Jonathan Caras and Michael Hasson
In this post, we will respond to the article written by @TrustlessState, where David outlines a general token economic model. This piece will be the prelude to a series we intend to publish which will describe a framework for a generic value capturing token model with follow-ups exploring potential use case examples.
Does your application need a token?
Since the ICO boom and bust there have been many attempts at launching blockchain based network tokens of numerous forms (payment tokens, governance tokens, work tokens, etc) with the aim of coordinating network participants to collaborate and bring value to new decentralised networks (in most cases, marketplaces). To be clear, we are not talking about base layer “commodities” like BTC, ETH, ATOM, DOT, XTZ and the like. We are talking about tokens for networks designed to disrupt “such and such” industry, built on the infrastructure of one of the aforementioned base layer protocols.
To date, most token economic models for dApps and protocol networks have been flawed, likely because the success of Bitcoin and Ethereum led entrepreneurs to think “Hey let me create my own network specific token and I too can ride a rocketship to the moon”. Bitcoin and Ethereum are examples of commodity monies which can be the basis of a new economy, but services built using these monies will need to follow the same time tested rules governing the offline economy — ie businesses exist to generate a profit. We do believe that open source systems built on public blockchains will enable organisational enhancements and that the vision of Web3 will be realised, but that at the end of the day it will be because it will make the best parts of the existing capitalist system work better.
We have spent a lot of time over the last year thinking about models for tokens that better capture value, as well as, profitable DAO structures. Many analysts have posited that the general buckets of potentially valuable tokens include commodity tokens, utility tokens, and security tokens. We believe that the two most important to focus on for the evolution of this industry are 1) Commodity Tokens and 2) A specific type of Utility Token, what we call Network Equity Tokens. We will describe our Network Equity model in more detail in our next article. David’s post sparked us to respond and begin putting our thoughts down on paper so here we go…
A response to “A generalized token model for exposure to application growth”
We want to thank David Hoffman, for putting together this fabulous article outlining his view of a general purpose token model. We will now review the token model he introduced and its mechanism for providing a means of organising, incentivising and coordinating multiple actors within the PoolTogether protocol.
If you have not read David’s article, we recommend doing so. The success of the space depends on critically thinking through value capture, and our goal here is not to disagree with David per se, but rather to expand and tweak what he presents.
Not all applications need tokens. After the euphoria of 2017–18 died out, the community discovered that tokens are generally unnecessary, and if you can build your app without one, then you probably should.
David starts out by saying that tokens are mostly bad because they create friction for the end user. We agree. We envision most users will only ever touch one of a few potential general purpose payment tokens which will be accepted across multiple venues. This could include DAI, ETH, BTC, or some other hyper accepted token (likely not XRP ;).
However, there is a “generalised” token model that any application can leverage.
This token model does a number of the positive things that the ICO mania was praised for enabling (although it never achieved)Allocates capital to projects who want/need itGives users upside to the growth of the applicationAligns incentives between funders and projects.
Here’s how this token works:Create an application that captures ETH or Dai into a reserveCreate a token that has a claim on these reservesSell the token in a token saleAllocate the funds generated to the reserveBecause the reserve is larger, the value of the application increasesThis generates more revenue from the applicationThe revenue generated from the application is added to the reserves
Let’s break this down one by one….
This token model does a number of the positive things that the ICO mania was praised for enabling (although it never achieved)
There were three major problems with 99.99% of tokens that came out of ICO mania:
Infrastructure to actually build out the visions described by most whitepapers had not yet come into existenceBusiness models and value accrual mechanisms were completely flawedOverfunded projects and founders with little liability, and direct access to all capital
Allocates capital to projects who want/need it
Years of building consumer facing products have taught us that there are two ways to easily kill an early stage venture:
Underfund the projectOverfund the project
2017 was a clear case of the latter. Founders, often with little or no experience in company building, were given millions of dollars and zero oversight. To succeed in the startup space you must always have a sense of hunger, and a feeling that your time is short, and the day is long. When a team receives millions of dollars before they have released a product, the drive to succeed is greatly diminished.
Ongoing financial rewards based on milestones and accomplishments are necessary in order to align incentives between investors and founders. Founders must not have the ability to exit before investors see a good ROI on their investment. During the ICO boom, many founders received their exit on day 1 of fundraising. Even in cases where founders committed to extended lock ups, the financial windfall they saw at the start of the project reduced their personal risk to essentially zero. With no personal liability, it’s not surprising that most of these projects never came to market.
A successful token raise will need to exist in a format where the founding team is not able to “exit scam”. In our Network Equity Token Model, we will outline how to fund a project, yet prevent the founders from exiting before the investors see a return on their investment.
