allocated to the company and insiders shall not be less than [X]% of the total crypto token supply.
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Lock-Ups
Founders should beware of short lock-up periods. Investors may push for early unlocking of their tokens to sell quickly, which could destabilize the project, cause irreversible reputational harm, and introduce existential legal and regulatory risks. Pushing for shortened lock-ups is both dangerous and irresponsible.
Lock-up schedules should be consistent across investors, founders, employees, and other shareholders of the original development company. This ensures all parties have skin in the game for the project’s long-term success.
a16z Crypto’s standard term sheet provides that all insider-held tokens be locked for at least one year following the public token launch or the date tokens become transferable (if not transferable at launch). Generally, a16z Crypto advocates for a four-year lock-up schedule for insider-held tokens, with a full one-year lock followed by a three-year gradual unlock. This helps maintain stability in the token network during the critical early days post-launch and ensures all insiders bear meaningful market risk for at least one year after the token launch.
Such lock-up periods can also strengthen the project’s regulatory position regarding securities laws applicable to specific tokens. The standard terms also ensure that all tokens held by insiders unlock on the same schedule, further reinforcing incentive alignment between founders and investors.
Sample Term
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Any lock-up schedule for these tokens shall be agreed upon, provided that the lock-up period shall be (1) no less than one year from the date of crypto token issuance, (2) no more than four years from the date of crypto token issuance, and (3) no more restrictive than the schedule applicable to tokens held by the company or any of its officers, directors, employees, shareholders, or other investors.
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Protective Provisions
Founders should beware of unconditional approval rights over token issuance. These predatory terms may allow investors to delay token launches in order to renegotiate better deals, causing unnecessary delays and strategic misalignment.
Investors generally should not have approval rights over the timing of a project’s token launch. Token launches carry significant risks, and the decision on timing is inherently a business judgment—one that founders are better positioned to make. They are best equipped to determine when and how to structure a token launch effectively. Approval rights may enable investors to exert undue influence over these decisions to maximize their expected financial outcomes (e.g., delaying a launch to force partnerships with the investor’s other portfolio companies), which could harm the project’s trajectory.
a16z Crypto’s standard term sheet allows the project to issue tokens without investor approval, as long as the issuance does not circumvent any investor’s token rights. Generally, if each investor receives their entitled token allocation, no investor approval is required. This gives operators maximum flexibility while preserving incentive alignment with investors.
Sample Term
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Prior approval of a majority of preferred stock is required before creating, reserving, selling, distributing, issuing, or otherwise disposing of any token, coin, crypto asset, virtual currency, or other asset built on blockchain technology (“crypto token”), provided that such restriction does not apply to (i) sales, distributions, issuances, or dispositions made in a manner that does not conflict with the “Token Rights” provision below, or (ii) sales, distributions, issuances, or dispositions made pursuant to customary exceptions.
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Network Use
Founders should be cautious of deals that impose no restrictions on how investors and founders use the company’s technology. The absence of any limits may allow certain investors to exploit loopholes to control the network, undermining the founder’s vision and project goals. Conversely, overly broad restrictions may stifle collaborative development and decentralized value creation.
For example, investors and founders should be restricted from using the company’s developed technology to launch competing platforms. This protects the interests of both investors and founders and ensures the integrity of the project. At the same time, any restrictions should remain balanced enough to avoid hindering necessary partnerships and integrations.
We recently updated a16z Crypto’s standard terms to restrict investors and founders from exploiting the company’s developed technology for personal gain or in ways that compete with the company’s objectives, while allowing for customary exceptions for ordinary, non-commercial, and non-competitive use. These exceptions may include a founder’s personal use of the protocol as an end user, academic research conducted in partnership with universities, advisory roles within other blockchain protocols, or collaboration with services compatible with the company’s developed protocol. These exceptions allow founders to contribute to the industry in ways consistent with Web3’s open-source and collaborative ethos, while ensuring they can develop the company’s technology without compromising obligations to investors or alignment with the community.
Sample Term
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The company, founders, and investors agree not to use or exploit the company’s network or protocol for commercial purposes unless done directly through the company, subject to certain customary exceptions.
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Compliance
Investors who do not prioritize compliance are unsuitable partners for Web3 projects. Some investors may show little interest in—or prefer ignorance of—the laws and regulations applicable to blockchain networks and products built on them. Avoid working with them. Given the industry’s significant regulatory uncertainty and associated existential risks, compliance obligations must not only be addressed but prioritized.
In theory, both founders and investors should want the token network to comply with applicable laws, thereby reducing risk and enabling sustainable long-term growth. However, in practice, not all Web3 stakeholders share this view. Short-sighted, predatory investors may prioritize profit through regulatory arbitrage over compliant development, sacrificing project stability in the process.
a16z Crypto’s transaction documents include provisions ensuring the project exercises appropriate caution in network design, product development, and token issuance, and that investors support this process. These include requirements for the company to (i) adopt comprehensive compliance policies, (ii) make reasonable efforts to inform investors of any laws or regulations applicable to its blockchain products or services and their potential adverse implications, and (iii) engage counsel specifically to assess legal and regulatory risks of these products and services and implement appropriate safeguards. These covenants further empower investors to support each stage of this process.
Sample Term
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Prior to the public release of any new blockchain product or service, including the distribution of any token (if applicable), the company shall engage counsel to evaluate and analyze the form, mechanics, and structure of the product or service—and the token distribution (if applicable)—for risks to the company (considering security holders, including investors). When the company requests any investor to provide advice on the planning or design of any such blockchain product or service, including any digital token, cryptocurrency, or other blockchain asset related thereto, the company shall engage additional external counsel, approved by the company’s board, to review the risk assessment and analysis related to any such product or service, and use best efforts to ensure any such product or service is offered only in compliance with all applicable laws.
Properly structuring token rights in the early stages is crucial to a project’s future success. Yet many projects—through no fault of their own—may find themselves bound by predatory terms that can be difficult or even impossible to unwind later. By following the guidelines and sample terms outlined here, founders and investors can create a balanced framework that promotes stakeholder alignment, innovation, and project stability. This approach not only mitigates many of the inherent risks in venture capital and Web3 transactions but also positions projects to thrive within the evolving Web3 ecosystem.
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