Interview with a16z Legal Expert: Do's and Don'ts of Token Issuance

2024.09.02

Interview with a16z Legal Expert: Do's and Don'ts of Token Issuance

How to avoid common pitfalls when searching for product-market fit?

2024.09.02 - 04:47:33

代币a16z

Navigating Web3 tides with focused insights

How to avoid common pitfalls when searching for product-market fit?

Compiled & Translated: TechFlow

Guests: Eddy Lazzarin, Chief Technology Officer at a16z crypto; Miles Jennings, General Counsel and Head of Decentralization

Host: Robert Hackett, Operating Partner at a16z crypto and Head of Content & Editorial

Podcast Source: a16zcrypto

Original Title: Token do's and don'ts

Release Date: August 8, 2024

Background Information

This episode of the a16z Web3 podcast offers a comprehensive exploration of tokens—covering their role in decentralized protocols, different token types, and key considerations in designing and launching tokens.

The guests are Eddy Lazzarin, CTO of a16z crypto, and Miles Jennings, General Counsel and Head of Decentralization, who have advised numerous projects on protocol and token design. They discuss how Web3 differs from earlier tech eras, common pitfalls to avoid when seeking product-market fit, and how to evaluate various design strategies in terms of risk and reward.

The Necessity of Decentralized Protocols

Core Functions of Tokens

Eddy explains why decentralized protocols require tokens to ensure sustainability and incentivize participation from all stakeholders. He emphasizes that tokens are not just payment instruments but mechanisms through which users and network participants express ownership and control. Tokens should be viewed as tools enabling users and stakeholders to represent their ownership and governance rights within a network—not merely as currency for purchasing traditional goods.

Tokens vs. Traditional Protocols

Comparing Web1 and Web2 protocols, Eddy notes that while early protocols like HTTP and SMTP were decentralized, they were eventually absorbed by large corporations, resulting in users losing control. He argues that decentralized protocols, by introducing tokens with economic incentives, can maintain decentralization. This incentive structure allows protocols to operate sustainably without relying on centralized entities, thus avoiding dominance by giants like Gmail.
Eddy adds that the strength of decentralized protocols lies in uniting all stakeholders and using token-based economic models to ensure long-term sustainability and value creation. He views tokens as essential tools because they can be programmatically encoded and enforced, ensuring the protocol operates as intended.

Types and Classifications of Tokens

Eddy discusses several types of tokens, each serving distinct functions and market roles within decentralized protocols. Common categories include:
- Stablecoins: Such as USDC and USDT, these tokens are typically pegged to fiat currencies to minimize price volatility, offering users a stable store of value and medium of exchange.
- Arcade Tokens: Used within specific applications or platforms, similar to points or rewards in gaming systems, earned through user engagement or task completion.
- Meme Coins: Often originating from internet culture or social media humor, these tokens may lack substantive utility but can attract significant attention and speculative interest due to strong community dynamics.
Eddy stresses that when designing and launching tokens, teams must carefully consider their intended function and target market to ensure effectiveness and sustainability within the protocol.

Legal and Regulatory Challenges

Regulatory Uncertainty

Miles highlights the legal risks and regulatory uncertainty surrounding token launches and decentralized protocols. As cryptocurrency and blockchain technologies evolve rapidly, regulators worldwide are increasing scrutiny. However, immature legal frameworks create complex compliance challenges for projects during token design and issuance.
Miles advises project teams to carefully assess their legal structure to avoid potential liabilities and enforcement actions. Recommended strategies to mitigate risk include:
- Compliance Review: Conduct thorough legal and regulatory assessments during the design phase to align with local and international laws.
- Legal Counsel: Engage expert legal advisors to stay updated on evolving regulations and develop appropriate compliance strategies.
- Transparency and Communication: Maintain open dialogue with regulators, proactively comply with requirements, and build trust to reduce legal exposure.
Miles emphasizes that despite the challenging environment, careful planning and professional legal support enable projects to navigate complexity and innovate responsibly within compliance boundaries.

Governance and the Value of Decentralization

Technical and Legal Advantages of Decentralization

Eddy and Miles underscore the importance of decentralization from both technical and legal perspectives. By distributing control, decentralized protocols offer greater autonomy and transparency to users and communities, enhancing system reliability and trust.
- Technical Advantages: Eddy explains that decentralized systems, built on distributed architectures, reduce single points of failure and improve resilience and security. This design enables continuous operation without centralized oversight and enhances recovery from attacks or failures.
- Legal Advantages: Miles discusses how decentralized governance reduces reliance on any single entity, thereby mitigating concentrated legal liability. Additionally, decentralized decision-making empowers community members, better aligning protocol evolution with user needs and interests.

