SAFTs and token warrants: what ails them and what alternatives exist

What are token warrants, why is this instrument suited exclusively for venture capitalists and counter to the principles of a decentralised economy, and what promising alternatives exist in this sector? Read about it in a detailed analysis by Web3-entrepreneur and lawyer Vladimir Menaskop.

Introduction

The SAFT idea wasn’t the best, but at least it was workable and at least somewhat aligned with Web3 principles. And token warrants — token warrants — are pure venture-capital instruments, not designed for ordinary people. For ordinary investors they offer at most airdrops, which compare poorly with seed and private rounds of funding.

The problem is that people quickly forget опыт Silicon Valley Bank, Signature Bank, FTX, Celsius, 3AC and other centralized structures, yet remember clearly any failures of decentralized projects. 

But now let’s try to assess the ‘innovative’ toolkit that venture capitalists are once again offering to the crypto market. It will, in my view, generate more trouble for the sector than funding illiterate managers from Pantera Capital, Sequoia and other giants of the field. 

There is very little material on this topic and in English, and in Russian. The reason is simple: practices are not so common. 

Basic vocabulary

First of all it is necessary to clearly define a number of terms:

• tokens — these are crypto-assets (native and/or derivative) inside a blockchain;
• primary token issuance — the operations initiating public circulation of tokens in the form ICO, IEO, IDO and so on;
• tokenomics — the economics of a blockchain project (whether it is a startup developing a modest dapp or a full-fledged protocol).

Of course, the meaning of these terms goes beyond the definitions above, but for our purposes this approach is enough. 

Now — onto the subject of the discussion:

• token warrant — a derivative financial instrument that gives the warrant holder the right to acquire the issuer’s tokens at a specified price within a defined period or by a certain date. The number of tokens issued to the holder upon exercise is typically proportional to the investor’s stake, though it may depend on the overall distribution of assets among investors. The holder is not obliged to exercise it. But if they do, the company must issue new tokens equal to their amount in the exercised warrant;
• SAFT — an agreement in which the investor (contributor) pays money upfront for the right to own a certain number of tokens after the network is completed. It can exist in classic form — as a document, or as wNFT or other technical entities.

SAFT terms typically include:

• the aggregate scale of token issuance;
• the share of assets allocated to investors;
• the token price at the time of transfer to the investor;
• the conversion event, i.e., the moment the SAFT converts into tokens for the investor;
• information on the granting of rights, locks and other encumbrances, important for the proper and secure operation of the project’s tokenomics.

Thus, to prepare a complete SAFT one typically needs a white paper (or at least a lite paper) describing token use cases, tokenomics and plans for token distribution.

Thus, a warrant conveys the right to acquire or buy future tokens, but not the obligation to do so. The amount of assets available to the investor is equivalent to the capital volume provided via a SAFE. Tokens do not replace obtaining company securities as an investor. Rather, they are used in conjunction with a standard equity agreement and a capitalization table. 

Let us briefly outline the pros and cons. 

Advantages and disadvantages of token warrants

The biggest problem with this instrument is often the lack of understanding by projects of the general features of their own tokenomics. Put simply, the industry continually draws in startups whose founders are not strong in Web3 architecture, yet now they can delay the moment of real engagement with it. 

One might respond that such a buffer lets the team dive deeper. But the reality is that Web3 in 2009, 2017 and 2023 are very different technologies and capabilities, and it is unlikely that the next 10–25 years will change much. The pace will only accelerate. 

But there are more serious problems: one of the most important is the increasing limitation of contributors’ opportunities.

So why did token warrants appear then? 

The simple answer: the SEC and its madness. Unlike SAFT, warrants are essentially informal agreements that are not registered with the Commission and do not promise future tokens (more precisely — obligations in respect of them). This gives options to both startups and investors.

The next advice exists on the sites of many consultancies. Suppose you are at the early stage of project development and have not yet registered a token company (token SPV). You also have not yet created your tokenomics.

In such a case, the best option for you is most likely to use a SAFE or convertible note in conjunction with warrants or a token side letter. The final decision will depend on several factors. 

