Tokens Over Equity? Reimagining Startup Compensation

September 04, 2024

Imagine you're Sarah Chen, a talented software engineer weighing two job offers. OldTech Inc. presents a familiar package: a competitive salary with stock options vesting over four years. DecentralizeCo, a blockchain startup, offers something different: "tokens."

These tokens aren't just equity. They represent a stake in the entire ecosystem DecentralizeCo is building. You can use them on the platform, participate in governance decisions, and potentially trade them for value.

This is token compensation—a new approach that's changing how some startups think about rewarding talent. It's not just about ownership; it's about participation in a digital economy.

Shifting Incentives: From Company Success to Network Growth

Traditional startup compensation aligns employee interests with the company's success. A modest salary paired with stock options incentivizes staff to work towards a singular goal: increasing the company's value. This model has driven Silicon Valley's growth, with employees sharing in the rewards when their company thrives.

Blockchain startups, however, are rewriting this script with token compensation. While both stock options and tokens represent a stake in the future, they fundamentally differ in what they incentivize.

This shift from company-centric to network-centric incentives is significant. Unlike stock options, which derive their value solely from the company's success, tokens can have intrinsic utility within the ecosystem they're designed for. It's as if your stock in Amazon also allowed you to buy products on the platform, or your Google shares gave you a say in the company's algorithm changes.

But the implications go even deeper. In the world of tokens, the line between employee, user, and investor becomes blurred. This is by design. With tokens, companies can align incentives across their entire ecosystem. The most active users, developers, community moderators – they can all be owners. It's a way of recognizing that in a decentralized world, value creation happens everywhere, not just inside the company.

A New Compensation Structure

This shift has profound implications for how companies structure their compensation. The unique properties of tokens allow for compensation strategies that were simply not possible with traditional equity. Let's break down some of these key differences:

Non-Dilutive Nature of Tokens: Unlike equity, which dilutes existing shareholders when new shares are issued, tokens often operate differently. Because tokens derive their value from the utility and adoption of the network, issuing new tokens doesn't necessarily dilute value in the same way.

Community-Centric Distribution: In the token model, some of the largest grants often don't go to executives or even employees. Instead, they're reserved for key community contributors – the people building applications on top of the platform, or those helping to govern the network.

Liquid From Day One: Unlike traditional equity, which remains illiquid until a company goes public or is acquired, tokens can be liquid from the moment they're launched. This creates a unique dynamic where early-stage companies suddenly have publicly tradable assets.

Unique Challenges of Tokens

The tax implications of token compensation are complex, and for good reason. Token companies find themselves in a unique position: they're often early-stage startups in terms of product development, but they're dealing with the tax complexities of public companies due to their tradable tokens.

Imagine if Google had gone public the day it launched its search engine, instead of years later when it was a mature company. That's essentially what's happening with many token projects.

This creates a perfect storm of tax complexities:

Volatility: Token prices can fluctuate wildly, making it difficult to determine fair market value for tax purposes.

Liquid tokens: Receiving tokens that are liquid can trigger taxable events much earlier than with traditional equity. When coupled with illiquid token markets, token holders often have to plan ahead to avoid significant tax bills.

Regulatory Uncertainty: The legal and tax treatment of tokens is still being figured out by regulatory bodies.

Navigating the Tax Maze: Strategies for Token Compensation

Given these challenges, companies are developing strategies to navigate this tax maze:

1/ Unlocks and Vesting

One of the most common approaches combines vesting with token unlocks:

Vesting: This determines when a person gains ownership of their tokens.

Unlocks: This determines when tokens become transferable or usable on the platform.

Much like a double trigger in equity, this separation creates two distinct milestones that must be met before the tokens become fully accessible. By doing so, companies can provide immediate ownership (vesting) while still ensuring long-term alignment (unlocks). For example, tokens might vest monthly but only unlock quarterly or based on specific project milestones.

2/ Calculating and Managing Tax Withholdings

Companies are getting creative with how they handle tax withholdings for token compensation. Some strategies include:

Net Settlement: Distributing fewer tokens to cover tax obligations, similar to how some companies handle RSU tax withholding.

Liquidity Provision: Some companies are setting aside funds or creating special purpose vehicles to provide liquidity for employees to cover tax obligations without having to sell their tokens on the open market.

Tax Payment Tokens: In some cases, companies are issuing separate tokens specifically designed to cover tax obligations, which can be exchanged for fiat currency at predetermined rates.

3/ Strategic Token Valuations

Valuing tokens accurately is crucial for tax purposes, especially for networks that have already launched. Even when tokens are publicly traded, they may lack sufficient trading volume for true liquidity. A valuation can account for this limited liquidity, potentially resulting in a lower, more favorable valuation for tax purposes than the public market price would suggest.

Some valuation strategies include:

Illiquidity Discounts: Applying discounts based on lock-up periods or transfer restrictions.

Milestone-Based Valuations: Tying token values to specific project milestones or network metrics.

Time-Weighted Average Pricing: Using average prices over specific timeframes to smooth out volatility.

These approaches can help lower the taxable value of tokens, reducing the immediate tax burden on recipients while still complying with regulatory requirements.

The Future of Compensation

As Sarah makes her decision, she realizes she's part of a broader shift in how we think about work and value creation. Token compensation is blurring the lines between employees, users, and investors, creating new opportunities and challenges.

This model may expand beyond blockchain startups. Imagine rideshare companies where drivers have a say in policies, or social media platforms where influential users earn governance rights along with their ad revenue.

The token revolution in compensation is forcing us to rethink fundamental questions about work, value, and incentives. In a world where a company's value can be as much about its community as its bottom line, how do we properly reward the people building that community?

As Sarah accepts DecentralizeCo's offer, she's not just joining a company – she's becoming a stakeholder in a new digital economy. Her journey will be one of many that shape the future of compensation in the digital age.

Join the conversation

We’d love to continue the conversation at NASPP Annual Conference in San Francisco this October 14-17th. We’ll be speaking more on The Future of Crypto Compensation. We’re proud to help amazing projects simplify their token management, and build practices that are emerging playbooks for the space.

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Yin Wu is the CEO and co-founder of Pulley. Pulley is the leading equity and token management platform. Trusted by over 4,000 companies, Pulley simplifies complex processes from cap table management to token distributions. Within Web3, Pulley provides crucial support in managing their tokens.

By Yin Wu
Co-Founder

Pulley