Original photo by Randy Fath
The token, this digital representation of ownership, is the most powerful incentivisation and coordination tool since the advent of equity thanks to its frictionless distribution and adaptable properties. While there has been healthy scepticism around token experimentations over the past two years, certain token designs are indubitably value-additive, and can become self-fulfilling prophecies, similarly to early-stage equity.
In this post, we will first briefly review critical elements in the cryptocurrency history that led us to where we are today, then we will define what early-stage equity ownership actually is, what it achieves, and how it accrues value ; and finally we will emphasise why tokens are the best medium to distribute ownership and incentivise collaboration.
Bitcoin, Ethereum and Tokens
A decade later, we can look back at Bitcoin as the first successful answer to two significant challenges of the internet:
- provable digital scarcity and thus provable digital ownership, enforced by code only and not by law. Until then, ownership was only enforceable by nations, violence, and laws — more here.
- Coordination of a global network of humans and machines that obey simple rules, where code is law, where incentive-mechanisms rule, and where no assumption of honesty or altruism from participants is made.
Fast forward to 2014 to what became the most influential Initial Coin Offering (ICO) to date, as Ethereum raised $18M in a decentralised crowd-sale where participants purchased a slice of the Ethereum project: Ether or ETH.
Ethereum’s ICO was indeed a significant moment in history where capital was globally coordinated towards a common goal, without relying on a trusted intermediary, to finance the development of a project and receive a digital representation of ownership in return: Ether or ETH. It is worth pointing out that ETH was only a commodity then, used to pay for transactions on the Ethereum blockchain, and not necessarily intended as an investment vehicle ; although humans have a tendency to speculate on many things…
The Ethereum token sale was similar to crowdfunding, which already existed at that time, with websites such as ArtistShare (2001), IndieGogo (2008), Kickstarter (2009) and GoFundMe (2010) ; although these platforms were rarely selling ownership, and instead were mostly donation-based or reward-based (pre-product launch), with few exceptions like CrowdCube (2011) or Seedrs (2012), two British-based equity crowdfunding platforms that still remain inaccessible from certain jurisdictions (e.g. US, Canada, Japan). It turns out that there were challenges to sell ownership in certain jurisdictions, most notably the US, which reserved equity investments to accredited investors (i.e. investors with a net worth of over $1M). This is evolving positively though, thanks to the JOBS act which allows since 2016 non-accredited investors to participate in equity crowdfunding (with certain limitations), giving birth to platforms like SeedInvest.
In 2017–2018, we saw a colossal number of projects replicate Ethereum’s fundraising mechanism. These projects had a vision, they were looking to attract capital to build it, and they crowdfunded and gave investors a token in return for their capital, like Ethereum.
However, and this might have confused some investors, many of these ICOs were not selling ownership, but were in fact selling a token that could eventually be used to pay for a service when the project comes to fruition. This could be classified within the family of reward-based crowdfunding, where the reward might be given in the future, and for which the claim on the reward (token) can be transferred and sold on secondary markets.
There was nothing inherently wrong here, depending on how the token was presented to investors, but it is clear that unless projects baked-in additional designs for their token to capture value, only a handful of projects could realistically make their token design work for investors who saw this as an investment.
The thesis was the following: given tokens have a maximum supply, investors were hoping that with enough demand for the future service and a limited token supply, this would increase the token value. This belief was probably founded upon the success of Ethereum, which by 2017 had already reached record-breaking returns, with a very similar token design based on future demand and with no clear value capture mechanics — which prevented many traditional investors from getting involved with Ethereum.
Ironically, Ethereum became the platform of choice to fundraise by issuing tokens via an ICO, and given people were investing in ETH, there was a sustained demand for ETH, giving ETH significant utility, and resulting in its meteoric rise we all know. This token design, with no real value capture mechanism and with hopes of future adoption, had turned into a self-fulfilling prophecy for Ethereum, mostly because adventurous investors were trying to replicate ETH’s returns elsewhere by:
- purchasing ETH
- > To participate in ICOs to replicate ETH’s success (some of which were successful)
- >> Which fueled further ETH’s value accrual (Supply & Demand), because most of these ICO held onto their ETH treasury.
- >>> Which attracted more entrepreneurs (and unfortunately opportunists) to build projects and fundraise via an ICO
- >>>> Which brought more investors purchasing more ETH,
- And repeat 🔁 …
Flows from left to right, with two consequences, and repeats via dotted arrow.