Gives users upside to the growth of the application
We disagree. We do not think that all users should necessarily get exposure to the upside of a particular network.
To clarify, it is important to clearly identify exactly who these “users” are.
Because we believe that effective token networks will all be architected in the form of marketplaces (which we will expand on in our next piece), it is important to remember that marketplaces include different categories of participants.
A marketplace will have, at a minimum, suppliers and consumers.
Successfully launching a new marketplace is challenging because it requires developing operating infrastructure and concurrently growing both supply and demand. The most healthy means to encourage individuals to take risk is to create an asymmetric upside.
A successful new crypto business will be one where those that took risk in the early stages will get the bulk of the reward if the business is successful. In a marketplace there will be many actors. Not all of those actors will be taking risk, and thus have no reason to share in the majority of the upside of the success of the platform.
Those actors deploying capital or working in the network (marketing, curating, developing, designing, debugging etc) all will need to see a major upside. In most healthy marketplaces, there is a 1% who will do the work to make the system functional, and the 99% that use the services, or consume the goods provided by the network. These consumers must be motivated by a quality product that competes in a free market (within and without the crypto space). To give a real world analogy, if you work at Google you get Google stock as part of your comp package. If you use Google to search, you don’t. The workers must be motivated for the long term success of the platform, and the consumers must love the service provided.
While the 2017 boom was fueled largely by the presumption that crypto networks would solve the chicken and egg problem facing new marketplaces and thus create supercharged networks with incentivized users (consumers), this has not played out in practice. What has shown to be true is that network payment tokens increase friction for consumers and have a value capture problem, therefore these tokens do not add value to a network in most cases. Most users aren’t coming to a platform in order to take risk, but rather to benefit from a high quality product experience. Therefore, we do not see a reason for most users to own a platform specific token.
We can illustrate examples where the native token is not touched by the general consumer. Consider this tweet by RSA.
Ryan lists MKR and REP as fundamentally different assets than ETH or BTC.
For the purpose of this article, we are exploring models for building services on top of Ethereum, similar to REP and MKR — services which will have a governance token (a grey area security token) which captures the value of the growth of the network. This token most likely will never be used by the general consumer of your protocol, only the investors and workers.
A consumer does not need to own REP to bet on Augur, nor does she need to own MKR to use DAI or make a CPD.
Let’s see a small fictitious example. Decentralised Taco’s…..
In order for “dTaco” to replace Chipole and Taco Bell, your network will require coordinated work by network operators, these would include employees such as cooks, advertisers, floor sweepers, brick layers etc. These early employees will be contributors to the success of the network, and if they can be incentivised by gaining exposure to the upside, it will likely lead to a better foundation to the business.
It is not helpful to structure the network where anyone who buys and eats a taco will get rich with the platform’s success. You need people coming and buying tacos because they are the best quality tacos at the best price. The people eating the tacos will not help you achieve success, the people helping build and iterate will.
Historically, distributing ownership, voting rights, etc for stakeholders in small or early stage businesses was expensive, cumbersome and required a lot of administrative overhead. Public programmable blockchains like Ethereum are potentially game changing in their ability to issue an ESOP with the click of a few buttons (ie issuing tokens). We believe that the ability to easily distribute small amounts of equity to business stakeholders is one of the most potentially impactful innovations that smart contract platforms can provide. This area has not been fully explored because most networks have not been architected to generate a profit like a traditional business.
Aligns incentives between funders and projects.
This point has a lot of overlap with the first two bullet points. It is essential that the funders and network operators are aligned, in many cases with early stage projects these network operators are the founding team. It is also essential that they are aligned on the success of the business. Just as the founders should not be in a position to put their personal gain ahead of the success of the business, there must be steps in place to keep the investors aligned with the success of the business.
Before moving onto the second section of David’s outline, where he explains how the token model works, let’s look at some of the goals that were not mentioned but we believe should have been:
Creates a sustainable profit model to cover the ongoing operational expenses of the network
In David’s paper, he ignores ongoing operational expenses, and views the product, Pool Together as an immaculately created protocol, which is future proof, needs no maintenance, no upgrades or other human interaction to continue its operation. All of which will require ongoing capital.
A simplistic protocol such as Pool Together piggybacks on Compound Finance to generate passive income. Pool Together may be an example of “completed work” and have an operating budget of zero, or close to it. In this case there is no need to collect a percentage of the profits, and funnel them through a decentralised capital allocation process (a DAO).
In most cases, entrepreneurs will create protocols which will need constant improvements, all which require focused allocation of resources, both human and capital. To date, most protocol services have not been architected with profit motives, and sustainable funding models have also been a question mark. We believe that is time to bring back dirty words such as “business, profits, and sustainability”.
