Token Compensation for Web3 Startups

Token-based compensation, a new and powerful form of incentive alignment, introduces novel complexity to startup compensation. There’s not yet much public knowledge and data about compensation in web3. Without a solid strategy, founders and hiring managers risk over-diluting tokens in the long-term, losing out on critical hires, upsetting or being unfair to employees, and ultimately, failing to build a healthy, efficient team/company.

This post — a deep dive into token compensation strategy at the pre-token launch stage — was a collaboration between Robin Ji, Co-founder of LiquiFi, and Zack Skelly, Head of Talent at Dragonfly Capital. With it (and a few posts to follow), we intend to demystify what it takes to create an effective hiring and token compensation plan in crypto, which should help you to make compelling and fair token-based offers to potential employees, and avoid messy allocations that will create headaches in the future.

Keep in mind that this is based on our experiences and observations in the space; it does not constitute legal advice. You should consult your own legal counsel on how best to structure your compensation and comply with tax codes when you’re creating a token compensation strategy.‍

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The Reason Why Top Talent is Flocking Into Crypto

It’s become clear that crypto offers spectacular financial opportunities for candidates. Total crypto market capitalization hit $3.3 trillion towards the end of 2021 (up from $800B less than a year prior), and candidates are noticing projects’ staggering growth and outsized rounds. Take, for example, Phantom, which raised a $9MM Series A, and then a $109MM Series B at a $1.2B valuation just six months later. That’s pretty unheard of outside of crypto. Or consider Alchemy, whose valuation nearly tripled to $10.2B in about three months.

This potential upside goes beyond salary and equity; it also manifests by way of tokens. Tokens are relatively new and foreign to many candidates. Individual projects like Uniswap, Axie Infinity, and Aave have reached up to $7B in individual market capitalization, and there are massive opportunities in pre-token-launch projects to achieve dramatic and life-changing outcomes. Token-based offers have significant differences when compared to traditional equity. These include:

• Instant liquidity and faster time-to-market (no need to wait for a company to exit by way of acquisition or IPO)
• No exercise cost or windows à la options
• Compensation that auto-scales to the market in real-time (as compared to a startup’s equity value, which is pegged to company value assigned at the last fundraising round)
• Rewards that are arguably more directly tied to the value of the company’s technology product and/or community, rather than being as subject to the financing/capital structure of the business
• The ability to differently compensate and retain global talent in jurisdictions where capital gains, salary taxation, and local regulations may result in unequal or distorted pay among individuals performing the same role
• Lending markets to access underlying liquidity without triggering a taxable event
• Staking, lending, and yield incentives for earning extra tokens
• No dilution (for fixed supply tokens), or at a minimum, dilution that’s transparent, with possible adjustments in the total token supply approached with transparency and by way of stakeholder coordination

That last point alone is a huge deal when considering average dilution at equity-based startups:

How Early-Stage Token Compensation Works From a Company Perspective

Sounds great, yeah? Cool. Now how do we set this up?

Firstly, don’t just do a token for the sake of doing a token. Tokens are not equity, unless you’ve decided to issue a security token. The token must have actual benefit to your product and community; it’s not fair to your employees and stakeholders, otherwise, and it carries significant reputational, financial, and potentially legal risk to deploy a token purely for the purposes of compensation.

If you do have a need, many projects initially offer employees equity with an additional option for receiving future yet unlaunched tokens. Given the uncertainty and complexity behind tokens and their markets, some companies decide to give employees both equity and tokens, with the goal of providing a risk-adjusted offer profile and rendering employees some benefit even if the company succeeds without a token launch. Whether this comes to fruition is largely dependent on the company’s business model and token economics, and with that, how value accrues to the equity and/or tokens individually. We strongly recommend consulting with legal counsel and hiring/crypto experts on how to best structure your overall compensation, and how to create sound token mechanics.

With that out of the way, you’re left to decide how many tokens to give employees. The approach here is similar to early-stage web2 startups deciding how much equity to allocate to the employee option pool and how much to award each hire. There is no one-size-fits-all blueprint, but you may want to consider the following:

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Total compensation benchmarks and industry trends

Tokens generally reach a liquidity event much earlier, and with smaller teams, compared to traditional equity exits like IPOs and acquisitions.

