??Unlike DeFi tokens, startup equity and its options are illiquid. Employees can sell DeFi tokens without a big haircut.
??DeFi employees don't need to wait for unicorn exit events to sell their tokens, which means grants of tokens are more incentivizing because, unlike startup equity, the payout is not years later, if ever. Incentivization is built into the DNA of DeFi - much time is spent optimizing incentivization.
??The vesting of DeFi tokens can be synced up with the roadmap of the protocol to incentivize employees to work particularly hard at key times.
??Currently, DeFi tokens are more likely to be worth something than startup equity - grants of future DeFi tokens are more likely to beget some actual net money for their holders as compared to startup equity options.
Here are the facts about startup equity compensation.
Typically employees receive stock options as part of their compensation package that vest linearly over years. Vesting theoretically keeps employees around long-term incentivized to make the startup as successful as possible. Your salary is usually lower than you could get at a mature company but the options supposedly make up for it. Of course, in order for the options to be valuable, the startup needs to not fail during your vesting period and its equity needs to be worth more than the option price - more specifically there needs to be someone around who is willing to buy the equity at higher than the option price. That is not the simplest thing. Yes, there are places to sell shares of non-public equity, even ones geared toward startup employees, but the liquidity is generally poor. Poor liquidity = selling at a big haircut. There's also the complication of the paper valuation of the startup's equity (driven irrationally high by intervention of VC investors) versus the actual value of the startup's equity, which in many cases is technically 0. (I mean, there's always hope that a cash-hemorrhaging startup with mediocre revenue and prospects might get acquired to take a competitor out of the market or acquire a specific asset, which would technically mean its equity has *some* worth, but I digress).
If you are a naive employee who keeps hearing about your startup's astronomical valuation, it might be a rude awakening to discover that there is no one interested in buying the equity of the startup for more than your option strike price, but most employees don't try to sell their company's equity as soon as it vests because they tend to be true believers in their startup (otherwise they would take the cushy high-paying job at FAANG instead). Just like the VC investors who supply endless amounts of cash hoping for a unicorn, so too do the startup employees hope for a unicorn exit for their equity - and rightly so, given what they have given up. There are two problems with this:
??Unicorn events are called unicorn events for a reason. They are very rare. The vast majority of startup equity options are worthless.
??Even if a startup does not reach a unicorn exit, some do reach a reasonably good exit. But it can easily be the case that, even if there is a good exit, employees get shafted on their equity. This happens with predatorily structured VC investments that entitle the VC investors' preferred shares to more than their fair share of the proceeds of an acquisition at the expense of the common shareholders.
On top of all of this, employees need to worry about the tax consequences of when they exercise their options. Thus, garden variety stock options often end up being less-than-ideal as a form of compensating employees.
DeFi tokens improve upon many issues with startup equity options as a form of compensation.
In the past few years decentralized finance (or DeFi) protocols have burst onto the scene. (For more information about what is DeFi, check out the linked article.) DeFi protocols provide various financial services without the need for centralized intermediaries like the centralized financial system we are all used to and, because DeFi protocols are not centralized, they are governed by holders of tokens issued by the platform. In this way, they are somewhat similar to a share of equity since equity also gives you the right to vote on certain things as to the company that issued it, but in a typical centralized company, shareholders elect a board of directors to oversee the big picture of the company, and the board of directors in turn hire executives who manage the day-to-day operations of the company. In a DeFi protocol, token holders have far more control than a shareholder. The types of decisions that tokenholders make in some cases would be akin to a shareholder of a bank getting to vote on how much interest savings accounts would yield. Also, typically the tokens are issued to people who use the protocol (and sometimes airdropped to other persons who have been active in DeFi governance of other protocols or things like that), so the people who use the platform are the ones making the decisions about its direction. (Note that initially DeFi protocols are controlled by a multi-sig comprised of the founders of the platform and control is slowly handed over to tokenholders according to a roadmap.) But these tokens, just like startup equity, is often used as compensation for the protocol's employees as well. And, although it is not really a focus of governance tokens, it occurs to me that several things about the nature of these DeFi tokens make them FAR BETTER at compensating employees than equity options.
?DeFi protocols are all about creating liquidity - it is a primary focus of DeFi. This means that employees will probably have a good place to sell their tokens without taking a haircut.
A big challenge for DeFi compared to CeFi is liquidity. In CeFi, centralized financial intermediaries make markets in practically every asset you may want to buy or sell. But in DeFi there is no centralized entities to make markets. This means that DeFi protocols must create liquidity through other means - this means is incentives to people for providing liquidity. This incentive approach has worked insanely well and total value locked in DeFi has soared. What this means is that DeFi tokens typically have pretty good liquidity - often extremely good liquidity. Granted there are some more suspect DeFi tokens that still suffer from poor liquidity. But on the whole DeFi tokens have far better liquidity than startup equity. This means that when DeFi employees' tokens vest, they can sell them for the tokens full value much more easily than traditional startup employees can sell the equity of their private startup. Of course dapps are not creating liquidity for the explicit purpose of allowing their employees to be able to sell their incentive tokens, but it is a very nice side effect that is not afforded with regular equity options.
