Token Vesting in Crypto Explained Simply

Token vesting is a way of distributing tokens to team members, advisors, and investors over a period of time, rather than all at once. This helps incentivize long-term commitment, prevent the dumping of tokens on the market, and make sure that everyone involved is invested in the project's success. We will have a closer look at token vesting - how and why is it done, the possible effects on the market, and important security considerations

What Exactly is Token Vesting?

When a new crypto startup issues its own token, usually about 20 - 25 % of that token's total supply is reserved for team members, early investors, advisors, and other contributors. The mentioned groups don't get their tokens immediately all at once, but rather agree in advance on the vesting conditions to protect the long-term interests of both the project and investors.

They lock the reserved tokens in a smart contract to be distributed gradually across a set period of time (about 1 to 2 years). The process of locking and gradual release of the tokens is called vesting.

The Reason Behind Token Vesting

If tokens would be distributed all at once, it's possible for team members, advisors, and investors to quickly sell their tokens (dump) and move on to the next project. This can create a sudden oversupply of tokens on the market, leading to a sharp drop in token price.

By utilizing token vesting, tokens are distributed over a set period of time, which helps prevent sudden selling and stabilizes the token price. Additionally, token vesting incentivizes team members and advisors to continue working on the project, in order to maintain the price.

Vesting in Traditional Finance

In traditional finance, vesting typically refers to the process of earning ownership of an asset over time. For example, a company may offer its employees stock options as part of their compensation package, but those options may vest over a period of several years. This means that the employee doesn't immediately own the options, but instead earns them gradually as they continue to work for the company.

Retirement plans: typically in the US., an employer issues a retirement plan for its employees, consisting of a compensation package (company stock or other benefits) that the employers earn over the years.

Startup equity: members of the founding team and investors usually have their equity (for example stocks) in the company locked within vesting schedules. The equity is released gradually, to prevent any sudden exit that may destabilize the company.

Designing a Vesting Schedule

Usually vesting in crypto is time-based, which means that tokens are distributed after a set time period passes. However, vesting can also be done according to the project's progress, such as milestone vesting. Here are the main types of vesting curves:

Linear vesting: tokens are released gradually over time, with a consistent release schedule. For example 25 % of tokens released every half year, over the course of 2 years.

Graded vesting: tokens are released in packages, with larger amounts being released later in the vesting period. Take a graded schedule of 12 months and 100 tokens, you might receive 10 tokens after 3 months, 20 tokens after 6 months, and so on.

Cliff vesting: a large portion of tokens or coins are released all at once after a specific period of time. May be followed by a linear or graded vesting schedule.

Vesting Smart Contracts

To automate the Vesting process, many smart contract solutions were introduced. They work by gradually releasing tokens according to predetermined conditions. 

Smart contracts are placed on-chain, which means that they are self-executing and no cannot be changed once initiated. This feature ensures that both parties making the contract follow the set rules without the need for a custodian.

Outsourcing: Third-Party Services

There is a possibility to outsource the vesting process entirely and many projects choose to do so. Companies specializing in this field provide complete solutions including vesting consultation and customizable smart contracts.

Popular choices for equity and token vesting management include EQVISTA, Ekoios, Liquify Finance, or Unvest.

Potential Effects

Here is a brief overview of what could happen after token vesting is implemented into a starting crypto project. The majority of effects are positive, however, there are certain implicit drawbacks to this method.

Benefits

• Helps align incentives: By requiring token holders to wait before selling their tokens, token vesting can align their incentives with the long-term success of the project. This can help prevent short-term thinking and encourage stakeholders to focus on the project's growth and development over time.
• Builds trust: Token vesting can help build trust between project teams and their investors, by demonstrating that the team is committed to the project's success over the long term.
• Reduces volatility: Token vesting can help reduce the volatility of a project's token price by limiting the supply of tokens that are available for immediate sale.

Drawbacks

• Limits liquidity: Token vesting can limit the liquidity of a project's tokens, as investors are required to hold onto their tokens for a certain period of time before they can sell them.
• Reduces flexibility: Token vesting can reduce the flexibility of a project's token distribution, as it requires the team to commit to a certain vesting schedule in advance. This can make it more difficult to adjust the token distribution in response to changing circumstances.
• Can discourage early investment: Token vesting can discourage early investment in a project, as investors may be reluctant to commit to holding tokens for a certain period of time. This can be particularly challenging for new projects that are trying to attract early investors.

Security in Vesting

Vesting percentages of a total supply of the token requires locking up hundreds of thousands, or even millions of USD value. Security is a very important aspect while working with such volume. 

Vesting platforms may be subjected to hacks or outright scams. In order to prevent this, it is essential to use trusted platforms with audited smart contracts and try them out beforehand. Additionally, Vesting platforms offering custodial services without smart contracts may be untrustworthy or otherwise compromised.

Comparison with Other Mechanisms

Token vesting is not the only method for ensuring that early contributors and investors do not dump the tokens too early. Here are some of the other widely used practices and how they differ from Vesting.

• Token Lockups: otherwise called the vesting period, is a time during which parties cannot sell or transact with locked tokens. After this period all tokens unlock at once. It is similar to cliff vesting but without the additional distribution.
• Liquidity Locking: is a way of preventing a large sum of LP (Liquidity pool) tokens to be redeemed for the actual tokens in the pool. Other than locking just one token, a pair, or set of tokens is locked in a liquidity pool, preventing scams, like rugpull.