A token company is a structure that sits within the legal framework of the project and is responsible for the initial issuance and distribution of tokens. It is typically registered in a jurisdiction where the law permits the issuance of digital assets and provides specific rules for the taxation of such operations. In practice your project is likely to be in Switzerland, Liechtenstein, the United States, Hong Kong or—quite probably—in Singapore. The next steps will depend on timing and the level of detail of the request. 

Despite a number of advantages, when investing in token warrants for token fundraising one should consider the following drawbacks:

• restrictions on the strike price. This means investors can choose only from a strictly defined range of token prices;
• expiry-related restrictions. The value of warrants declines as that date approaches;
• complex pricing. The price of the warrant is determined by many variables, including intrinsic value, time value and implied volatility. Forecasting the amount of profit is, to put it mildly, not easy;
• high risk. If tokens fail to reach the strike price, the investor will not realise any profit, and the project will owe them twice over. 

Let us attempt to assemble this via a contrapositive, i.e., by offering an alternative scheme. 

DAO, DAO & SPV, SPV

We have already described it in a article on the legal status of DAOs. But today we would like to discuss separately a tool called a DAO Token Agreement (DTA). What are its features? 

• no SPV tying you to a jurisdiction. The bZx case showed: if you register a DAO in Wyoming, proving that you have no ties to the United States becomes virtually impossible. 
• the agreement is best formalised through initial distribution smart contracts with locks for the required periods. Then the token will appear only together with the utility and governance-functionality: when the dapp is created and ready to use.
• and most importantly: the mechanism is simple, clear and transparent to the extreme. Partly described by Vitalik Buterin in the DAICO architecture, but today this concept can be supplemented with important theses. 

Here are the concrete steps:

1. We issue, for example, 1 000 000 tokens on the EVM network.
2. Create 100 lots according to a scheme convenient to us: standard or Dutch auction, pool-based purchase, and so on. 
3. Distribute one pool to the team, and set the rest at the specified prices (or minimums — in the case of Auctions).
4. Lock-up period runs from one to three years (or as long as needed, but linked to product stages: MVP, alfa, beta, release).
5. Tokens are redeemed, but they cannot be put into circulation, as the sole function of such a DTA is the initial gathering of participants via verified transactions and blocking capital for staged unlocking by those same participants.

There may be various branches. For example, one could:

• build on NFT 2.0 several micro-pools that will distribute funds gradually — depending on progress along the roadmap. That is, the DAO begins functioning as soon as the treasury reaches a soft cap, but if something goes wrong, it will have the right to wind up and partially refund funds;
• set a whitelist of tokens to use as highly liquid instruments, as well as many others: crypto-derivatives, NFT, illiquid tokens from other DAOs (for example, if they are willing to help with development) and more.

This list is entirely open and limited more by the founders’ imagination than by legal frameworks. 

What are the advantages of the approach? 

1. Regulatory risk reduction. First, you are not tied to jurisdictions that have not proved stable in their promises over the last decade when you consider the experiences of the United States, Russia, China, Singapore, South Korea and many others. 
2. Decentralisation at the core. You can attract both venture and crowd contributors. Moreover, unlike standard ICOs/IDOs, the event of initial token generation and its public issuance can occur only if the DAO is formed and the product is launched. 
3. Programmable assets that can be configured with maximum precision. This will allow, for example, storing liquidity until the next unlocking stage in Uniswap pools and thereby accumulating interest.

Conclusion

I have no doubt, as a lawyer and realist, that the venture-capital sector will continue to exert strong pressure on Web3 projects and the industry as a whole. But if we want to preserve a market with sufficient degrees of freedom, decentralisation, openness and anonymity, our path is to apply technologies to ensure their compliance, sustain them and develop them. 

DAICO, DTA and even simple IDOs are not for everyone. Yet the experience of projects such as MasterCoin, Ethereum, Tezos, Cosmos, Polkadot, Bancor, Brave, AAVE, Storj, Filecoin and, to some extent, EOS & TON, suggests that a positive outcome is quite possible outside the basic whale-driven trends from actors such as CBDC, non-public DLTs and Web3 regulation.

DTA encompasses cutting-edge advances in programmable-asset markets. Going forward the instrument could be further enhanced by adding ZKP-mechanics. We will surely cover this in a separate article.