Setting up a token compensation plan that fits your needs is a multi-step process with incredible depth and complexity involved. In our Employer’s Guide to Token Compensation, we explained what procedures setting up token compensation will entail, but we never dived deeper into how to execute those procedures.
Given our expertise in token grant administration, tax compliance across jurisdictions, and our extensive work with top clients in the space, we offer a practical, step-by-step guide on how companies can navigate the process of designing, implementing, and managing token grant agreements for their workforce. Additionally, we offer insights from early adopters, shedding light on best practices.
Challenges in Preparing Token Compensation Plans
Many crypto organizations understand how to send tokens, but don’t realize or deprioritize the legal, tax and operational risks they face when doing this in-house.
Meanwhile, crypto organizations that care about compliance in particular understand these risks but often struggle to get it right and end up with token compensation plans that are not standardized and unprepared for when the project scales up exponentially.
These challenges create many common mistakes we have seen from live crypto compensation plans that we redesigned and administer for our clients such as:
- Lack of clarity on total token allocation for the different compensation plans
- Not choosing the most optimal grant structure for their circumstances (For example, choosing to use RTU, RTA, Token Option, Phantom Tokens, etc)
- Lack of implementation details in token grant design stage
- Lack of clarity on the legality of token grant agreements in specific jurisdictions
- Lack of clarity on valuation method
- Lack of operational expertise to handle tax implications in each jurisdiction
The devil is in the details with getting the best incentive alignment for your organization, and in this article we’re going to delve deep to get you started on your token compensation plan.
Step 1: Allocate Tokens into the Token Grant Pool
Before launching a token incentive program, you need to decide how many tokens you are willing to allocate for the compensation pool for the core team in a “token grant pool”.
This pool will be used to reward both current and future employees in the form of “token grants”.
You might consider the following factors:
- Allocation. The importance of compensation in motivating employees and the percentage of the company's or project's tokens you are willing to allocate for compensation.
- Price. The value of the tokens in fiat currency (e.g., USD) that you intend to grant to each employee or contractor.
- Participants. The number of employees eligible to participate in the program, and the projected future headcount growth.
- Impact. The impact on your token ecosystem's overall supply and demand.
As a common practice, most organizations plan ahead and include a pre-allocated reserve of tokens within their tokenomics design specifically intended for the compensation pool. The typical percentage of the entire token pool allocated for employee compensation can vary significantly, and there is no one-size-fits-all. Generally, however, we commonly see 10% to 30% of the total token supply being set aside for the compensation pool.
In some cases, organizations might not have a pre-allocated reserve for compensation. In such situations, you can:
- Allocate existing tokens: In the absence of a dedicated reserve, you can allocate a portion of the existing token supply for the compensation pool. This approach can be viable if you have sufficient tokens available in your treasury and can accommodate the compensation requirements without negatively affecting other aspects of your tokenomics.
- Issue new tokens: You may decide to issue new tokens specifically for the compensation pool. This option leads to dilution and needs to be approached carefully to balance the creation of new tokens with the potential impact on token value and stakeholder interests.
Step 2: Determine Token Grant Details
Once you define the token grant pool, you may elect to establish the details of your grant administration in a token plan.
Token grant plans usually include the following:
- Eligibility Criteria: Define the criteria for employees to participate.
- Token Grant Structure: Determine which type(s) of token grant agreements are allowed under the token plan.
- Vesting Schedule: Determine how the granted tokens will vest over time to incentivize team members to stay committed to the project and contribute to its long-term growth.
- Valuation: Determine the method of valuation pre and post launch.
- Token Distribution: Describe how and when the tokens will be distributed.
- Termination and Clawback: Address what happens to unvested tokens in the event of employment termination or contractor agreement termination.
- Representations and Warranties: Include any relevant statements about the token grant program.
- Governing Law: Specify the jurisdiction and laws that govern the plan.
- Reporting Obligations. Determine the reporting requirements for your token compensation plan in all of the jurisdictions in which it will be administered and your employees are located.
Note that the token plan is the strategic framework that sets the guidelines for the entire token incentive program, while the token grant agreements are the individual legal documents that specify the terms and conditions of the token grants awarded to each specific eligible recipient. While you do not need to have a plan unless there is a specific need to qualify the plan under local law for some reason, the token grant must at least be in an agreement between the grantor and each grantee.
1. Eligibility Criteria
The plan must be provided only to certain employees, and the eligibility criteria will define which employees can participate.
