SAFTs & Token Warrants — What They Are and How They Work
The mechanics surrounding early-stage investment in company equity is a well-worn pursuit, honed over decades since HBS professor George Doriot raised a $3.5 million fund to invest in technology companies back in 1946.
Equity term sheets are relatively standard, and today, when funds invest in an early-stage company, they typically use an instrument such as a convertible or a SAFE note (secure agreement for future equity) — the latter popularized by Y-Combinator.
But what happens when you’re investing not in equity but in a web3 startup’s native tokens - an instrument that doesn’t come with the same regulatory clarity?
There are two mechanisms on offer.
SAFTs
SAFTs (secure agreement for future tokens) is one such mechanism. A SAFT is a security issued for the eventual transfer of tokens from web3 startups to investors.
Web3 startups can use funds from the sale of SAFT to develop their project, mint their tokens, and issue their tokens to investors who have an expectation that there will be a secondary market to sell these tokens to.
But this promise for future tokens has run afoul of the Securities and Exchange Commission (SEC).
Messaging app Telegram was forced to return US$1.2 billion and pay the SEC an $18.5 million penalty because its native tokens, GRAMS, were found to violate federal securities laws.
Rival messaging app Kik was also ordered to pay a $5 million penalty because its native KIN tokens were also found to violate securities laws.
The Howey Test
Both Telegram and Kik were found to fail the Howey Test — which determines whether or not a transaction qualifies as an investment contract and would therefore be deemed a security and subject to disclosure and registration requirements under the Securities Act of 1933 and Securities Exchange Act of 1934.
According to the test, an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”
Token Warrants
Investors have one alternative that, as of May 2022, is growing in popularity amongst web3 venture funds — the token warrant.
Unlike SAFTs, token warrants are essentially an informal agreement that is not registered with the SEC and does not ‘promise’ future tokens. It gives both startups and investors optionality.
Token warrants are typically issued to equity investors in an overarching corporation (for example, popular DeFi protocol UniSwap was built by Uniswap Labs LLC).
The total number of tokens received by an investor commensurate with the equity ownership percentage x the percentage of token allocation for investors.
For example, in the case of Maple, below, a seed investor who owns 10% of Maple’s equity would receive 2.6% of its tokens (10% x 26%).
This might seem somewhat unfair to investors, and startups might sweeten the deal for investors by offering a sizeable discount on the price of purchasing tokens in the future.
This space will no doubt evolve over coming years as more regulatory clarity is offered.
We can only hope that the executive order that Joe Biden signed in early 2022 regulates crypto investing in a way that amplifies rather than destroys its potential. Otherwise, the United States is likely to face a brain drain at a time when it can ill afford it.
Disclosure: I am not a lawyer, this is not legal advice, and you should seek out independent legal counsel for your unique circumstances.
Steve Glaveski is the founder of community-owned web3 accelerator and venture fund, Metarise, founder of innovation accelerator Collective Campus, and author of Time Rich: Do Your Best Work, Live Your Best Life.
He hosts the Future Squared and Metarise podcasts, and frequently contributes to Harvard Business Review. Find him on Twitter at @steveglaveski.