Web3 project needs to be financed, pay attention to these legal knowledge

Source: Lawyer Liu Honglin

With the recovery of the blockchain market, both virtual currency investors and Web3 entrepreneurs have become active Now, the news in the currency circle media that a certain project has raised millions of dollars has also begun to bombard the circle of friends, making many friends who are also entrepreneurs excited.

Entrepreneurship is all about resource integration. As a founder, in addition to figuring out strategies and building a team, you also have to find ways to raise money from investors. How is financing in the currency circle different from financing on the traditional Internet? What are the requirements for the establishment of a company and the issuance of Token? …

This article has sorted out the questions that Mankiw’s legal team is often asked by Web3 entrepreneurs during the investment and financing process. I hope it will be helpful to all Web3 entrepreneurs!

01 When an entrepreneurial team sets up a company, where is the best place to register it?

Whether a blockchain project requires the establishment of a company depends on the specific circumstances and goals of the team. In many cases, setting up a company can isolate risks for project members. With a corporate entity, the project will be much more convenient in terms of business activities, financing, and tax issues.

Due to my country's regulatory attitude towards blockchain projects, project parties generally carry out projects overseas based on legal and policy reasons and choose regions that are more friendly to Web3.0. Some common places of registration include Hong Kong, Singapore, Cayman Islands, BVI, etc. Specifically, the selection will generally be measured from aspects such as establishment costs, local policies, and investor preferences.

02  ;What is the difference between equity financing and currency financing rights?

Financing equity means investors invest by purchasing the company’s equity, while financing currency rights invest by purchasing the project party’s tokens.

As a traditional investment method, equity financing has stood the test of time. The protection of investors’ priority rights is relatively comprehensive, but liquidity is relatively limited and there are few exit channels. Generally, IPO, equity transfer, Bet on buyback.

Digital assets such as Token have stronger value-added potential, and their liquidity and exit methods are relatively flexible. However, there are risks such as regulatory uncertainty, possible severe market fluctuations, relatively new investment models, and high uncertainty.

What reflects behind the equity and currency circles is the issue of how to realize value. If you value the value of the company's future cash flows, you should pay more attention to equity investment; if you value the network ecological scale effect of the project itself, you should pay more attention to currency investment.

Compared with traditional equity financing, investors in many Web3.0 projects are more concerned about the free disposal of the tokens they hold after the tokens of the related projects complete the IEO and are unlocked; the project party has a high probability There will be no IPO of shares. In this type of project, the investment value is not reflected in equity but in currency rights. Investors pay more attention to the proportion and value of subscribed Tokens, and often choose to directly purchase Tokens instead of equity.

For some Web3.0 projects that may not have determined the intention to issue tokens during the financing stage, and may not necessarily create or issue Tokens in the future, they are usually similar to traditional investment and financing projects, with direct equity financing. Sign customary equity investment transaction documents.

03 What legal documents need to be signed for financing?

For project parties that have created Tokens and use Tokens as the financing target, they generally sign a Token Sale Agreement, which is relatively complete and usually includes the transaction status of purchasing Tokens, investor rights arrangements, risk warnings, Terms such as liquidated damages, representations and warranties.

For projects where the project party has not issued tokens and is not sure whether they will issue tokens in the future: SAFE+Token Warrant/Side Letter is usually signed: the investor and the project party sign SAFE, and the funds invested by the investor are characterized as Equity investment, and both parties sign a Token Warrant or Side Letter, agreeing that if the project party issues Tokens, the investor has the right to obtain a certain number or proportion of Tokens for free or at a very low price.

For projects involving Web3.0 projects, but which are likely to be conventionally listed in the future, equity financing will be adopted, and transaction documents such as SPA, SHA, and MAA will be signed.

04 What are the differences in terms of transaction documents between equity investment and Token investment?

There are some differences between equity investment and Token investment due to different targets. The main differences are as follows.

05  ;What is the SAFT protocol often heard in Web3.0 financing?

SAFT is: Simple Agreement for Future Tokens, which is generally called "Simple Agreement for Future Tokens" in Chinese. Usually the project company has decided on the type of tokens to be issued, the token economy, and the Coin issuance plan, etc. Before the token is issued, investors can sign an agreement to pay a consideration to obtain a specific number of tokens in the future. The core function of the SAFT protocol is to allow investors to invest in unfinished projects in exchange for the right to receive tokens when the project goes online.

A standard SAFT agreement generally includes the following terms and elements:

(1) Investment currency (legal currency or virtual currency) and payment account or address

(2) The number of Tokens obtained: a certain proportion of the total amount, a fixed quantity, or a fixed discount for the next round of financing

(3) Statements and guarantees from investors and the company

(4) Buyback/refund events: bankruptcy and liquidation, failure to achieve agreed goals

(5) Applicable law and dispute resolution

(6) Notice terms for residents of various countries

06 What is the SAFE agreement?

Although there is only one word difference between the SAFE agreement and the SAFT agreement, their contents are quite different. SAFE (Simple Agreement for Future Equity) can be understood as a variant of an equity purchase agreement, which is mainly suitable for investors to provide funds to the company in exchange for equity issued in the future. Traditional equity financing in the early stages often involves complex equity structures, numerous legal texts, and detailed legal due diligence. The SAFE protocol simplifies the early financing process and improves the speed and efficiency of transactions. It was introduced in 2013 by YC (Y Combinator), a well-known startup incubator and venture capital company, to simplify the financing process, reduce the complexity of legal documents, and improve the speed and efficiency of transactions, providing an easier way for early-stage startups , flexible and fast financing methods.

What terms do SAFE agreements usually contain?

• Investment amount: Agree on the amount of funds that investors will provide to the startup company.

