How should Web3 startups build a reasonable token reward system?

Author: Robin Ji, Co-founder of LiquiFi; Zack Skelly, Talent Lead at Dragonfly Capital

Compiled by: Yang Shu, foresightnews

Token-based compensation is a new and powerful form of incentive alignment that brings new complexities to the compensation structures of startups. There is still limited public knowledge and data on compensation in Web3, and without reliable strategies, founders and hiring managers face the risk of long-term excessive dilution of tokens, leading to the loss of key employees, employee dissatisfaction or perceived unfairness, and ultimately an inability to build a healthy and efficient team or company.

This article delves into token compensation strategies before token issuance, intending to unveil the mysteries required to create effective hiring and token compensation plans in cryptocurrency, which should help you provide compelling and fair token-based compensation offers to potential employees and avoid chaotic distribution plans.

Why Top Talent is Entering the Crypto Space

It is clear that cryptocurrency offers incredible financial opportunities for those entering the industry. By the end of 2021, the total market capitalization of crypto reached $3.3 trillion (up from $800 billion less than a year prior), and everyone noticed the astonishing growth of crypto projects and massive fundraising.

Take Phantom as an example, which raised $9 million in Series A funding and then completed a $109 million Series B round at a $1.2 billion valuation just six months later. This is unheard of outside the crypto space, including Alchemy, whose valuation nearly doubled in about three months to $10.2 billion.

These potential benefits are not just in terms of salary and equity; they also manifest in tokens, but for many candidates looking to enter the industry, tokens are relatively new and unfamiliar. However, individual projects like Uniswap, Axie Infinity, and Aave have market capitalizations reaching $7 billion, and there are numerous opportunities for projects that have yet to issue tokens to achieve dramatic and life-changing potential.

There are significant differences between token-based compensation rewards and traditional equity, including:

• Immediate liquidity and faster time to market (no need to wait for a company acquisition or exit via IPO);
• No exercise costs or option choices;
• Compensation that automatically adjusts in real-time according to the market (unlike equity in startups, which is tied to the company valuation from the last funding round);
• Rewards are more directly linked to the value of the company's technological products or community, rather than being constrained by the company's financing and capital structure;
• The ability to compensate and attract global talent differently in jurisdictions where capital gains, payroll taxes, and local regulations may lead to pay inequality among individuals playing the same role;
• Access to potential liquidity through lending markets without triggering taxable events;
• Additional token incentives through staking, lending, and yield incentives;
• No dilution (for fixed-supply tokens), or at least transparent dilution, through transparent and stakeholder-coordinated means;
• Possible adjustments to total token supply;

Given the average dilution of equity in startups, the last point alone is significant:

How Early Token Compensation Works from a Company Perspective

Sounds good, right? Cool, but how do we build this framework?

First, don’t issue a token just for the sake of issuing a token. Tokens are not equity unless you decide to issue security tokens. Tokens must have real benefits for your product and community; otherwise, it is unfair to your employees and stakeholders, and deploying tokens purely for compensation purposes carries significant reputational, financial, and potential legal risks.

If you do have a need, many projects initially offer equity to employees and provide additional options to acquire tokens that have not yet been launched.

Given the uncertainty and complexity behind tokens and their markets, some companies decide to offer employees both equity and tokens, aiming to provide risk-adjusted offers and allow employees to gain some benefits, so the company can succeed even without a token issuance.

Whether this process can be realized largely depends on the company's business model and token economics, as well as how value accumulates separately to equity and tokens.

We strongly recommend consulting legal advisors and hiring crypto experts to understand how best to construct an overall compensation structure and how to create a sound token mechanism.

With this, you can decide how many tokens to allocate to employees, using a method similar to how early Web2 startups decide how much equity to allocate to their employee option pool and how much equity to grant each employee.

There is no one-size-fits-all blueprint, but you may want to consider the following:

Total Compensation Benchmarks and Industry Trends

Compared to traditional equity exit methods like IPOs and acquisitions, tokens typically achieve liquidity release earlier and with smaller team sizes.

Generally speaking, the average size of companies that achieve liquidity release (e.g., Token Generation Events "TGE") is between 20 and 40 people (based on Crunchbase, LinkedIn, team pages, and other public data sources). Interestingly, the average time to token release is usually less than 1-3 years.

On the other hand, traditional IPOs average around 11 years after founding, with these companies typically having hundreds or thousands of employees.

How much budget does the team want to achieve key business milestones (e.g., TGE)?

Similar to how you set a budget pool for equity rewards, you need to set a budget pool for token rewards and only retain the amount you plan to use (as tokens typically have a fixed supply and can be allocated for other strategic purposes).

According to Carta and Holloway (Foresight News note, an equity management platform), the traditional equity employee option pool for seed companies is 10-15%, while Series D companies are at 15-20%.

According to Craft (Foresight News note, a U.S. supply chain intelligence service platform) and SaaStr (Foresight News note, the world's largest business software community), founders typically retain 15-25% of company equity before an IPO.

As companies hire more employees and allocate equity rewards, the option pool increases over time, and as the company's valuation increases, the number of options added to your pool each round and the amount of equity you give up will decrease.

