Paying in Tokens | What DAOs Can Learn from Startup Equity Compensation
Introduction
“How should DAOs pay contributors?” must be one of the most vexing questions for DAO founders and governance. Great compensation attracts talent, but it can be a steady drain on the treasury. Set it too low, and the old adage “Pay peanuts, get monkeys” will suddenly ring truer than can be desired. Pay too much, and the DAO might just go under.
Many DAOs have experimented with paying contributors partly or fully in native tokens. The theory being that token payments align the incentives of contributors with the well-being of the DAO and reduce value extraction and other kinds of nasty behavior for the DAO while being “Manna from heaven” for contributors.
In practice, paying in tokens comes in a wide variety of flavors. Crypto is all about setting the right incentives, and depending on the exact way that token compensation is calculated and distributed, it can do wonders to retain top talent or work in the exact opposite direction of what is intended.
We want to illustrate the most common pitfalls of token compensation and propose a way that truly aligns with long term success. We took startup equity compensation and translated it into the DAO and token space, because we believe that startups have more experience with this particular problem, and DAO governance can learn from them.
First, a very important disclaimer: Tokens are not equity!
We will use startup equity compensation as a guideline because we see that it is very desirable for employees and we wish token compensation to have a similar effect.
Startups usually don’t pay their early employees in stock, but in options to purchase the company’s stock at a later prace, as soon as it is available. Remember that most startups don’t have stock available at the get go, so most options become valuable only in the event of a public offering or private sale of the startup. Let’s dive into options 101 to develop a deeper understanding of how they work.
Options 101
We’ll only cover call options here, because no company ever paid its employees to short itself. Options are always a derivative which represents a right, but not an obligation, to purchase the underlying stock. An employee receiving options is free to choose whether they want to purchase stock or not. But options expire at a defined point, after which they no longer entitle their holder to a stock purchase. European options allow holders to buy stock only at the expiration date, while American options allow the holder to purchase stock up to the expiration date.
Options have a strike price, which is the price the owner of the option has to pay for the underlying stock when they are exercising their option. The market price of an option is what the market is willing to pay for the option, but not all options are available on the open market. The market price is fundamentally different from and has nothing to do with the strike price. The former is what people are willing to pay for the opportunity to purchase stock at the strike price.
The strike price should be set at or above a company’s current valuations allocated across equity classes to arrive at fair market value (FMV). For public companies these valuations are known from the stock market, but for private companies it involves a so-called 409a process, that has to be performed once a year and is usually done by external auditors.
When employees get paid in options two other parameters come into play. These are the cliff and the vesting duration. The cliff is the amount of time that has to pass until an employee is entitled to options compensation, while the vesting duration is the amount of time that has to pass until the employee is entitled to all of the options in his salary package. Apart from time-based vesting, some companies chose milestone-based vesting where options only become available once certain milestones have been met, usually sales or profitability targets.
Okay, that was all extremely theoretical, here’s an example.
Jane Doe just got hired by HotStartup, Inc and receives a salary of $120k a year plus an options package. The options package has a one year cliff, and a four year vest, and allows her to purchase HotStartup, Inc stock ($HSI) for a strike price of $10 and a maximum of 8,000 stocks per year of employment.
Here’s what Jane gets: After one year, she can purchase up to 8,000 options for a total of 8,000$ (1$ per option). These options take another three years before all of them are available for her free disposal, because there’s a four years total vesting duration. Usually every year after the cliff she would be able to purchase 33% of the stock she’s entitled to by her options. She can purchase HSI stock for $10 per stock. The intricacies of how employees buy stock they are entitled to offer some intricacies that we don’t want to explore here, because they are not important in this scope.
Now, let’s say HSI is doing great and after a banger IPO one stock trades for $50. Jane just made the bank, because each of the options that she paid $1 for allows her to buy a stock that is worth $50 for just $10, a neat 5x. Depending on how many options she bought this could be worth a lot more than her salary. If the stock price is above the strike price the option is said to be in-the-money.
If the stock isn’t so hot, her options would be worth less, or nothing at all (called being out-of-the-money).
Options align the employee with the long-term success of the company well. Plus they allow the employee to dial the exposure to their liking. We want token compensation in a DAO to have the same features, ideally.
Token compensation, taxes and sell pressure
DAOs like to pay in native tokens for three main reasons:
- DAOs have native tokens in their treasuries
- DAOs want to give contributors a say in governance
- DAOs want to align contributors with the DAO
Paying in native tokens provides a cost advantage to DAOs. Depending on when the tokens are issued their cost can be well below their current market value. Take the seed sale of SOL, Solana’s native token, as an example. Early investors could buy one SOL for $0.04. While it cost Solana almost nothing to “produce” the token, there is an opportunity cost that the DAO incurs by not selling the token as part of that seed round, but instead giving it to contributors.
If the Solana foundation would pay contributors with tokens from the seed sale batch, the opportunity cost to the foundation is only $0.04 per token, but they could use these tokens at market value when paying contributors. Of course, this assumes the token price went up since the seed sale, otherwise a DAO might be better advised to pay in stablecoins or other cryptocurrencies, or buy tokens on the open market to decrease sell pressure.
We have now covered the supply side of tokens. Looking over to the demand side, the contributors, we see that contributors do not keep all the tokens they earn, even if they believe the tokens are going to be worth a lot more in the future.