The average size of companies reaching their liquidity event, such as the token generation event (TGE), is between 20–40 people (based on Crunchbase, LinkedIn, team pages, and other public sources of data for company size of projects with recent token launches). Anecdotally, the average time to token launch is typically <1–3 years. Traditional IPOs, on the other hand, occur on average 11 years after inception, and these companies typically reach hundreds or thousands of employees.

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How much does the team want to budget to hit a key business milestone (e.g., the token generation event)?

In the same way you’d budget a pool for equity awards, you’ll want to budget a pool for token awards and reserve only as much as you plan to use (since tokens very commonly have a fixed supply and can be allocated for other strategic purposes). The traditional equity employee option pool for Seed companies is 10–15% and for Series D companies is 15–20%, according to Carta and Holloway. Founders generally retain 15–25% of the company equity pre-IPO, per Craft and SaaStr. The option pool increases over time as the company hires more employees and distributes equity awards. The amount by which you increment the option pool with each round and the amount of equity you give away decreases, as the company’s valuation increases.

For crypto companies and projects, research driven by Lauren Stephanian and Cooper Turley (aka Coopah) indicates that typical team (i.e., founders and employees) token allocation is 17.5%, as distributed between 20–40 people.

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Who and how many people do you need to hire to get to the next milestone/inflection point, and how many tokens do you need to budget for each hire?

Based on the averages mentioned above, you may want to budget around 15–20% of token supply for about 30 employees and the founders. Not all teams and companies are the same, so use this as a general guideline and not a hard, fast rule. The average team size of 20–40 people is a reference range, and each team’s plans will differ based on their traction, business model/strategy, and token economics. Given your own project needs and company projections, you’ll want to estimate how big your team will get to reach your token liquidity event. Headcount and roadmap planning are critical prerequisites here.

While total token supplies are generally fixed, your allocations (i.e., the percent you allocate to employees, versus investors, versus your community) can be modified before your token launch. We suggest being conservative in projecting employee token allocations; if you imagine it’ll take longer than it might and require more people than you initially expect to reach your TGE, you’ll more likely be able to issue additional tokens to close critical hires and investor partnerships if necessary.

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Creating a Hiring Plan for Token Compensation

For the purposes of this post, a “hiring plan” forecasts how much equity and/or tokens you want to allocate to each employee you intend to hire. Below is an example that illustrates token percentages using some bogus numbers. We repeat: These numbers are arbitrary. Please do not use them for your own business. You can work with legal counsel and/or the portfolio support function at your VC to come up with sound numbers, depending on your overall token/equity compensation strategy and goals.

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We’ll be doing a deeper dive on how to come up with token allocations for each employee in an upcoming article. Stay tuned!

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General Guidelines for Benchmarking Your Allocation Against Traditional Web2 Startups

Web2 equity ranges can be a guideline for token equity allocation between founders, investors, and employees. In a traditional equity cap table, founders usually own 20% of the equity, employees are allocated 20% via the pool, and investors own 60% of the company. Based on this trend and the 17.5% token allocation average, you might allocate founders and employees roughly the same ratio and use that as a starting point for a potential token budget.

For example, if your token allocation for the team is 20%, and founders and employees have roughly the same amount of equity ownership (based on the 20% employee stock option pool and the 20% average founder ownership by IPO), you can split the 20% token allocations into the founder portion (10%) and the employee portion (10%).

It’s worth noting, too, that there are a few different well-regarded, broad-stroke models for follow-on employee equity compensation in the traditional web2 startup world. You can consider using these ratios as a benchmark and budgeting them against your available employee token allocation. The Holloway Guide to Equity Compensation, for instance, suggests granting 2–3% to the first engineer hired, 1–2% to the second, and so on. Sam Altman writes that about 10% in total equity should go to the first 10 employees, 5% to the next 20, and 5% to the next 50.

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With an understanding of crypto-specific nuance, you can furthermore apply web2 equity data in calculating individual employees’ token compensation offers. (Again, more on this nuance in the upcoming post we mentioned.)