Pros and Cons of Token-Based Governance

Regarding token governance, Eddy and Miles explore its potential benefits and drawbacks. Token governance typically allows holders to vote or participate in protocol decisions, fostering community involvement and democratic legitimacy. However, they note several challenges:
- Participation Rates: While token governance grants users voting rights, actual participation is often low, potentially allowing large holders to dominate decision-making.
- Complexity and Efficiency: Decentralized governance can slow down decision-making and increase operational complexity, affecting responsiveness and innovation speed.
Despite these issues, Eddy and Miles believe decentralized governance remains a critical factor for long-term protocol success and sustainability.

Product-Market Fit

Definition and Importance

Product-market fit refers to a state where a product successfully meets the needs of its target market and establishes a clear market position.
Eddy emphasizes the concept’s significance in decentralized protocols and token projects. He states that achieving product-market fit is essential for widespread adoption and sustained usage—the cornerstone of project success.

Strategies for Achieving Product-Market Fit

User Needs Analysis: Eddy recommends that teams deeply understand user needs and pain points to ensure product features genuinely solve real problems. This requires extensive market research and user feedback collection.
Iteration and Optimization: Continuous product refinement helps adapt to changing market conditions and user demands. Eddy stresses that flexibility and rapid response are vital to achieving product-market fit.
Community Engagement: In decentralized projects, active community support is crucial. Eddy believes strong community relationships yield valuable insights and feedback, enabling better strategic adjustments.
Market Education: For emerging technologies, educating the market is key to driving understanding and adoption. Eddy advises investing in educational initiatives to boost awareness and acceptance.

Challenges and Solutions

Reaching product-market fit is difficult. Eddy identifies common obstacles such as intense competition and diverse user needs. He suggests differentiation and unique value propositions as countermeasures, along with maintaining sensitivity to market trends and user feedback for timely optimization.

Best and Worst Practices in Token Launches

Token launches are pivotal for fundraising and ecosystem growth in blockchain projects. However, there are both sound and problematic practices that teams must recognize and follow. Below are common examples:

Best Practices

Decentralization:
- Eddy and Miles stress that decentralization is a core tenet of blockchain technology. It reduces reliance on central authorities and brings both technical and legal advantages.
- Decentralized systems better protect users from information asymmetry and lower the risk of being classified as securities under law.
Clear Economic Model:
- Ethereum is cited as a successful example due to its well-defined economic model that sustains long-term value.
- Tokens should have clear utility, not exist solely as speculative assets.
Community-Driven and Participatory:
- Effective token launches encourage genuine community participation, with transparent and necessary use cases and governance mechanisms.

Worst Practices

Decentralization Theater:
- Miles references "decentralization theater," where projects claim to be decentralized but remain under centralized control. This provides no technical benefit and increases consumer risk.
Tokens Without Clear Utility:
- Issuing tokens purely for governance—especially when governance isn’t truly needed—is considered poor practice.
- As noted by Robert Hackett, some projects force users to adopt their tokens despite lacking real functionality or value.
Legal Risk:
- Publicly selling tokens in the U.S. may classify them as securities. Miles warns against this due to severe legal consequences.
Premature Token Launch:
- Miles points out that many projects launch tokens too early—before establishing clear use cases or product-market fit—often leading to failure.
By adhering to best practices, project teams can increase the likelihood of successful token launches and lay a solid foundation for long-term development.

Summary and Recommendations

Importance of Decentralization:
- Decentralization is not only a legal imperative but also a core technical value. It enhances system robustness and global adaptability, fostering trust among users and developers.
- It reduces dependency on management and lowers risks of information asymmetry—a central concern in securities regulation.
Define Token Utility Clearly:
- Projects must clearly define a token’s practical use before launch. Tokens should serve the protocol and ecosystem, not exist merely as speculative instruments.
Avoid Premature Token Launches:
- Many projects rush to issue tokens without proven product-market fit or clear utility, inviting legal risk and market failure. Tokens should only be launched once their function and demand are validated.
Legal Compliance and Risk Management:
- Teams must prioritize legal compliance, especially in the U.S. Avoid high-risk activities like publicly selling tokens that could be deemed securities.
- Strategies such as decentralization, excluding U.S. investors, or restricting token transferability can help mitigate legal exposure.
Community Participation and Governance:
- Community involvement is vital for long-term success. Projects should implement thoughtful governance structures that enable meaningful community input when necessary.
- Voting should be a last resort, used only when essential—not as the primary justification for issuing a token.
Economic Models and Incentive Design:
- Tokens’ economic models must be carefully designed to discourage speculation and market manipulation. Focus should be on building sustainable, resilient economic ecosystems.
- Incentive mechanisms should balance the interests of supply and demand sides to ensure market stability and predictability.
Focus on Product, Not Just Token:
- Eddy emphasizes that founders should prioritize protocol design and implementation over token-centric thinking. The token is part of the protocol—not the whole.