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Well-crafted term sheets keep investors and token issuers’ incentives aligned

Investors are discovering that as venture firms’ portfolio companies turn to token sales and initial coin offerings to raise funds, the path from making equity investments to holding tokens is not straightforward.

Take, for example, cybersecurity company MetaCert, which previously raised a couple million dollars in seed funding and late this month plans a private utility-token sale targeting $40 million.

The digital-token funding means some of the company’s equity investors are in uncharted waters, grappling with how to hold the new asset class on their books.

“When we made the investment, the ICO process was unknown, not even on the horizon,” said Venktesh Shukla, partner at Monta Vista Capital of Sunnyvale, California, one of MetaCert’s seed investors.

The company provides security to combat phishing scams on messaging platforms. It gained traction among cryptocurrency enthusiasts who use messaging platforms like Slack or Telegram and are prime targets for hackers hoping to steal their bitcoin or ethereum.

Launched in 2016, MetaCert had closed two seed rounds totaling $2.4 million from small venture firms, angel networks, family funds, and entrepreneurs. But the company needed to scale quickly to meet growing demand from the cryptocurrency sector.

With previous term sheets silent on the subject of tokens and ICOs, “the process introduces a whole lot of other variables that VCs do not control and had not anticipated,” Shukla said.

Shukla’s experience is far from unique, as more companies that raised seed and early-stage funding turn to ICOs and token sales for their next funding rounds.

For example, six of the 11 companies that held the largest ICOs or token sales in 2017 previously raised seed or venture funding, a VCJ analysis shows.

But equity investors have yet to reach a consensus on how to approach the token sales of portfolio companies.

VC Fund Blockchain
Bart Stephens, co-founder and managing partner, Blockchain Capital. Photo courtesy of the firm.

“If you have company XYZ that’s done a Series C, and then has a tokenized network, does the value accrue to the token holders or accrue to the equity holders?” said Bart Stephens, managing director of Blockchain Capital. “The jury’s still out.”

Some view token offerings as liquidity events, while others view them additional fundraising rounds.

Just as investors are not granted part of the new option pool when a company goes through a financing round, venture investors shouldn’t necessarily be granted ownership of tokens that a portfolio company raises, said Michael Berolzheimer, managing partner of San Francisco-based Bee Partners. “Do you think every investor in Uber gets free rides?” he asked.

And equity investors who do become token holders have no established path to follow.

“For tokens, every deal seems to be different, and companies and investors are still trying to figure out the right way to do it,” said Drew Volpe, managing partner at First Star Ventures in Boston.

“If you’re doing a typical equity round, you can grab the” National Venture Capital Association term-sheet “template, or every law firm has its own template,” he said. “But for tokens today, there isn’t a good default.”

Some term sheets explicitly carve out rights for investors to automatically receive tokens in proportion to their equity investments.

Others give investors rights to invest in token sales, often at a discount, while still others give investors the right to block a token sale or require their vote of approval to hold one, like a successive round of equity fundraising.

And with the regulatory and economic landscape of cryptocurrencies and digital assets changing rapidly, standardizing term sheets for token sales and issuances can be difficult.

Although enforcement agencies like the SEC and CFTC have taken action against individual issuers, they have not weighed in with broad regulations, and it is unclear when or whether that will happen.

“It’s hard to know in six or 12 months, when the company is ready to do a [token] sale, what the right structure or model will be,” Volpe said.

Despite the uncertainty, a few red flags prompt Volpe to pass on deals.

If a company or team proposes that the money raised in a token sale flow to a nonprofit or the founders themselves, that can misalign their incentives from building the company and raise the possibility of poor governance, Volpe said.

Stephens offered a similar take.

To prevent a startup’s founders and other key employees from cashing out their tokens immediately after an ICO and abandoning the company, Stephens says tokens raised through an ICO or token sale should vest over time. “This incentivizes them to launch a project and maintain it,” he said.

On the investor side, Stephens said he wants to see lockups for venture investors, to prevent them from selling the tokens as soon as they are tradeable.

“Many hedge funds are coming in early and demanding some sort of discount, and then flipping the tokens to retail investors in the public sale,” said Stephens, whose firm invests in blockchain technology and the crypto sector. “That type of short-term mentality is not sustainable in the long term.”

Stephens also said he wants to see caps on funding amounts when companies hold token sales.

He pointed to a company that his firm backed, which aimed to raise $30 million through an ICO and wound up raising $150 million.

Instead of returning the excess funding, the company, which Stephens declined to name, kept it.

“That’s a real no-no,” Stephens said. “You’re just raising money for the sake of raising money.”

Blockchain startups early on often reject venture investments in favor of raising lump sums through ICOs. But raising too much money too soon can eliminate a team’s incentive to build a successful company.

“There’s a strong argument that the venture system has evolved in tranches — Series A, B, C — for good reason,” he added.

As MetaCert prepares its token offering, Founder Paul Walsh aims to avoid the mistakes that issuers have made.

Participants in the MetaCert token offering will be subject to a lockup period, with 25 percent of their tokens available when the platform goes live, and the remaining 75 percent vesting over three years. This keeps company employees and token holders invested in the company’s success, he said.

“It would be very easy for a company to just launch a token, [for] the team to cash out with immediate liquidity, and the other shareholders standing by wondering what the hell just went down,” he said.

“This is not a pump-and-dump exercise,” he said. “We want to demonstrate that we are abiding by best practices so that other companies can look to us.”

Photo of digital-money concept courtesy of dem10/iStock/Getty Images.