Crypto native businesses will attempt to gain market share from the general population of humans on earth. In order to do so they will need to compete with centralised organisations, which can create awareness through marketing, can optimise upgrades based on market feedback, and can bring together great teams through capital expenditure (ie, pay a dev teams salary).
The advantage of centralised organisations is the efficiency provided in decision making and allocation of resources. An organisation like MolochDAO, where everyone votes, and there is a two week window to determine the group’s decision will have a hard time competing with an organisation that can execute quickly and allocate capital efficiently.
In order for decentralised protocols to compete with their centralised cousins, they will need to be able to delegate responsibilities to service providers, and fund them, with minimum overhead. Without the ability to capture a percentage of the profits generated, and funnel these profits back into the operations of the network, it is unlikely these networks will be sustainable during lean times or after their initial presale fundraising runs out.
Now let’s return to our response to David’s article, jumping into the part about how the token works…..
Step #1 Create an application that captures ETH or Dai into a reserve
Software melts like ice. Practically speaking, the longer an application exists in the wild, if it lacks ongoing maintenance, new features, and upgrades, its value to consumers will decline rapidly.
David seems to imply that “Create an application…” is a one time deal, which occurs at a fixed point in time, and is magically funded once with little or no need for active capital injections to improve over time, and no recurring operational costs. While PoolTogether is a relatively simple application, which could in theory be created over a weekend by students, most applications will require significant resources to get up and running, and even more resources to be maintained.
A better way to phrase this step is to “continuously develop, maintain and improve” an application that captures ETH or Dai into a reserve….
Step #2 Create a token that has a claim on these reserves
This token, may be considered a security in the USA, but for the sake of this thought experiment, I will deem that irrelevant. MakerDAO has done a phenomenal job of avoiding the classification as a security token, and I am confident that if executed delicately, the high level model we are exploring here could also avoid this classification.
In the Pool Together model, the entire operational budget of the crypto business is zero, and in theory, every member could withdraw their claim by burning their Pool Together token back into the reserves.
At this point the reserve would drop to zero, or near zero, (depending on the specific math and rounding errors).
Because the business has no expenses, Pool Together could in theory continue running with no major hiccups, and profits from the business would funnel back into the pool, incentivizing new investors to mint more native tokens, thus growing the pool, and we are back to where we started. Rinse wash and repeat.
Imagine our decentralized chihuahua loving Taco Stand, with its native token DTS (decentralized Taco Stand), bootstrapping on the funds pooled together from the initial token sale, paying rent, hiring workers, dog groomers, buying that fake meat everyone is raving about.
Now imagine one day, 80% of the token holders of DTS, burn their token, wiping out the vast majority of the funds within the reserve. These were the funds needed to provide ongoing operating capital to dTaco. dTaco went from being a profitable young crypto startup to bankrupt all within a few block confirmations.
Owning DTS is similar to owning a share of a company. Imagine if owning Apple Stock entitled anyone to go to Apple’s bank account and drain their funds proportionate to the percentage of ownership. I suspect Apple would be out of business within a week as the majority of stock owners would see a far greater return by burning their shares than by selling the stock on the secondary market.
By enabling a shareholder to liquidate their position and gain access to the business’s total reserves, the incentives of what’s good for the investor, and what’s good for the business become quickly misaligned.
Step #3 Sell the token in a token sale
Our goal here is to create the initial working capital to be used by the business to get off the ground and become profitable. In the case of PoolTogether, this money was sent to Compound and created passive income with an operational budget of zero (maybe someone donates some pizza to the developers).
In most crypto businesses, things won’t be so simple and the majority of these initial funds will need to be spent to build the protocol, and cover monthly expenses related to the ongoing operational costs of the network, including developers, the marketing budget, designers, customer support, etc.
In many cases, the marketing budget will exist in the form of a loss leader, to incentivize the initial adoption and growth of the network.
Each crypto business will need to determine its own budget allocation for its continued operation, and over time it is expected that the budget will need to be adjusted, both in total cost and in department allocation. What’s important is that a structure is in place to enable the DAO running the business to allocate capital.
Step #4 Allocate the funds generated to the reserve
In this step, all the funds raised in the token sale have been collected into the reserve. The token owners are free to trade their tokens on the open market, or to burn those tokens back into the reserve through a mechanism such as a bonding curve, in order to redeem their portion of the reserve.
As mentioned earlier in this article, if the funds of the reserve are to be used as a means for the token holders future redemptions, there isn’t any capital allocated to cover the operational expenses or growth of the network.