There are various eligibility criteria you may choose to incorporate, but the most important ones focus on:
- Tenure and employment status: Determine the minimum tenure required for team members to be eligible for the token grant program. This could include factors like a probationary period.
- Employees: For employees, determine eligibility based on their status in good standing and length of tenure past any probationary period.
- Contractors: For non-employee contractors, establish eligibility based on the terms of their independent contractor agreement and ensure that the token grant aligns with their level of involvement in the project.
2. Token Grant Structure
You need to determine which types of token grant agreements are allowed under the token plan to standardize the scope of your token grants.
As outlined in previous sections, various types of token agreements have their unique characteristics. While many projects often grant a single token agreement structure (e.g., RTUs for all employees), your token plan can allow for multiple structures as long as the overall administration meets the requirements of local law for employee compensation, such as non-discrimination provisions. Regulations surrounding tokens and compensation can vary from country to country, and certain structures might be better in specific jurisdictions or more adaptable to regulatory change.
The optimal token grant structure for your organization can also depend on the lifecycle of your company considering that token grant agreements can be issued both before or after a token generation event. The earlier an employee is granted tokens that can be recognized as received for tax purposes, generally the better off the employee will be tax-wise since the token’s low value at that point will minimize income to the employee. Also, since tokens will usually receive capital gains treatment, early tax recognition starts the long-term capital gains clock as well.
On the other hand, the earlier the token grant, the less visibility both the grantor and the contributor will have into the token details, mechanics and allocation, but so long as the grant is not structured as exercisable options, the employees should be relatively indifferent to these details with an outright grant. For example, before a project launch, most companies opt for either Token Purchase Agreements (TPAs) or Restricted Token Agreements (RTAs). These agreements allow workers to pay taxes at grant when the token value is low. Post-launch, projects often switch to RTUs which entail tax obligations only on vesting, but these are spread out over time.
If you are using the services of an Employer-Of-Record (EOR), you will need to consider whether the grants of your tokens will be granted by the local EOR employer, or by the original issuer of the tokens, such as a foundation. This subject becomes more complicated if a local jurisdiction, or your own organization, considers your tokens to be unregistered securities under the relevant countries’ laws.
3. Vesting Schedule
You need to determine how the granted tokens will vest over time to incentivize team members to stay committed to the project and contribute to its long-term growth.
Most token vesting schedules are similar to traditional equity-based compensation: four years to fully vest with a one year cliff. In this schedule, vesting begins pro rata at the cliff, after which time the tokens continue to vest on a monthly basis until the vesting period ends. Typical grant agreements have cliffs of 6 months or 1 year, and a vesting period of either 3 or 4 years.
Most projects use linear vesting post-cliff which leads to a gradual distribution of tokens over time. With linear vesting, tokens are vested incrementally at regular intervals, allowing team members to receive a portion of their granted tokens consistently, usually monthly or quarterly. However, note that vesting can be based on any length of time, periods or triggers. Vesting could for example be triggered based on a future event of unknown timing, like a project milestone.
While technically solutions exist that enable the real-time streaming of token-based payment (and hence continuous vesting of token grants), these solutions pose significant challenges in terms of tax withholding and compliance. Most tax authorities do not recognize continuous vesting and streaming, making it complex to accurately calculate and withhold taxes in real-time.
There are jurisdiction specific clauses for vesting schedules that must be considered. For example, in Canada, tokens must be delivered within 3 years of the end of the applicable service year in order to avoid immediate taxation under the salary deferral rules under the Canadian Income Tax Act.
Smart Contract Vesting
One of the unique features of tokens is that vesting and other restrictions can be programmed into them via “smart contracts.” Although we are optimistic on the future of “on-chain” token grants and structures, we typically do not see many companies using smart contracts vesting tokens at this time.
4. Valuation Methods Pre and Post Launch
Before a token is launched its value may or may not be well known. Whether the value is well estimated or not is important for two reasons: (a) the first is to communicate with the recipient the value they are receiving as part of their compensation; and (b) the second, more important reason is for tax purposes. Tokens do not have an equivalent private valuation standard like a 409A valuation used for private company stock. The method of valuing a token for tax purposes is determined by the relevant tax authority in each jurisdiction.
At the pre-launch or “pre-sale” stage, neither an exchange price nor a price on the blockchain explorer would be available. In that circumstance, the company may need to engage with a valuation consultant specialized in tokens to provide an audited, pre-launch price based on projected financial metrics similar to how private companies value their private stock before it is traded on an exchange.