?DeFi employees don't need to wait for exit events to sell their tokens because there is no expectation that there will be the equivalent of a unicorn exit event. The wait for the unicorn exit event makes startup employees' stock options much less incentivizing because the payout is years later, if ever.
One of the big problems with startup equity options is that employees generally hold onto them, even after they vest (or they exercise and then hold onto the equity itself) all the way until the unicorn exit event comes (if it ever comes...). This means that the stock options are not nearly as good at incentivizing employees as tokens are. This is because DeFi employees can sell their tokens immediately after they receive them, but as described startup employees typically hang onto them for years after they actually vest. Research shows that a reward is much more rewarding when it is received soon after the action you're trying to reinforce. The fact that startup employees have to wait years or even decades to see their payday means that stock options are not as incentivizing as tokens with their potential immediate payout. Also, startup employees have to come up with the cash to actually exercise their options. (Of course DeFi compensation could also be token options rather than token grants, but in most cases compensation involves grants, not options, at this stage.) I don't know if it is because DeFi is all about incentives at its core, but people involved in DeFi seem to understand how much rewards like token grants can incentivize people - the TVL in DeFi is evidence of that. And, in general, people in DeFi are more fair in how they allocate resources than in typical companies, at least currently. The people currently involved are mostly the dreamers and true believers, but the people driven purely by profit are flocking to DeFi. I fear with all the venture capital flowing into DeFi (??????all my fears about venture dollars in DeFi), this sharing spirit will disappear. We'll see.
?The vesting of DeFi tokens can be synced up with the roadmap of the protocol to incentivize employees to work particularly hard at key times for the protocol's success.
DeFi tokens are a lot more flexible than stock options. Dapps can plan for employees to receive chunks of tokens right after critical points in the roadmap of the protocol. Unlike the stock options of startups that vest linearly over three or four years which may or may not line up with the roadmap of the startup, DeFi protocols can have tokens vest unevenly at whatever times make sense. They can even program the transfer of DeFi tokens as incentives to employees if certain milestones are reached at certain times. This can all be public knowledge if it is literally written into the smart contract (unlike startup equity options which is typically not public although it is of course known to investors in the company). This gives tokenholders the ability to assess the strength of how well incentivized the employees of a dapp are. Granted this could be done with stock options but it isn't, really. It wouldn't really be that seamless, either.
?Currently, generally, DeFi tokens (especially those from dapps that actually hire employees) are more likely to be worth something than startup equity - in other words, grants of future DeFi tokens are more likely to beget some actual net money for their holders as compared to startup equity options.
As I mentioned, startup equity is notoriously not that great as compensation because:
??liquidity is poor;
??there are tax consequences from exercising your options;
??the options are often underwater;
??you have to come up with capital to exercise your options (there are loans to do this but then you have to pay interest);
??you have to wait years or decades to get your payout and the payout is not synchronized with the roadmap of the startup.
But on top of all of that is the fact that the options are often basically out of the money. This is partially driven by the fact that poor liquidity decreases the amount you can receive for your equity and partially driven by the over-inflated valuations of startups. In contrast, most DeFi tokens, even those at the more suspect projects, are worth something. Most compensation is done in the form of grants. Therefore, your chance of actually making money from your DeFi token compensation is far higher than from startup equity options. (Note: I am not sure whether the expected value is less or more for DeFi.) This may change as the industry matures. But at this stage I would far rather have DeFi tokens from a random repsectable protocol than equity options from a random respectable startup. (One further side note is that part of the reason for the erosion of value of startup euqity options is that there are simply far too many venture-funded startups because there is far too much venture capital because there are far too many people who want to start a venture fund with 2% a year fee on principal and 30-40% carry fee on any profit. The excess of VC dollars has led to the funding of many very questionable startups and in turn that has led to a larger percentage of startup equity being worthless, at the expense of the employees, founders, and LP investors in the VC funds. But I really digress.) DeFi tokens are inherently far better as compensation than startup equity options. They were not developed with this intent in mind but I think they are only going to improve as people begin to think about this more.
*I am calling it now - startup options will be tokenized, like practically every other asset whether it should be or not, and people will be able to sell those tokens but only to accredited investors on centralized markets - in other words this "innovation" would not help at all with the issues I described.
About the Author: I am Harvard/Columbia grad?? who formerly worked in the finance industry?? who is passionate about smart contracts and DeFi and has been investing in and using crypto?? for many years. I am now opening a fitness studio????+? and starting a crypto hedge fund. I was inspired to write this blog covering the basics of DeFi, liquidity mining, farming, and tips and tricks and mistakes to avoid for DeFi newbies, as well as other smart contract-related topics, to make DeFi more accessible. Feel free to reach out with questions about law, finance, crypto, and entrepreneurship!
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