Looking back, we can pinpoint Ethereum’s success to multiple factors/events essential to its growth until 2017 which allowed the ICO movement:
- The success of Bitcoin
- The distributed ownership, which meant many talented individuals could be involved in the project early, have skin in the game, and be active evangelists for the project — more than any traditional startup could ever dream of, which resulted in a rapid growth of the Ethereum ecosystem and its infrastructure.
- The development of exchanges, creating liquidity in the secondary market and fueling further speculation on ICOs, and helping ETH as we have seen.
- Enterprise interest, with the Ethereum Enterprise Alliance, which helped comfort investors that there could also be a future “enterprise adoption” of the platform and thus of ETH.
The biggest contributor was all the other projects who tried to replicate Ethereum’s success. They rapidly turned Ethereum into a self-fulfilling prophecy, attracting more talent, creating more value for the network, and turning ETH into a good investment and thus a good store of value in the mind of investors, which helped boost its perceived value, especially as Ethereum is now moving to ETH 2.0 with clearer value capture mechanics with proof-of-stake and possibly fee burning (EIP-1559).
The story for many of these token experiments however, is less exciting. Unfortunately too many ill-intentioned projects were funded, too many teams were perhaps deliberately too ambitious on their roadmap, and too many investors lost money along the way because these projects raised too much money. After all, many startups fail, and decentralised projects are no different. But, it was also a time of rapid experimentation, and there were clearly success stories ; many teams managed to design their tokens well, with real utility beyond payments, a topic that we already covered two years ago. These experimentations were not in vain, and were the early days of an important paradigm shift: distributed ownership of early-stage technology projects at a global scale.
What exactly is ownership in an early-stage project anyway?
For a long time in history, it was easier to lend money to companies than purchase shares in them, partly because until limited liability companies were introduced in 1811, investors could be liable for the companies’ liabilities. If you are curious about this part of history, I highly recommend reading A Brief History of the World (of Venture Capital), by Nicolas Colin.
Nowadays, investors have a strong appetite for equity investments, because unlike credit investments, the potential returns are uncapped if things go extraordinarily well, although the probability of losing all capital is higher too.
However, there is another interesting property of equity: you can trade it both for money and for time. This begins with the founders who put effort and intellect into something they own together but is yet to be of value to any third party. Anyone working in a startup knows this well, where it is not unusual to trade a lower pay for higher ownership, incentivising to push further, to create more value and to turn this initial sacrifice into a lucrative outcome (the “overnight success”). In the old world of credit, this could also be achieved by promising bonuses based on the future success of the company, but actual ownership certainly feels more adequate ; and it allows to further re-invest capital, fuel more growth, and further increase chances of a large liquidity event.
At a time where a business, or a project, is cash-constrained, equity is a fantastic tool to reward people who invest their time in the project and to further incentivise them to work towards the success of that project.
Time is needed, but usually not sufficient to build a successful venture, so for those who prefer to invest money, like VCs and angel investors, there is another way to get skin in the game and purchase equity ownership. There is fierce competition to invest money in the best projects, so investors differentiate themselves with their value-add: services they are willing to do “for free”, to improve the odds of success of the venture and improve the returns prospects.
Ownership in early stage projects can therefore:
- be purchased with either time or money, thanks to the equity instrument
- is able to align human and financial capital towards a common objective: the success of the venture.
How does early stage Equity accrue value?
Valuation remains subjective in the early stages of a company for a while. There are methods to anchor this perception, such as market opportunity, team experience and comparable deals, but the main factor is a subjective perception of the opportunity and what is achievable in the best case scenarios. For a long time, the end goal is imaginable, but the path is strenuous, and most importantly the probability of success is slim ; and it is only through hard work and well aligned incentives between investors and team members that the finish line can be crossed.
Until the company reaches a critical size of recurring revenue, equity remains mostly speculative because everything is still to be done, and value increases whenever someone is willing to pay a higher price to acquire that equity, i.e. whenever the potential value increases in the eye of the beholder. This might be driven by the market evolving, the business succeeding, or a subjective evaluation that what has been built thus far will be more valuable in the future, possibly thanks to a clear roadmap. At the end of the day, an investor now believes the equity is worth a higher price given the circumstances because of what has been built thus far and what can still be achieved ; perhaps because it gives them access to cashflow, synergies, or they feel the probability of “success” has improved.
Frequently though, in industries of innovation or high growth, due to worthwhile operational or capital expenditures, there are no free cash flows nor dividends, i.e no value extraction. There might not even be a liquidity event in sight. But, there is always a subjective and contextual opinion on the probable future value created, and an envisioned opportunity to eventually extract value, and therefore a price one is willing to pay today, risk-adjusted.