Of course, allocations can differ. For early-stage companies, many variables come into play; amounts offered can be dependent on things like the company’s perceived upside, the solidity of their business/product roadmap, revenues and sales pipeline, the ability to negotiate, the early team’s network, and the company’s chosen offer profile (salary, bonus, equity, and tokens).

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Avoiding Under-Allocating Tokens in Your Employee Pool

Since total token supply is generally fixed, you’ll want to avoid under-allocating tokens to employees. What’s the best way to do so? It warrants saying again: Build in some buffer and plan conservatively, with the assumption that you’ll need more people than you imagine and more tokens to close competitive candidates. LiquiFi can help you with token cap table projections, as well as forecasting and budgeting your employee token allocations. Revisit your hiring plans and token budget regularly based on your business’ progress.

Given volatility in the market and valuations, you may also consider having extra reserves so that you can “true-up” employees if the value of the tokens drop materially and sustainably, and it becomes necessary for retention. (Do this with extreme caution and consult your advisors beforehand, as this isn’t something you can easily reverse, and it carries meaningful consequences. To mitigate the need/risks, you should also be intentional about hiring folks who understand the inherent market cycles of crypto and educate/remind your team of these cycles regularly.)

Another (less common) way to safeguard/structure your token allocation is to factor in performance-based token bonuses. Many candidates are likely to balk at this, though, if they’re used entirely in lieu of guaranteed, regularly vesting tokens.

In time, with the greater proliferation of DAOs, we can imagine performance-based token compensation tying in with some form of on-chain reputation or credibility to validate one’s work (e.g., you were awarded N number of tokens for generating the first X $MM in sales for a particular initiative, and this is verifiable by looking at the smart contract that paid out the award).

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Running Out of Tokens in Your Employee Pool

With mindful planning, you’re much more likely to avoid running out of employee-allocated tokens as you get to your next milestone (e.g., the TGE). If, though, you wind up needing to hire more employees than planned or otherwise run low on tokens in the employee pool, there are ways to address this.

It’s highly unlikely all employees will vest the full amount of their initial grant, and you can reserve their unvested tokens for future hirings. If necessary, and likely as a last resort, you may find yourself needing to dilute another source of token allocations, such those reserved for founders, community, treasury, ecosystem incentives, and/or investors. Once you have a live token that’s trading, it becomes easier to buy-back tokens from the open market and/or employees.

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Long-term Ownership in Token Vesting

Token compensation almost always carries a vesting schedule. While we’ve seen vesting periods as short as 6–12 months with no cliff, a standard vesting schedule of four years with a one-year cliff is more common. Longer vesting schedules with cliffs/lockups tend to work best in incentivizing longer-term employee buy-in and gaining trust from the community, as well as sustainable growth and profitability over short-term hype and revenues.

While shorter vesting schedules can be a competitive advantage in closing candidates, it’s not a lever we suggest you pull lightly, as they can be a negative “risk” signal and deter community members and investors from your project. They can also have an impact on employee retention.

We do recommend being transparent about token ownership with your community. We do not recommend founders and/or core team members assign themselves very short vesting periods, enabling them to sell their tokens right away.

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Variations on Vesting Schedules

Vesting as it applies to employees or advisors is generally based on time with the company, and/or in rarer cases, some kind of performance metric or milestone. Unlike employees, investors don’t have vesting schedules, since they own all the tokens and there’s no condition for them to fulfill after their initial investment. Investors often do, however, have lockups (more on this below).

Most vesting schedules unfold over four years, although some teams are experimenting with other timeframes (e.g., three or five years).

Here’s a look at different types of vesting:

• Linear (most common): Employees vest 25% per year over four years.
• Back-weighted: Employees vest a larger percentage each year. This is less competitive from a hiring perspective (because it gives employees less ownership upfront), but it also incentivizes longer-term retention. At some point, several large tech companies were employing this strategy:
  — Amazon: Year one: 5%; Year two: 15%; Year three: 40%; Year four: 40%
  — Snapchat: Year one: 10%; Year two: 20%; Year three: 30%; Year four: 40%. (Snapchat has since switched to a linear vesting schedule.)
• Front-weighted (least common): Offering larger annual grants up front may compel candidates to join, but reduces the financial incentive for employees to stick with the company long-term.
  — Google: Year one: 33%; Year two: 33%; Year three: 22%; Year four: 12%

When it comes to post-cliff vesting frequency, monthly is most common, followed by daily and quarterly. Real-time streaming of token-based payments is also possible and unique to crypto.

