Alternative Investment

Navigating Web3: Insider Guide

How to structure funding deals in the next generation of the Internet

Ready or not, the Internet’s third act is coming. Otherwise known as Web3, it’s yet to pass proof of concept stage but already creating plenty of buzz in fund management circles. What can you expect from Web3, how can you prepare for it, and what the heck is it exactly? Here’s a brief tutorial to break it all down for you, bitcoin by bitcoin.

What is Web3? To explain Web3, you need to start with Web 2.0 and the worrisome questions it raised about privacy, censorship, and centralized ownership. Web3 seeks to fix all that by letting users weigh in on decisions and access new functionality on the networks they frequent. It also provides encrypted wallets to protect online identities. Web3 users will instead rely on a centralized identity, eliminating the need to log in for each and every site visit.

In democratizing ownership, Web3 would also bring transparency to the way data is stored and managed. (No more deleting “offensive” content on the fly!) The vision for Web3 is to take the read/write web into the read/write/own era.

Ok, so how does it work? In a nutshell, Web3 replaces the binary framework of Web 2.0 with a blockchain distributed ledger system designed to make data more secure. It also decentralizes ownership and control of data by using “permissionless” blockchains, which levels the playing field for users. Corporations don’t own the data. Users do. In doing so, blockchain changes the very foundation Web 2.0 is built on, where companies wring all the data they can get from users.

Basics of blockchain-based fund deals. It’s important to remember the quid pro quo blockchains operate by. Users give blockchains computing power, and blockchains offer cryptocurrencies in return. The one caveat: Users need to believe cryptocurrencies are worth investing in. Community, it follows, is key to Web3’s long-term success.

The same logic applies to blockchain-based fund deals. Because Web3 is still largely speculative, the best funding deals give investors a mix of equity and tokens. Whether you take a traditional startup route and keep the stock value in the company or issue value in the form of a token, investors want to know they’ll see a return on their investment. By offering both equity and tokens, you allow for that return no matter which direction you decide to take in the future.

Basic terms. To succeed in this new paradigm, you need to speak the language. Here are five basic terms to know when structuring Web3 deals.

Equity. Web3 deals structured around equity use either a simple agreement for future equity (SAFE) or a priced equity round. Structure them so investors understand the risks and rewards.

Token. With the token approach, you promise investors tokens if and when you issue them. To maximize the deal, aim for a fair and equitable token distribution to give investors an incentive to help you succeed. When the token value increases, so does their investment.

Token Instrument. You grant token rights to investors through a legal contract, typically a token warrant or token side letter. Token warrants entitle investors to buy future tokens at a specified price. A token side letter is a less formal means to the same end, similar to a note versus a loan.

Token Pool. Picture the tokens you give investors as a pie. The whole pie is the token pool, defined by total supply or insider allocation. Total supply reflects the total number of tokens you distribute. Insider allocation refers to tokens set aside for insiders – partners, employees, and the like. The upshot: Insider allocation is best, since it gives equal incentives to all.

Token Percentage. Using the pie analogy, a token percentage is a slice, in this case either fixed or pro rata. A fixed percentage of the token pool means the size of the slice is set in stone. A pro rata percentage gives the investor a percentage of tokens based on equity.

Key takeaway: The best token structure for a Web3 deal is a pro rata percentage of insider allocation, or a slice of the pie based on equity with a set-aside for insiders. Hungry? Or just hungry for a deeper look at Web3? Read this article. Got questions about a blockchain-based fund deal already in the works? Reach out to our resident expert, Steve Vlasak.