There are a few ways to get around this:
Solution #1: Token Holders can vote through a DAO to dilute the rights to redemption by minting new tokens and issuing them to service providers (developers, marketers, lawyers etc) in order to cover operational and growth expenses.
At first glance this approach works because small continuous inflation in order to pay workers is a proven model for many real world governments.
There are some significant drawbacks however:
The cost, and negative impact on the token holders is difficult to calculate. This model is essentially a hidden tax on all token holders. This is exactly why inflation is so popular for world governments, it’s easy to obfuscate from currency holders of the economy.This model does not protect from misalignment between the success of the crypto business and the token holders. What is best for the success of the network may be to dilute the tokens by a large percentage, thus causing a dramatic drop in token price. A situation can arise where large investors could block the minting of new tokens, and instead elect to cash out, essentially depleting the business of the funds needed to cover its expenses.
Solution #2: Two pools are created, the first called “The Earnings Pool” the second called “The Operations Pool”.
The Earnings Pool, in this model works exactly like the “Reserve Pool” outlined by David. Business profits will be rolled into the Earnings Pool, and token holders will be able to burn their tokens at any time and receive their percentage allocation from the Earnings Pool.
The Operations Pool will be used to cover operational expenses of the network. Access to the funds in the Operations Pool would be determined through governance via the network’s DAO.
Token holders would vote on what percentage of the capital collected would be allocated to operations and what to earnings. In some cases, all of the funds raised would go to operations, and only over time as the business became profitable would funds begin to accumulate into the Earnings Pool.
Like in the first model, ongoing fundraising would be possible by a vote to mint more tokens which redeem from the Earnings Pool, but without the conflict of interest.
This solution is superior to the first because it ensures the business cannot become bankrupt through investors with a short term time horizon. If the financial success of the investors is dependent on the success of the business, then it is more likely that decisions will be made to increase the chances of success of the business.
The two pools, one which is working capital, accessible by the founders, and another, which is allocated to earnings, accessible for redemption by the investors, offers and interesting dynamic where as investor’s trust in the founders increases, a larger percentage of the earnings pool can be allocated to the founders. This ensures the business has access to significant capital, without the ability of the founders to exit early. The operators of the network now are motivated to perform well, in order to receive additional capital, earmarked by investors.
Step 5: (ok it’s not really a step) Because the reserve is larger, the value of the application increases
This is an interesting concept. If I own a company that loses $1M per month, but we have $100M in the bank in reserves, what is the valuation of my company? To answer that question we would need much more information, but at a high level it would be inaccurate to say that the value of my reserve translates directly to the valuation of my business.
Does the value of my business go up if I grow my reserve to $150M, but my losses per month increase to $2M? In most cases no. In short we cannot say definitively that an increase in reserves translates to an increase in enterprise value.
In David’s example of Pool Together, the service had no expenses, and predictable recurring profits. In this case it is correct to say that increasing the reserve translates directly to an increase in valuation. Unfortunately, most business will not have the luxury of zero expenses and fixed profits from day one.
The rate of growth of the Earnings Pool will be a major determining factor of how valuable the market views an emerging crypto business.
Step 6: This generates more revenue from the application
In the PoolTogether example, where the profits are generated via lending the reserve pool, this description is correct. For other business models, simply increasing the size of the reserves will not increase the revenue the business brings in.
Step 7: The revenue generated from the application is added to the reserves
As previously explained, a portion of the gross revenue will be added to the Earnings Pool (the Reserve) and will be accessible to investors to withdraw from at any time, without hurting the underlying business.
The crypto business’s DAO, operated by the token holders, will determine how much of the profits to funnel to the Earnings Pool and how much to allocate to grow back into the business.
This article covered at a high level a number of important topics, which we hope to address in greater details.
Public blockchains enable the creation of new business models, which can be powered by new token economic models, which we called the Network Equity Token ModelThese businesses will have ongoing operational expenses and will need to make profits and allocate some of those profits to operations in order to be sustainableThe Network Equity Token model can be applied to many different types of businesses, specifically to marketplace businesses
In our next article we will outline in more detail the Network Equity Token model and begin to give examples of how existing projects can use this crypto economic model.
We have created a presentation on our Network Equity Token Model, which we are currently reviewing with teams building interesting projects in the DeFi space. If you have insights on how to improve this model, please be in touch via Telegram (@madcapslaugh) or Twitter (@madcapslaugh)
David’s article was important because it began to articulate a token economic model which touches on the idea of distributing network profits
In our response we have begun to discuss a more generalised version of his Generic Token Model based on what we call the Network Equity Token
In our next piece we will summarise the goal and architecture in more detail
Thank You to all the people we have gotten great feedback on this model from (this list will hopefully keep Growing)
Paul Razvan Berg