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Token Lockups

Lockups (meaning restrictions on the right or ability to sell or transfer tokens) may be implemented by pre-TGE companies. They typically start at the token generation event and are set for one year. Note that this is different from vesting.

As an example, let’s say an employee has a four-year vesting period with a one-year cliff, starting on January 1, 2022. Let’s also presume that your token launches on January 1, 2023. Under the typical one-year lockup, the tokens would not be sellable until January 1, 2024. If the employee leaves the company sometime in 2023, they will still have ownership of the vested tokens, but again, cannot sell until the unlock date.

Lockups can apply to both investors and core team members, and they’re used to manage token supply and market dynamics. This aligns token holders to the same unlock dates, because you don’t want any stakeholder to sell immediately upon launch or ahead of anyone else. To prevent massive selling pressure at the same time, you might want to strategically stagger lockup schedules for the team, pre-seed investors, seed investors, advisors, etc. For instance, seed investors might get a lockup period of six months after TGE, team and advisors might get a lockup period of 12 months after TGE, late-stage investors might get lockup period of 18 months after TGE, and so on.

Take caution around the implications of moving a market if a large swath of tokens unlocks at once and many people decide to sell. This is something we again encourage you to consult your legal counsel and/or VC portfolio support team on when designing your token plan.

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Tax and Compliance Considerations

Regulations on tokens and token-based awards are not as solidified as those geared towards traditional equity awards. Using equity-based awards as a reference, companies should consider if and when tax laws are applicable to token compensation.

Neither Robin nor Zack, the authors of this article, are lawyers, and this is not legal advice. You’ll want to consult your own legal counsel, but below are some questions and topics to potentially discuss:

• Structure for token awards: Should awards be granted as restricted tokens, token options, or restricted token units (RTUs)? How do we best approach the conversion of equity into tokens?
• Tax strategies and optimizations: What’s the right approach around if and when to file 83(b) elections?
• Calculating tax liabilities for token awards: How should we be thinking about cost basis? What’s the right way to calculate the amount of taxes owed? What and when are taxable events?
• When does token compensation qualify as taxable income? Upon grant? Upon vesting?
• What happens if tokens vest before the token generation event?
• What valuation for a token is safe to stand by if there isn’t a reliable market price or sufficient trading liquidity?
• What are the tax considerations for US-based full-time employees and independent contractors? Who assumes responsibility for what?
• What are the tax considerations and responsibilities for non-US employees and contractors?
• Should we be implementing blackout periods for selling tokens, and/or policies on trading based on non-public information (similar to traditional equity rules)?

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Conclusion

Token-based compensation is an incredible tool for companies, and often, a major boon to employees. It’s important to mindfully use available data, benchmarks, and best practices to structure your hiring plan, particularly pre-launch.

Our next post in this series will be a broader, high-level overview of tokens, with a focus on those that are already “live” (i.e., launched/minted/trading). We’ll also explore strategies for calculating the right amount of tokens to award team members.

Portfolio support teams at venture firms with deep early-stage company and crypto expertise, like Dragonfly, can be invaluable in getting you going down the right path and working through complex nuance, as well as coaching you on the best way to structure and deliver compelling offers.

Tools like LiquiFi are also instrumental in creating frameworks and streamlining processes necessary to hire great employees using token-based compensation, and in automating the management of their offers over time.

Here’s what LiquiFi can provide:

• Tools for planning your employee token allocations and proper budgeting/forecasting
• Automation in setting up token vesting and grants, without any additional implementation work
• Security, compliance, ease-of-use, and tax/financial reporting support

Join LiquiFi’s waitlist (live and onboarding customers now!), and reach out to Dragonfly if you’re getting a crypto project off the ground. We both want you building. Many thanks to Haseeb Qureshi, Tom Schmidt, Dmitry Lapidus, Lindsay Lin, and Kevin Li for their 👀  and input on this article.