If we look back at many startups, for a significant amount of time, the equity of these companies is probably worth close to zero. However, there is always a founding team with a vision of what they can achieve, and for them, this equity is valuable. And in most cases, if they want to succeed, they need to grow the team, and so they distribute ownership and possibly even sell ownership to finance growth. This ownership is still effectively worth close to nothing in the eyes of the world, except for a few that understand the vision ; and the belief that it might be worth something someday is enough to align incentives and help this entire team deliver on its vision.
In the minority of cases, the hopes do crystalise, and the ownership that was worth nothing as far as the world is concerned, is now worth a lot. Like that, an instrument which aligns interest and incentivises people to work towards a common goal, allows value creation at a large scale, despite being extremely subjective to value for a long time, and eventually becomes a self-fulfilling prophecy — just like Ethereum.
The motivation that comes from investing one’s time or one’s money in exchange for ownership is enough to incentivise value creation, even if the path to value extraction remains unclear for many years. It is the boost required to beat the odds.
Investing Money vs Investing Time
Thanks to new equity crowdfunding platforms, retail investors can now trade money for ownership in early stage companies, such as Crowdcube, but there is still significant friction there and it remains fairly exclusive.
As we have seen, it is also usually possible to trade time for ownership in one company at a time, when they are involved early in the lifecycle of a project — but this is also fairly exclusive as few can afford to do that.
Time investments can be more creative however, and it does not need to be a full-time investment to be valuable. What if people could invest temporarily their knowledge, their expertise, or their network, in exchange for ownership?
One recent example of such practices is from YouTube, and I am sure there are many more. As the YouTube platform was starting to professionalise, we saw the emergence of multi-channel networks, which are trusted third parties who work with content creators and offer to handle most administrative processes, such as promotion, funding, or negotiating with brands on their behalf in exchange for a share of their revenue.
In France, there was a network called Talent Web, and one of their growth strategy was to give equity ownerships to the biggest French YouTubers at the time, so that they were incentivised to help grow the network ; which logically worked as most YouTubers in France would be comforted to join the network of their idols.
And it worked out: within a year, the network was acquired for €25M by Webedia, a global media company, and the top 3 youtubers received €12.8M for their shares (source in French). It is quite clear that most of the value created here arose from incentivising the right people to leverage their network, and yet they had the freedom to also invest their time in other ventures.
It is clear that ownership aligns incentives and creates value, so intuitively this should be frequently done? Why is it so rarely done? There are multiple reasons, such as the cost, the regulation and the complexity of distributing ownership (and the trust required from the recipient), especially as liquidity events are rare in the equity world. Could there be a better way to easily distribute ownership?
Re-introducing … the token
Equity is a fantastic coordination tool, both for human and financial capital. It is also a great incentive lever: if one owns equity in a hotel chain, now one has an additional reason to book a room with them — similarly to loyalty points.
In practice however, equity ownership is not as trivial to distribute as loyalty points. It is often un-economic to reward contributors for their time with equity below a certain threshold, due to legal complexities, and there is a question for the acquirer of:
- Practical Value: how much is this equity worth, based on what, and how easily can I sell it on secondary markets?
- Trust: can I trust this team to continue working on the project, so that the equity is worth something.
- Governance: do I have any rights?
All these barriers mean that ownership is cumbersome to acquire, to own, to trade, despite it being the single best incentive tool.
With the world being increasingly digital, surely there is a way to represent ownership digitally? As we have seen, it was not trivial, and it took decades of research in cryptography, but Bitcoin has now set the precedent for provable ownership with no reliance on trusted third parties.
Could there be a way to easily distribute ownership, or to reward contributors for their time with a share in the platform being built? … With the introduction of smart contracts in Ethereum, as well as dispute resolution mechanisms, we can build self-enforcing contracts that reward work with ownership.
Could there be a way to represent digital ownership of a project, or a company, that can be easily transferred or traded, and which could grant governance rights? Again, yes, … with a token!
A token allows to transfer ownership at very small cost to anyone.
A token allows to encode incentive mechanisms, such as: if Alice does xyz, she receives 10 tokens, all autonomously. This is much more flexible than equity, which grants the right to a stream of dividends or eventually liquidity. Here, tokens can grant the right to participate actively in future a stream of rewards in return for attention, expertise or liquidity.
