Axios Pro Rata

Over the past couple of weeks, VCs hoping to invest in buzzy cryptocurrency project SushiSwap haven't spent their time wining and dining entrepreneurs as usual. Instead, they were busy commenting in online forums and joining Discord audio chats — since their ability to invest hinges on getting approval from SushiSwap’s token holders.

Why it matters: This isn’t the first time VCs have needed to win over a vast cryptocurrency community, and it certainly won’t be the last.

Background: SushiSwap, which debuted in August 2020 and currently has roughly 60,000 token holders, is a decentralized cryptocurrency exchange that lets participants transact with each other without a centralized entity.

• A proposal from Sushi community leaders earlier this month pitched boosting the project’s available cash reserves for tech development by selling about $60 million in tokens from its reserves to institutional investors.

Yes, but: The proposal, which token holders would have to approve, has been particularly controversial because VCs would get tokens at a discounted price.

Between the lines: The central question is “what does it mean to bring on people to a cap table?” says Michael Dempsey, general partner at Compound. Dempsey personally owns Sushi tokens but isn’t involved in the proposal.

• VCs have long enjoyed discounts and other forms of preferential treatment when backing companies, under the industrywide belief that they “add value.”
• But Sushi community members are saying the quiet part out loud: "Prove it."

State of play: Sushi members immediately questioned the potential investors’ commitment to the cryptocurrency protocol’s future — and wondered what, exactly, the investors would do to help its development.

• Opponents of the proposal say incoming VCs haven't earned a discount.
• Arguments in favor have largely come with a caveat that investors should have a long lockup period to prevent them from quickly flipping the tokens.

What they’re saying: “Digital assets flip [the model of VC ownership] on its head — the majority of assets go to the stakeholders, the customers or developers working on the asset,” Arca chief investment officer Jeff Dorman, a loud opponent of the initial proposal, tells Axios. “You’re now on equal footing with the investors.”

The big picture: This isn’t the first such case. MCDEX, Lido, the Index Cooperative and other decentralized autonomous organizations (DAOs) have successfully raised millions from VCs in the past.

• Cryptocurrency protocols that let participants execute various transactions directly with each other through the networks instead of using intermediaries have been exploding in popularity.
• And while many self-governed projects began with an organization leading its early development, some are now forming organically in a decentralized manner as project developers attract like-minded participants.

The impact: Decentralized groups of token holders are likely to continue raising funds from VCs — not only as a way to raise the equivalent of “growth financing” for a more mature protocol, but also at earlier stages for startup capital.

What's next: The SushiSwap community is currently parsing through a number of new proposals from VCs and community members on how it should raise new funding.

The bottom line: If true believers in decentralized finance (DeFi) are correct, wooing community members will soon be a more common part of the crypto VC's job.

The "initial coin offering" (ICO) boom of 2017-2018 ended in a slew of lawsuits from U.S. regulators over securities law violations, and even fraud. But startups in the space are still raising funding.

Why it matters: With the boom in DeFi projects, startups and groups looking to raise funds to build out new cryptocurrency networks and tokens are not going away.

Flashback: In 2019, the U.S. Securities and Exchange Commission issued a long list of factors it considers when evaluating whether a digital token is a security.

• While not the hard and fast rules the industry had been hoping to get from the agency, it gave more clues to startups, investors and their lawyers as to how to better stay within the limits of the law, says Fenwick & West associate Jacob Wittman.
• The framework leaves open the possibility that a token can be a utility and not a security once a network is sufficiently decentralized, though all clues suggest that pre-selling tokens to finance the building of these networks is akin to a sale of securities. And folks have been structuring financings as such.

Today: Cryptocurrency startups that are building a protocol with tokens typically structure their fundraising from VCs in one of two ways, according to lawyers and VCs:

• A traditional equity round, with additional provisions for token ownership rights: This is pretty similar to a traditional VC fundraising mechanism, though the documents include terms for allocating (usually on a pro rata basis) tokens to the investors if and when these come into existence.
• This is most popular for early-stage startups, where the network and tokens are far down the road.
• It’s also popular in cases where the investors want to back the underlying company (and get a piece of the future tokens) if they see the protocol it's developing as just one of the technologies it will build.
• A SAFT ("simple agreement for future tokens"): Developed by law firm Cooley and Protocol Labs in 2017 based on the popular “simple agreement for future equity,” the SAFT got a bit of a bad rep stemming from some misuse and questions about its legality.
• But it’s still popular today, lawyers and VCs tell Axios — though everyone’s significantly more vigilant about only letting accredited investors participate.
• Long lockup periods are also commonplace now to ensure that no one is flipping the tokens.
• The SAFT is also more common for startups on the verge of deploying their network and tokens than for those that are years away.

The crypto world is not short on novel financial ideas. Here are two worth keeping an eye on:

Security token offerings: STOs have been slow to gain popularity, especially when compared with the explosion of initial coin offerings — but proponents have tried to pick up where the latter left off. Unlike offerings of “utility tokens” (that is: digital tokens that exist to be used within a tech ecosystem’s applications), STOs aim to be full-fledged securities but on the blockchain.

• As securities, they’re regulated in the U.S. by the SEC and require approval to be offered for sale to all investors. Only a handful have gotten that approval so far, but some experts predict they’ll eventually gain more popularity.

Venture DAOs: Decentralized autonomous organizations aren’t just for cryptocurrency projects. Venture capital can also be deployed and managed this way.

• Unlike a traditional VC firm, typically set up as a partnership, venture DAOs function as a collective of members who put up the organization’s funds, then source, conduct diligence, and vote on potential investments.

• MetaCartel Reimagines Venture Capital for a DeFi Future (The Defiant)
• PancakeSwap, Uniswap, SushiSwap and More: What to Consider When Parking Crypto in a DeFi Exchange (Coindesk)
• Wyoming's 'DAO law' passes State Senate in a 28-2 vote (The Block)

The first initial coin offering was actually a few years before the boom of 2017-2018.

• Question: Which protocol conducted the first ICO? (Scroll to the bottom for the answer.)