• Conversion event: Agree on a trigger condition. When the condition is met, the SAFE agreement will be converted into the company's equity according to the agreed ratio. Common conversion events include the next round of financing, the company being sold or going public, etc.

• Conversion ratio: Determine the investment amount and the proportion that can be converted into equity in future financing rounds.

The optional terms in the SAFE agreement mainly include the following:

(1) Valuation Cap

Valuation Cap is used to constrain the company's valuation ceiling in future financing rounds. It provides investors with a protection mechanism to ensure that they can convert their equity on favorable terms when raising funds in the future. Valuation Cap is a set maximum valuation limit that determines the price at which investors receive equity in future financing rounds. When the company's valuation in a future financing round is lower than or equal to Valuation Cap, investors will convert their investment amount into equity according to a set ratio. This allows investors to enjoy more favorable equity conversion conditions as the company's valuation grows.

For example, assume that the investor invested a certain amount when signing the SAFE agreement and set the Valuation Cap to US$10 million. If the company raises capital in a future funding round at a valuation of $50 million, the investor's SAFE agreement will be tied to this valuation at an agreed-upon conversion ratio, determining the amount of equity converted into equity.

The main role of Valuation Cap is to protect the rights and interests of investors, especially when the company's valuation increases rapidly. If the company's valuation exceeds the Valuation Cap when financing in the future, investors will convert equity according to the valuation cap, ensuring that they can obtain equity at a relatively low price and enjoy investment returns.

(2) Discount (Discount)

Discount is used to determine the discount rate for investors to convert equity at a preferential price in future financing rounds. Discount is the preferential discount that investors enjoy when converting the SAFE agreement into equity. It is expressed as a discount rate, usually expressed as a percentage. The discount rate is generally between 10% and 30%, and the specific value is determined by negotiation between the two parties.

For example, suppose an investor invests a certain amount when signing a SAFE agreement and agrees on a 20% discount. When the company raises funds at a price of US$10 per share in a certain future financing round, investors can convert equity at a price of US$8 per share according to the agreed discount. This means that investors obtain equity at a lower price and enjoy a discount compared to investors who have not signed a discount.

The main purpose of Discount is to reward early investors and reflect their early risk-taking on the company. Since early-stage investors face higher risks and the company's valuation is usually lower, giving them an equity conversion discount is an incentive to attract more early-stage investment.

(3) Most Favored Nation (MFN)

MFN (Most Favored Nation) aims to ensure that investors receive the same benefits as others in future financing rounds Investors are treated the same. The role of the MFN clause is to protect the interests of investors and prevent them from being unfairly treated in subsequent financing. According to the MFN clause, if the company conducts other financing after signing the SAFE agreement and gives other investors more favorable terms or conditions, then the investors have the right to request that these more favorable terms or conditions be applied to their SAFE agreement.

For example, assume that the investor and the company sign a SAFE agreement, agreeing on the investment amount, conversion ratio and other terms. Later, the company raises its next round of financing, offering other investors better terms, such as a lower stock price or higher equity. If the SAFE agreement contains an MFN clause, investors can request that these more favorable conditions be applied to their SAFE agreement in accordance with the MFN clause to obtain the same treatment as other investors.

The existence of MFN clauses helps ensure equal treatment among investors and encourages companies to maintain consistent and fair treatment of all investors in subsequent financings. The purpose of such clauses is to protect investors from adverse conditions or the risk of dilution in subsequent financings, thereby protecting their rights and investment returns.

Valuation Cap, Discount and MFN are not terms that must be included in all SAFE agreements. Their use is related to the specific design of the investment agreement and the negotiations between the investor and the company. Different investors may have different requirements for Valuation Cap and Discount settings. Therefore, when formulating a SAFE agreement, both parties need to fully negotiate and clarify their respective interests and expectations.

In addition, in addition to the above three common optional clauses, additional clauses can also be added according to specific circumstances, such as priority and information disclosure requirements.

07 Toten Warrant

Since SAFE mainly involves equity investment and future equity conversion, it only deals with equity-related laws Therefore, if investors want to obtain the relevant rights and interests of Token subscription, both parties need to arrange the related matters of Token subscription, and then they often need to sign a Token Warrant or Token Side Letter.

When a Web3 project chooses the appropriate financing document for itself before a seed round, it is important to consider any regulatory restrictions on token trading imposed by local regulators on the project development company. If they are strict, or there is a high risk of regulatory uncertainty (such as in the US), then it is better to use a Token Warrant.

Token Warrant is a document often used by Web3 projects to attract early investment. It gives investors the right to purchase a portion of the tokens during the initial token sale and fixes the price of the tokens.

The risk factors and regulatory requirements involved in Token issuance may be different from traditional equity investments. Token Warrant can contain specific risk disclosures and legal terms related to Token issuance to ensure that investors have a clear understanding of the risks and comply with relevant regulatory requirements. By developing more specific and customized terms to suit the needs of the project and the requirements of investors.

Usually, the core terms mainly include:

• Token distribution: How many tokens are reserved for investors.

• Token generation event: For more flexibility, you can specify a deadline.

• Token purchase right: Investors have the right to purchase Tokens not exceeding the specified limit. Token purchase right is the right to purchase Token in the future. In order to determine the best way to build it, it is necessary to evaluate a project’s readiness for Tokenomics. If the project’s Tokenomics are not finalized, investors can negotiate a discounted rate for their token purchases. Then, based on the investor’s equity ratio, the number of Tokens they can purchase at a discounted price is calculated.

• Purchase price: The fixed price at which investors will purchase Token.

• Token transfer: Various restrictions on Token transfer, such as lock-up period.

• Exercise terms and rights: First, the project team should inform investors in advance of the exact date of the Token generation event. Secondly, investors are given a definite period within which they can exercise their rights to purchase Tokens.