A token can be used to give governance rights to even the smallest investors, something that is usually impractical. As communities form around these networks, it incentivises token holders to go above and beyond thanks to a sense of ownership and community.
A token, by virtue of being a digital good, can easily be sold as the friction to create secondary markets has nearly disappeared with the advent of decentralised exchanges.
Therefore, the token is a powerful tool, and like all tools, it needs to be properly used. For a token to make sense, it needs to be properly designed.
The right token design
As we have discussed, equity is not just a fundraising tool, it is also a coordination tool, which makes it more effective than credit. The best token designs therefore are the ones with the best coordination tools, and through smart contracts, the possibilities should be limitless (but are limited by the law).
Therefore, what are good token designs? To generalise, every network, every dApp, every company is somehow bridging with varying degrees of trust participants which have resources to sell (time, infrastructure, liquidity, knowledge, …) and participants looking to purchase these resources, i.e. marketplaces.
Concretely, this can take many forms, for example a crypto exchange:
- provides and maintains an infrastructure backed by human capital and expertise.
- incentivises market participants who provide liquidity and build infrastructure with their time.
- is a convenient way for traders who gladly pay a small commission to leverage this infrastructure when they are looking to trade one asset for another.
In this example, there is a value transfer between the different actors involved to create both a profitable business and a useful service, and all actors benefit from the marketplace creation. This is a fundamental difference between traditional marketplaces and networks, because in the latter, the marketplace participants own the marketplace, so they collectively stand to benefit from the addition of new participants, even if they do not directly serve them.
At its root therefore, the best token design would incentivise essential network participants to take a risk in adopting a new platform before it is clear that it is worth it, and reward them with ownership that will have future value thanks to their contribution.
The token cannot be exclusively a fundraising tool, otherwise this will rarely work out, unless the team is extremely efficient with the capital raised and builds the service entirely. Therefore, distributed ownership via a token must be given in exchange for valuable contribution, and this should be done disproportionately when these networks need it the most. Some examples:
- Compound, Curve, and Balancer are open finance protocols which provide incremental value to their users as the assets deployed in their smart contracts increase. The earliest liquidity providers play a vital role, and by being the first, they also take the greatest risk in terms of opportunity cost and security risk. By rewarding them with tokenised ownership, early adopters have additional incentives to invest their time and energy in adopting the protocols, and to grow the network.
- In projects which rely heavily on governance, like MakerDAO, Nexus Mutual/Unslashed, or a DAO that invests funds like MetaCartel or StakeDAO, there could be a pool of ownership (tokens) distributed to those who contribute the most to further incentivise participation (note: incentivised governance is easier said than done, there can be unforeseen consequences)
- In projects that aim to bootstrap a marketplace, like Ocean Protocol for data, or Orchid Network for bandwidth & privacy, the first participants who invest their time in integrating the platform should be rewarded with ownership.
- If a project needs integrations to succeed, then they should not hesitate to give ownership to incentivise integrations.
There are many examples, but to summarise: the token is a coordination tool, and a way to incentivise work with potentially outsized payouts for contributors, and it is therefore a project’s biggest lever to bootstrap one or multiple sides of its marketplace.
Value capture in the context of a token
It is difficult to incentivise people if they do not assign value to a token. That is why money as a trusted medium of exchange has been essential in coordinating humans.
Just like early-stage equity can be a self-fulfilling prophecy, it can be the same for tokens, as long as there is a value capture mechanism built-in. Importantly, the token does not need to capture value from day 1, but there needs to be a path to it, either because the token directly captures value, or indirectly because it represents ownership in something that is valuable. There needs to be a clear reason why one is receiving tokens today for their help and not good old cash.
The best example we have in traditional companies is Amazon, which re-injected profits in the Amazon network, and which had warned its investors early with a letter from Jeff Bezos in 1998: Path to value extraction was clear, but it was rightfully delayed in order to build a more valuable network. (more on YouTube in the context of Web 3 and Capitalism from Richard Muirhead).
To capture value, a token could eventually:
- take a fee on the value created and distribute it to token holders, either indirectly via burn or directly via distribution.
- have a token design that incentivises token ownership, such as fee reduction.
- Have a “work token” that must be staked for the right to participate in a marketplace (e.g. taxi medallion).
All these designs can work, and we have written in more detail on these here. Of course, even the best token designs do not guarantee successful networks or successful returns, and there are ideas that simply will not work, but it is one piece of the puzzle that gives leverage to a great team to deliver on their roadmap quicker.