If contributors rely on their work in a DAO for their income they have bills and taxes to pay. Rare is the landlord and unseen is the tax authority whose claims can be postponed “to the next bull run”. So some of the tokens paid will inevitably land on exchanges and fiat off-ramps to keep the family fed and the contributor out of prison for tax evasion.
Depending on how pay-outs to contributors are scheduled across the DAO, token compensation can create short bursts of sell pressure. Think of a DAO with 50 members who each receive $8,000 of native tokens on the same day. If all of them cash out 60% on the day they get paid, and the native token is still in its infancy, each “pay day” would create sell pressure to the tune of $240,000. This is more than the daily exchange volume of $ZEON, the #225 on Coinmarketcap. Certainly more than the liquidity of many nascent DAO tokens. Such a concentration of sell orders would create massive slippage, painful losses and unhappy investors and contributors alike.
If DAOs pay in native tokens they should spread payments out over the days of a month to reduce sell pressure. Laser eyes and HODL memes quickly take a back seat to real and pressing concerns of paying mortgages or schooling fees.
Translating options compensation to tokens
The most important difference between options and tokens is that options are merely a right to buy. Liquid options for digital assets exist only for a handful, like Bitcoin or Ethereum. Paying options for tokens might not be a possibility for the vast majority of protocols and DAOs, although protocols like UMA offer permissionless ways to create options on ERC-20s.
But the functionality of options can be translated to the token world. Let’s rehash: options allow their holders to purchase stock at the strike price, regardless of what the current market price for that stock is.
What if DAOs would award contributors the right to purchase their tokens at a predefined price. For example, what if MakerDAO would set a token “strike” price once a year, and contributors would be able to purchase tokens from the protocol at that price. If the token price is above the price set, contributors would be “in the money” and profit handsomely. The DAO would pay a subsidy on tokens purchased to make them available at the predetermined price, but contributors would have to choose whether they want to purchase the tokens at that price or not. Maximum quantities on subsidized tokens can be set during budget allocations.
The amount of tokens bought by the workforce would give DAO governance valuable feedback on how excited contributors are about the DAO’s prospects. Very low purchasing rates would indicate that either the subsidized price is still too high, which could happen during bull runs, or that contributors are not interested in the token, which spells trouble.
Below is a chart showing what a 100 day moving average would look like:
We can see that contributor MKR vesting would be “out of the money” during MKRs long price decline starting mid August 2021. If we take MKR as a proxy for the “value” of MakerDAO, the compensation model does exactly what it should. Contributor pay would be reduced during a difficult period for the protocol. Of course token compensation could also be tied to other metrics. In MakerDAO’s example it could be the supply of its stablecoin DAI, or protocol profitability.
Setting the right subsidy price for tokens based on other metrics than historical price is a formidable challenge, though. DAO governance needs to think about the incentives it wants to bake into compensation, and approach the subject from that angle.
Cliff and vesting are easier to emulate. Making the subsidy only available to contributors with a certain tenure and then spreading out the amount of tokens they can purchase over the vest lengths is a simple and straightforward process. To illustrate: Let’s say a contributor receives a subsidy for 100 tokens after one year, vested over five years total the distribution would look like this:
The subsidy rate would be determined by the end of the first year of contribution. As you can see these subsidies can provide massive benefits to early contributors and dwarf the amount of stablecoin salary, should a DAO choose to pay that.
While stock in private companies is usually not liquid, tokens are, from the minute they are generated. Contributors can sell them the minute they get paid. DAO governance has to keep that in mind and either make sure the token has incentives to hold built in, or think about just increasing the non-token part of the compensation, if possible.
DAOs that do not have a token yet, but plan on having one in the future, could give contributors token warrants. These warrants entitle their holders to a certain percentage (fractions of a percent) of tokens in the event the DAO releases them in the future. Early contributors can get in on the very ground floor that way.
Advantages of token based compensation
Token-based compensation is better than stock options in some ways. First and foremost tokens are tradeable, the moment they get released. Most protocols make sure there’s some liquidity on at least a DEX or two, to incentivize token purchases by anons and investors.
The same is not the case with stock options. Options for stock in private companies have no liquid markets, and only become valuable in the event of an IPO or exit. Even in the case of an exit to private equity, liquidity events are often tied to further milestones that delay the payout. Sometimes these milestones are unrealistic, leaving the stock options worthless.
Liquid markets have led to much higher valuations for a couple of token-based projects than would be possible in the traditional finance world. Take Uniswap for example.
The token had a $25bn market capitalization a mere six months after its introduction and at a time when the Uniswap Labs had few employees. We couldn’t find any example of a private or public company with $25bn of market value and less than hundreds of full-time staff.
Uniswap’s team received 21.51% of the initial token allocation! A similar upside is unheard of in the non-token startup world.
Conclusion
Token compensation only aligns contributors with the DAO, if the tokens are designed to have fundamental value. If the only use case for a token is “Numba go up”, then contributors are acting in their own best interest when dumping as soon as possible, lest the music stops while they’re holding the bag.
DAO governance should make sure that contributors are not used as bag-holders of first and last resort. Systems-thinking and wargaming token models can make sure designs are as good as they can be, so they have the best chance to succeed in the market.
Tokens are not stocks and are not equity, but they can be a very important part of contributor or employee compensation. Just make sure to get the basics right: fundamental value, fair token launches, and setting vests and subsidy prices at levels that delight contributors and attract talent.
