A Framework for Token Compensation

February 15, 2023

At Pulley, we’ve had conversations with some of the leading Web3 projects, protocols, and investors about using Tokens in compensation. From these conversations, we created a loose framework and set of questions you should ask before considering issuing tokens to employees.

Disclaimer: This article is for general informational purposes only, and does not constitute legal, financial, or tax advice on any matter from Pulley. Pulley provides tools to help you navigate token tracking, taxation, and distribution, but you should consult qualified tax and legal advisors for any questions or advice.

Can I issue tokens legally?

In the US, it’s a good bet that your token is considered a security. SEC chairman Gary Gensler said as much in 2022, “of the nearly 10,000 tokens in the crypto market, I believe the vast majority are securities.” So, if you plan to issue tokens in the US, or to US employees, you’ll likely be dealing with securities law.

What this means: issuing tokens should be treated as consequently as issuing equity

This entails significant legal, financial, and administration concerns: Rule 701, Section 409A, incentive plans, etc. To complicate matters further, there is significantly more uncertainty in token issuance than equity; if you’re not in an appropriate stage to deal with this risk and uncertainty, you should reconsider using tokens for the time being.

When is a good time to issue token agreements?

In theory, you can issue token agreements before a token generation event – such as in a Future Token Interest – or afterward, RTUs, restricted tokens, or options.

In practice, we have found it preferable to have a clear idea of your token mechanics, allocation, and release timeline before issuing employee agreements. Prior to this, you may under or over-allocate tokens commiserate to employee value. You also may need to be careful about how you structure vest, settlement, and lock-up dates to minimize future tax burdens (depending on when you plan to launch your token). For example, securities generally require a mandatory one-year lockup period before becoming transferrable. You will also have to keep in mind employee release structuring to prevent excess token volatility and price dumps.

TIP: When you issue tokens, and when you distribute them, you’ll need a third-party token valuation which can be issued from services like Pulley, Redwood, or Teknos. A valuation is used to determine the tax basis for token awards as required by the IRS. These expire quickly – less than 30 days – and it’s best practice to issue token grants in tranches to employees and group distribution dates.

How many tokens should I issue to employees?

Granting tokens to employees can be a great way to sweeten compensation and generate upside. Token grants also help align contributors’ work to the value they’re creating. This follows the same philosophy as stock compensation: you’re more likely to care about a project when you have real skin in the game.

Warning! Tokens, in the US, should not replace normal wage compensation (i.e. salary). Tokens are currently considered as property, not currency, and paying employees or contractors only via tokens can run you afoul of various minimum wage laws.

However, tokens can diverge from the traditional value proposition of equity. For example, a token might represent in-game currency, governance rights, or even a portion of revenue, as opposed to the shareholder rights equity entails. Each of these rights has a varying level of value and should be accordingly balanced in allocation. For example, you should be able to answer the following questions:

  • Do you utilize both equity and tokens? Will this change in the future?
  • How does value accrue in each instrument?
  • How many tokens does it make sense for employees to hold versus the community?
  • What is the potential monetary value of these tokens?

With the complexity of tokenomics, it often makes sense to hold off on employee tokens until you have a clear understanding of the value to you and your employees.

How much time will it take to distribute tokens?

Many projects will issue token agreements and ignore them until the first distribution dates are approaching (usually after a lock-up or cliff period). This often leads to the initial distributions being hectic, delayed, and filled with calculation errors.

This is because managing token distributions is a full-time job. Unlike airdrops or giveaways, tokens given to employees have to be recorded into payroll, have taxes withheld, follow reporting procedures, and be distributed according to legal settlement schedules. Much of this process cannot be automated away via smart contracts and requires manual calculations in excel or a system of record like Pulley.

We’ve seen a number of projects burn entire weeks every month handling distributions and reconciling errors - all on managing just a handful of employees.

How can I issue tokens to international employees?

Every country has specific regulations around crypto, payroll, and securities. This can make it challenging to legally issue token agreements as well as correctly pay taxes when distributing tokens. For example, if you were to distribute tokens via a Restricted Token Unit (RTU), you are generally liable to withhold taxes upon each distribution event. This withholding amount will vary widely for different jurisdictions and require nuanced tax knowledge across multiple countries.

The most common set-up we’ve seen is to have one country of operations and leave outside, non-local contributors as contractors. That way the issuing company is generally not liable for tax withholding for independent contractors, and only has to manage a single payroll process for each distribution event. Platforms like Pulley can also help you integrate with your payroll system and automatically reconcile your token withholdings with each distribution.

So, should I use tokens after all?

There’s no clear-cut answer: this is a balance between your risk and compliance appetite and the potential value your employees will find from receiving tokens. In our experience, token compensation is tremendously valuable in winning, and retaining, top talent for the leading protocols in the Web3 space; but it can come with a large administrative burden down the line.

Pulley can help you manage this process with a complete platform for token management, valuations, and distributions. Schedule a call with us today and see how we can help.