Ultimately, similarly to Ethereum and early stage equity, a token is a self-fulfilling prophecy. It is because one has successfully incentivised enough contributors, that a network attracts enough attention, and that ownership of that network via a token becomes valuable — similarly to equity.
Take Binance’s BNB for example, objectively one of the most successful tokens to date. BNB had the right properties to capture value:
- A fee reduction mechanism for token holders.
- A passive redistribution of profits via supply reduction (token burning).
But that was not enough. It is the fantastic execution from their team that reinforced the value of the token, turning into a self-fulfilling prophecy and allowing the BNB token to add more use cases and make financial sense for its early adopters.
Concern of tokens being classified as a security
A concern in the digital space, and likely the reason for many 2016–2018 tokens having poor token designs, is the fear to be prosecuted for conducting an unregulated security offering, i.e. selling a token to retail investors which meets the 4 conditions of the Howey test.
There is plenty of literature on the topic, but in brief:
- It is best not to sell tokens until the network is live
- it should not be a problem to gift a token that has security-like properties in exchange for work
- the token designs that require active participation to capture value (e.g. staking -> work -> fees), are less likely to be securities.
- When a network is sufficiently decentralised, it is less likely to be classified as a security, which is helpful for governance tokens which might eventually vote to modify their token design and introduce features that would fit the Howey Test such as direct profit distribution.
There is clearly uncertainty around this law, so please do seek legal guidance and do not take any of this article as legal advice, but a point worth making is that the regulators usually want to incentivise innovation and value creation, whilst protecting retail investors. One can hope that there would be tolerance for token designs which might be close to securities, but for which the innovation has clearly resulted in value creation, as opposed to token sales which were clearly nefarious.
Token distribution: getting it in the right hands
Given the best tokens are incentivisation tools, the right hands would be those that bring value to the network early. It feels therefore that the best way to distribute tokens is to distribute some to the contributors which are most crucial to the network’s success. The recent success of Compound’s COMP token is a good example, which by incentivising people to use the platform and provide liquidity, reached the #1 position in DeFi protocols, increasing value locked five-fold. In this case, the only way for the wider public to acquire this token is through active participation in the network, which means only users receive the token and thus network ownership.
Given projects need capital to finance coordination and operations in the early days of the network, it is normal to sell some tokens to private or public investors, and preferably to investors who provide the most value in addition to their capital. In some projects, value might come from expertise, vested interest, or simply wide distribution. There is no one size fits all, but in most cases, good investors include:
- venture capital investors or angel investors who have relevant networks/expertise
- Active community participants with disproportionately influential voices
- future marketplace participants
Imagine if you received equity in Youtube per thousand views your videos generated in 2007, even if the equity was worth a few dollars at the time. Would you have ever uploaded a video elsewhere, or promoted a competitor?
Imagine if every time you took or gave an Uber ride in 2012, you received some equity in the company. Assuming you are happy with Uber, and the company keeps growing, would you have ever taken lyft? What if you received equity for referring new customers on top of the usual cashback?
Imagine if every time you sold an item on Amazon in the early 2000s, you received some equity in the company. Could Amazon have grown even faster?
These ownership incentives do not even need to replace existing incentive mechanisms, but can clearly become complimentary. Intuitively, one can see how this can disproportionately reward those who take risks early, and invest their time in building these platforms, and literally play a vital role in the platforms’ successes. Without early adopters, these platforms would obviously not be here today.
Leveraging tokens to distribute ownership allow platforms and networks to scale faster than ever before. Once your early adopters/contributors also have ownership in your success, they become your biggest advocate.
Ownership has never been this simple to distribute, with the advent of blockchains, digital scarcity, and smart contracts. A token is much more than a fundraising tool, it is a coordination tool, and it has the properties to become the most useful coordination mechanism we have seen so far. Networks that leverage tokens correctly stand to create much more value than the ownership dilution.
The debate between features that would make a token fit under the equity category or not is unfortunately a distraction for this space. Clearly, there needs to be a way to capture value for a token to be valuable, whether it is passively with mechanics helping the token to increase in price, or actively with mechanics that require holding the token to extract value from marketplace participation. For a long time, Amazon’s equity would have been considered a bad token with no value extraction, and yet, they have created one of the most influential networks in history. Now, with the opportunity to bake incentives in the token, and more importantly, the possibility to evolve and adapt these mechanics through time, a token is more fit for the future than simple equity.
This is why we at Fabric Ventures believe that tokenised ownership is the way forward. Some revolutions take time, and we know tokens will remain complimentary to equity for some time.
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