Thus, valuing pre-launch tokens for grant purposes can be a complex process, as it often requires considering factors such as market dynamics, token utility, and the company's overall financial performance. Like for 409A private company valuations, some common methods for token valuation include:
- Market-based valuation: Using market prices or exchange rates to determine the value of tokens.
- Discounted Cash Flow (DCF) valuation: Estimating the future cash flows generated by the token and discounting them back to the present value.
- Network Value-to-Transaction (NVT) ratio: Comparing the market value of the token to the volume of transactions on the blockchain network.
- Comparable Company Analysis (CCA): Comparing the token's valuation to that of similar companies or projects in the industry.
In the United States, the IRS provides that when an exchange price is not available, a crypto token shall be valued by a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates the value of the cryptocurrency at the exact date and time of any transaction.
5. Token Distribution
You need to consider when and how the vested tokens will be distributed. Some companies settle vested tokens right away, while others impose lockups and trading restrictions prior to settlement. Transparent communication regarding these release periods is vital to manage expectations and keep grant recipients informed about when they will receive their vested tokens, and under what conditions.
From process perspective, vested tokens are usually transferred from a company’s custody account or a multisig to the recipient's wallet.
6. Termination and Clawback
You need to establish clear policies regarding what happens to unvested tokens in the event of employment termination or the termination of a contractor agreement.
If an employee voluntarily leaves the organization before completing the vesting period, most companies choose to forfeit all unvested tokens. In cases of involuntary termination, such as layoffs or terminations for cause, the company may opt to accelerate the vesting of a portion or all of the unvested tokens or decide to forfeit unvested tokens. Whether grant management is handled on-chain or off-chain will have a large impact on the mechanics of these processes.
In the case of contractors, the treatment of unvested tokens upon termination of the contract agreement would follow a similar approach as in employment termination.
As discussed earlier, to protect the organization from potential misconduct or poor performance, you may also incorporate clawback provisions into the token incentive program. Clawback provisions enable the company to reclaim vested tokens from employees or contractors in specific situations, such as breaches of ethical conduct, violations of company policies, or fraudulent activities.
7. Representations and Warranties
As would be expected for any similar compensation agreement for stock or other assets, you will need to assure token ownership, availability, and legal compliance through specific representations and warranties. Grant recipients will warrant eligibility, acceptance of terms, and compliance. These statements provide clarity, legal protection, and mitigate risks, fostering trust and fairness in the token incentive process. In addition to normal concerns for incentive compensation arrangements, you will want your legal counsel to focus on key risks related to blockchain technology, custody, distribution and classification.
8. Governing Law
Again, as with any similar agreement you will want to specify governing law, forum and venue, including arbitration if desired. In addition to normal concerns related to all compensation plans, you will want your counsel to consider the law, forum, venue and mechanism that can best consider blockchain based compensation agreements that are still quite new.
9. Reporting Obligations
Local governments have new and highly evolving rules regarding the reporting of crypto transactions, not only for organizations providing token compensation to employees, but also obligations on the employees themselves that they need to know.
Some jurisdictions require that organizations report token compensation at the point of making the grant, while others require it during the year of vesting. Some require individuals to report the receipt of the token at the moment they have it, while others require that they report transactions annually on their tax returns. In the appendix, you can find several jurisdiction specific considerations for key countries, along with the local reporting requirements.
Step 3: Draft and Localize the Token Grant Agreement
Once you define the token plan details, you will need to prepare legal templates for token grant agreements you want to give to your employees.
To ensure compliance, provide locally compliant legal documents to grant recipients in specific jurisdictions for specific grant structure (e.g. RTU or RTA). Laws and regulations related to tokens, compensation, and employment can vary significantly between countries, and non-compliance may lead to severe legal, financial and reputational risks. Tailoring grant agreements to the local legal environment additionally enhances clarity for recipients and optimizes tax obligations.
Setting up a token compensation plan that is fully aligned with your project’s objectives and fully-compliant with every region your employees are in is a massive challenge.
Although this article runs down a comprehensive list of details that all compliant token grants must have, the final implementation and mechanisms that each organization needs are always different.
At Toku, we advise, design and administer these token grants with you through our Token Grant Administration platform. As an all-in-one solution, Toku makes it simple for leading organizations like Protocol Labs and Hedera Hashgraph, among many others.
Make your Token Grant administration simple. Skip out on those sleepless nights by working with Toku today.