Token Equity Convertible (TEC) — a new way to invest in Crypto companies

Last week we compared buying tokens to buying equity in early stage crypto companies.

TL;DR — for early-stage, formative crypto companies, our firm, Pillar, believes investing in equity helps keep investors aligned with founders (they also own equity). This is our preferred route, even if spreadsheets suggest that sometimes investing directly in tokens is the better economic deal.

But does it need to be strict choice? Are there ways for investors to participate in both equity and tokens without it being completely unfair to the founder?

In this post, we introduce the notion of a Token Equity Convertible (TEC), a mechanism for investors to buy equity in a crypto company and have the option to exchange that equity for tokens in the future.

TEC has the virtue of keeping parties aligned in the early days of the company as the business model evolves but also gives participants a path to liquidity once the company reaches a stable network launch.

But first, the menu of choices we considered before creating TEC:

1. Buy equity (or a SAFE that converts into equity)
2. Buy tokens (or a SAFT that converts into tokens)
3. Buy tokens and buy equity through two separate transactions
4. A recent creation called the SAFE-T which gives investors a right to convert into both equity and tokens. This is the moral equivalent of a participating preferred in a traditional equity financing. Have your cake and eating it too. Perhaps good for some, but not our style.

We think alignment is critical in the early stages of these companies as business models change, tokens are structured (or restructured), tokens are reserved for or distributed to network participants and other sources of revenue are considered.

But at some point, the picture begins to stabilize, the model is established. The company has a network up and running with tokens in use and happy users.

At this point, the traditional paths to liquidity for participants are:

1. Sell the company
2. Take it public
3. Have the company sell tokens it holds and distribute the cash as a dividend
4. Distribute tokens directly to shareholders

In the latter two cases, any distribution is done pro-rata across all shareholders. But what if some shareholders (founders and employees included) want to keep their tokens in the company while others would like to receive (some or all) tokens to achieve liquidity.

Enter the TEC.

Token Equity Convertible enables a holder to exchange their equity for an equal proportion of company owned tokens.

For example, if an investor owns 10% of the equity of company Foobar, and Foobar owns 25% of all outstanding Foo tokens, the investor can exchange (i.e. give up) their 10% equity and receive 10% of the 25% company owned Foo tokens (2.5% of all outstanding tokens).

We used a TEC on a recent investment and believe in doing so, found a fair and aligned approach to financing the company.

The key parameters we considered were:

1. The exchange ratio — what % of equity exchanges to what % of company owned tokens
2. Window opening — when can holders initiate this exchange
3. Limitations — are there any limits to how much or how quickly holders can exchange and sell
4. Eligibility — is this for investors only or is this available for founders and employees as well

So far so good with the TEC. We don’t claim it to be the final answer, but a step forward in keeping participants aligned and enabling individual parties to find liquidity as they choose.

We’ve included an anonymized term sheet describing our Common Stock (see a better way) investment with the TEC feature as prepared by our counsel at Cooley.

Please review, comment, and share with others. An electronic version is here.