Tokens do not equal startup equity

Tokens do not equal startup equity


Startup equity ≠ tokens

Most crypto projects’ tokens drop 90%+ within two years of launching. Why? Because most web3 projects mistake their tokens for equity and treat them the same.

In this article we’re going to break down why tokens and startup equity are very different mechanisms that as used today, serve two very different contradictory purposes. In this article we’ll cover:

  • Token vesting basics
  • Why treating tokens like startup equity is a mistake
  • Vesting schedules & mechanisms

Token vesting and supply

As I covered in ‘Tokenomics: supply and demand 101', there’s a lot that goes into understanding the supply of a token but the key questions to understand are:

  1. How many tokens are on the market?
  2. How many will ever exist?
  3. How quickly are new tokens being released and to whom?

Those are the key questions dealing with supply. In this article I want to zoom in on question #3 and insider vesting is the biggest factor affecting it. While token inflation and overall supply is critical for the long term health of a token, in the shorter term timeframe of the first few months and years of a project, nothing matters quite as much as the insider distribution and vesting dynamics.

Example token distribution allocation. Source:
Example token distribution allocation. Source: Liquity Protocol.

Token vesting basics

In the early days of crypto, there was no vesting. Bitcoins are simply mined. Same for Ethereum tokens. Token vesting entered the crypto market during the ICO boom of 2017, when projects were minting tokens and then simply dumping them on retail investors. To prevent this and align incentives between the builders of a project and the token holders, the web3 world borrowed the popular startup mechanism of equity vesting. Using Carta’s definition:

Vesting is the process of earning an asset, like stock options or employer-matched contributions to your 401(k), over time. Companies often use vesting to encourage you to stay longer at the company.

The standard practice in startups¹ is a four year vesting schedule with a one year cliff. Meaning that each year you work at a company you’ll earn (i.e vest) 25% of the shares that the company has promised you. To earn all the shares, you’ll need to stay at a company for four years. The one year cliff means that if you leave before a year ends, you’ll receive no shares. It’s a standard practice to incentivize employees to ideally stay for a long time and at the least a year.

In web3, vesting means something similar. You earn your tokens over the vesting time period. There are however a few key differences:

  1. In startups, you can’t do anything with the equity you’ve vested, whereas in web3, you usually can: In startups, equity isn’t liquid and tradable. Just because you’ve worked at a company for four years doesn’t mean you can actually DO anything with your equity. In web3, vested tokens are usually fully tradable. The standard template contract designates exactly this.
  2. In startups, non-vested equity can’t be used for anything. Legally, it belongs to the company. For tokens, that’s not necessarily the case — a topic I’ll discuss in depth in a future article on how to legally structure token sales. But suffice to say that depending on the type of token vesting structure some non vested tokens can be used in other ways like staking or governance.

These two differences lead us to the key issue which leads to token prices collapsing. Treating tokens like startup equity is a huge mistake.

Why treating tokens like startup equity is a mistake

Startups use equity for one thing, and only one thing: to align interests among different stakeholders in the company. This alignment of interest is achieved by providing a share in the companies’ ownership and participation in financial upside. The way it does this is by making sure that employees stick around for a long time by locking up the liquidity of the shares in the company that employees own. The lock up on liquidity is what makes sure this mechanism works. If an employee had the option to sell their shares when they vested, they would detach their longer term alignment of interest with the company, negating the value that the equity sharing mechanism gives in the first place.

This is NOT the case in tokens. Thanks to decentralized exchanges like Uniswap and Sushiswap, liquidity can be found for almost every token out there, immediately. Tokens today try to serve two conflicting purposes:

  1. Align incentives between builders and long term holders
  2. Provide liquidity for the project economy: token utility, governance and financing

These two goals don’t work together. For the first you need to lockup liquidity. For the second, you need to unlock it. As long as this contradiction remains in place, there’s a tradeoff, and at the moment, it’s the tokenomics, and token holders, that are suffering in 99% of web3 projects. Let’s see how this plays out.

Tokens and equity are NOT the same

I’ll compare startup equity and web3 token granting to make the differences clear:

  • Equity is ownership in a corporation. With all the legal implications. Tokens have no such inherent connection.
  • Startups offer ownership with a four year vesting period. However they reach liquidity on average 11 years. Web3 tokens offer ownership with a four year vesting period, but reach liquidity with their tokens immediately or at latest after just 12 months. That’s a six year difference of achieving liquidity.
  • Startups reach liquidity after engaging with sophisticated investors, releasing a long detailed description of their business (a S-1 filing) and receiving commitments from investors interested in buying and holding their shares. Good IPOs are oversubscribed anywhere from five to ten times. Web3 tokens reach liquidity after releasing a twitter thread and a white paper. They’ve usually only engaged with small group of early adopters and seed investors. There is no large group of retail or institutional investors bought in to the token.

The difference between tokens and startup equity

  • Startups reach liquidity on mature exchanges, trading on well known public exchanges. Web3 tokens reach liquidity on decentralized exchanges (DEXs) or immature centralized exchanges (CEXs), each suffering from issues. DEXs can have liquidity issues, no oversight and regulation or control. Being listed on CEXs has been ripe with front running and pump and dump mechanics.
  • Startups reach liquidity as mature companies, employing thousands of people and reaching tens of millions in annual revenue. Web3 tokens reach liquidity with teams as small as two and at most 40.
  • Startups reach liquidity when their shares are distributed among many shareholders: 15–20% by the founders, 15–20% by employees 60–70% by investors in the company. All together there are quite a lot of people on a startups capital table when it goes public. Web3 reach liquidity with a different makeup. Token distribution is on average 18% are held by founders, 32% by investors and 50% to the public or community in various forms (either through a community pool or a public sale).
Average token distribution in web3 projects. Source:
Average token distribution in web3 projects. Source: Lauren Stephanian & Cooper Turley

What does this all mean? Startups reach liquidity with a fairly large and diverse set of shareholders: many investors, thousands of employees, founders and advisors. The reach liquidity many years after inception and importantly only if they’ve proven product market fit and have built a company with millions of dollars in revenue. Only 1:1000 startups reach the IPO stage where their equity earns liquidity. There’s a brutal natural selection process that happens.

Web3 tokens on the other hand reach liquidity with a smaller set of token holders, meaning more concentration and less public liquidity. Projects are nascent, almost always before product market fit and proving the utility, use case and organic demand, for their token.

How this plays out is inevitably the same across 99% of crypto tokens. Project tokens aren’t ready for the liquidity that arrives and prices collapse.


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Designing Tokenomics by Yosh Zlotogorski