For crypto companies and projects, research driven by Lauren Stephanian and Cooper Turley (aka Coopah) indicates that the typical token allocation ratio for teams (i.e., founders and employees) is 17.5%, distributed among 20-40 people.

Who do you need to hire and how many people to reach the next milestone, and how much budget in tokens do you need for each hire?

Based on the averages mentioned above, you may need to budget around 15-20% of the token supply for about 30 employees and founders. Not all teams and companies are the same, so consider this a general guideline rather than a hard rule.

The average team size of 20-40 people serves as a reference range, and each team's plan will vary based on their attractiveness, business model, development strategy, and token economics.

Given your own project needs and company forecasts, you need to estimate the scale at which your team will achieve token liquidity release, where staffing and roadmap planning are key prerequisites.

While the total token supply is typically fixed, your allocation (i.e., the percentage allocated to employees, investors, and the community) can be modified before the token release. We recommend being conservative in forecasting employee token allocations; if you believe the time to reach TGE will take longer than expected and you need more people than initially anticipated, you are more likely to issue additional tokens as necessary to close key hires and investor partnerships.

Developing a Recruitment Plan for Token Compensation

For the purposes of this article, a "recruitment plan" forecasts the amount of equity or tokens you wish to allocate to each employee.

Here is an example using some fictitious percentages of tokens. We reiterate that these numbers are arbitrary, and please do not use them for your own business. You can work with legal advisors or investment support teams from VCs to set reasonable numbers based on your overall token/equity compensation strategy and goals.

In upcoming articles, we will delve into how to allocate tokens to each employee, so stay tuned.

General Guidelines for Comparing Your Allocations with Traditional Web2 Startups

Web2 equity allocations can serve as a guide for token allocations among founders, investors, and employees in Web3.

In traditional equity cap tables, founders typically hold 20% equity, employees are allocated 20% through a pool, and investors own 60% of the company. Based on this trend and the average token allocation of 17.5%, you can allocate roughly the same proportion to founders and employees and use it as a starting point for your potential token budget.

For example, if you allocate 20% of tokens to the team, and founders and employees hold roughly the same amount (based on a 20% employee option pool and 20% average founder ownership at IPO), you could split the 20% token allocation into a founder portion (10%) and an employee portion (10%).

It is also worth noting that in the traditional Web2 startup world, there are several widely acclaimed models for subsequent employee equity compensation, and you might consider using these ratios as benchmarks and budget them according to your available employee token allocations. For instance, the "Holloway Guide to Equity Compensation" suggests giving the first engineer 2-3% equity, the second engineer 1-2%, and so on. Sam Altman wrote that about 10% of total equity should be allocated to the top 10 employees, 5% to the next 20, and 5% to the next 50.

By understanding the nuances specific to cryptocurrency, you can further apply Web2 equity data to calculate individual employees' token-based compensation offers (which we will elaborate on in the upcoming post).

Of course, allocations may vary. For early-stage companies, many variables come into play, so the specific amounts offered may depend on the expected advantages of the company, the solidity of the business/product roadmap, revenue and sales channels, negotiation power, the early team's network, and the company's chosen offers (salary, bonuses, equity, and tokens).

Avoiding Insufficient Tokens in the Employee Pool

Since the total token supply is typically fixed, you need to avoid insufficient tokens in the employee pool. What’s the best way to do this? It’s worth repeating: build some buffer and conservative plans, assuming you need more people and more tokens than you imagine to outpace competitive rivals.

Given the volatility of the market and valuations, you might also consider having extra reserves so that if the value of tokens significantly declines and retention becomes necessary, you can "adjust" employees (please do this very cautiously and consult your advisors in advance, as this is not easily reversible and can have consequences; to mitigate risks, you should also consciously hire individuals who understand the market cycles in the crypto industry and regularly educate/remind your team about these cycles).

Another (less common) way to protect/build token allocations is to consider performance-based token bonuses. However, if they are used entirely in place of guaranteed, regularly distributed tokens, many may hesitate.

Over time, with the increasing popularity of DAOs, we can imagine performance-based token rewards combined with some form of on-chain reputation or credibility to validate a person's work (for example, you earn N tokens for achieving a specific level of transaction volume in a particular program, which can be verified by looking at the smart contract that pays out that reward).

Depletion of Tokens in the Employee Pool

With conscious planning, you are more likely to avoid depleting the tokens allocated to employees as you approach the next milestone (e.g., TGE). However, if you ultimately need to hire more employees than planned or if there are insufficient tokens in the employee pool, there are some ways to address this issue.

It is unlikely that all employees will receive their full initial grants; you can retain unallocated tokens for future hiring. If necessary, and possibly as a last resort, you may find yourself needing to dilute another source of token allocation (e.g., those reserved for founders, the community, treasury, ecosystem incentives, and investors). Once you have a trading token in real-time, it becomes easier to buy back tokens from the open market or employees.

Long-term Ownership of Token Releases

Token rewards almost always come with a vesting schedule, and while we see release periods as short as 6-12 months, sudden unlocks are rare, but standard four-year vesting schedules with a one-year cliff are more common. Longer vesting schedules with lock-up periods and final unlock releases are most effective in incentivizing long-term employee engagement, gaining community trust, short-term publicity, and achieving sustainable growth and profitability.

While shorter vesting schedules can become a competitive advantage, we do not recommend doing so lightly, as they may signal negative "risk" and deter community members and investors from engaging with your project, and they may also impact employees.

We recommend being transparent about community token ownership, and we do not advise founders or core team members to allocate themselves very short vesting periods that would allow them to sell their tokens immediately.

Changes to Token Release Schedules

Release schedules applicable to employees or advisors are typically based on their tenure with the company, and in rare cases, based on some performance metrics or milestones.

Unlike employees, investors do not have release schedules since they own all tokens and have no conditions to fulfill after their initial investment; however, investors typically have lock-up periods (more on this below).

While some teams are experimenting with other timeframes (e.g., 3 years or 5 years), most release schedules are achieved within 4 years. Here are different types of release schedule schemes:

1. Linear (most common): Employees release 25% each year over four years.

2. Back-weighted: Employees have a larger release percentage each year. From a hiring perspective, this is less competitive (as it gives employees less upfront ownership), but it also incentivizes long-term retention. At one point, several large tech companies were adopting this strategy:

• Amazon: Year 1: 5%; Year 2: 15%; Year 3: 40%; Year 4: 40%;
• Snapchat: Year 1: 10%; Year 2: 20%; Year 3: 30%; Year 4: 40% (Snapchat has since switched to a linear release schedule);

1. Front-weighted (least common): Providing larger annual bonuses upfront may entice candidates to join but reduces the financial incentive for employees to stay long-term.

• Google: Year 1: 33%; Year 2: 33%; Year 3: 22%; Year 4: 12%;

In terms of the frequency of unlocks, monthly is the most common, followed by daily and quarterly. Real-time streaming forms of token payments are also possible and unique to cryptocurrency.

Token Lock-ups

Lock-ups (which restrict the right or ability to sell or transfer tokens) may be implemented by companies before the TGE, typically starting from the token generation event and set for one year. Note that this is different from vesting.

For example, suppose an employee has a four-year vesting period starting January 1, 2022, with a one-year lock-up. We also assume your tokens are released on January 1, 2023; under a typical one-year lock-up, these tokens cannot be sold until January 1, 2024. If the employee leaves the company at some point in 2023, they still own the vested tokens, but they cannot sell them until the unlock date.

Lock-ups apply to investors and core team members; they are used to manage token supply and market dynamics, aligning token holders with the same unlock dates, as you wouldn’t want any stakeholders to sell immediately after release or before anyone else.

To prevent simultaneous massive sell-off pressure, you may want to strategically stagger the lock-up schedules for teams, seed pre-investors, seed investors, advisors, etc. For example, seed investors might have a six-month lock-up after the TGE, while teams and advisors might have a 12-month lock-up, and later-stage investors might have an 18-month lock-up after the TGE, and so on.

If a large number of tokens unlock simultaneously and many decide to sell, be mindful of the market impact. We again encourage you to consult your legal advisors or the investment support team of your VC when designing your token plan.

Tax and Compliance Considerations

The regulation of tokens and token-based rewards is not as solidified as that for traditional equity rewards. Using equity-based rewards as a reference, companies should consider whether and when tax laws apply to token rewards.

The authors of this article, Robin and Zack, are not lawyers, and this is not legal advice. You need to consult your own legal advisors, but here are some potential discussion points and topics:

• Structure of Token Rewards: Should rewards be granted in the form of restricted tokens, token options, or Restricted Token Units (RTUs)? How do we best convert equity into tokens?
• Tax Strategies and Optimization: Regarding whether and when to file an "83(b) election"? (When making an "83(b) election," the IRS can confirm income at the time of grant and tax on the acquisition of company shares rather than at the time of release);
• Calculating tax liabilities for token rewards: How should we consider the cost basis? What is the correct way to calculate the amount of tax owed? What constitutes a taxable event and when?
• When does token compensation qualify as taxable income? Upon grant? Upon release?
• What happens if tokens are released before the token generation event?
• What is the valuation of tokens if there is no reliable market price or sufficient trading liquidity?
• What are the tax considerations for full-time employees and independent contractors in the U.S.? Who bears what responsibility?
• What are the tax considerations and responsibilities for non-U.S. employees and contractors?
• Should we implement a lock-up period for selling tokens or a trading policy based on non-public information (similar to traditional equity rules)?

Conclusion

Token-based compensation is an incredible tool for companies and often a boon for employees. Be sure to use available data, benchmarks, and best practices cautiously to build your recruitment plan, especially before token issuance.

The investment support teams of venture capital firms with deep early-stage company and crypto expertise are invaluable in getting projects on the right track and handling complex nuances, as well as guiding projects to build and deliver compelling products in the best way.

Our next article in this series will provide a broader and more advanced overview of tokens, focusing on those that have already "gone live" (i.e., launched/minted/traded), and we will also explore strategies for calculating the appropriate number of tokens to reward team members.