I’ve been thinking about utility tokens and how to shoehorn them into the traditional capital stack on and off for about a year, and Clarke’s tweet this morning started me up again. Below, I’ll argue that the misalignment of incentives between a token issuer and its investors creates a moral hazard that makes utility tokens impossible to value prior to the launch of the network they power.
In traditional corporate formations, the firm raises money from investors to fund operations in three ways. Equity, debt, and various hybrids of the two. To an investor, the stack can be understood as a fairly linear spectrum of risk and reward. Equity holders are generally not required to be paid back but have the greatest upside potential, usually in the form of claims on cash flows (dividends) and capital appreciation. Debt holders (and this is obviously simplifying) are the first to get paid back (and indeed must be paid back at some scheduled date in the future), but the upside is capped contractually.
In this old school capital formation, the incentives of the firm and the investor are aligned. If the firm does well, employees will be compensated, debt holders will recoup their investment with interest, and equity holders will benefit from capital appreciation and dividends. This alignment means that pricing the risk of investment is fairly straightforward if you understand the firm’s income statement, balance sheet and business model. If you know the management team, all the better. The methodology varies, and is outside of scope here, but suffice it to say that generations of MBAs have these models pretty much dialed in, and with very few exceptions (convertible notes I’m looking at you) they all rely on this alignment of incentives.
Over the last 18 months, firms have discovered the ICO. Thousands of firms have raised billions of dollars using this new, fourth way to raise capital. Broadly defined, in an ICO a company presents the theoretical foundation for a cryptoeconomic network and sells the tokens that will someday power that network to investors in exchange for ETH or BTC. Presumably, they’ll act in good faith and sell their new BTC and ETH for fiat to fund operations and build the network they promised investors. But, and this is important, the only thing a token grants to its holder prior to mainnet launch is the option to participate in whatever actions may be happen on that network. Which didn’t exist when the tokens were minted and sold. And which may not exist in the future. And which the firm selling the tokens is not obligated to create. They’ve already got your money with no covenants. A utility token is essentially a very out of the money call option, written by an issuer with no downside if it is never exercised.
Let’s take a moment to appreciate how absolutely bonkers this is. New school crypto-economic design is built (go to 22:46) on managing and aligning incentives. Indeed, the foundation of the Bitcoin whitepaper is an incentive structure that drives rational network participants to reach consensus. Infinite words have been spilled on Medium hypothesizing about how to value crypto-economic networks and the tokens that run them. Nearly all of the words describe or accept as fact that within the networks, users’ incentives are aligned. And that’s a great academic exercise, except that by and large these networks do not exist in the real world.
It becomes impossible to measure the economic value of a utility token when you cannot measure the probability that the network it runs on will be successfully launched. I believe there are (at least) two main risk vectors. The first is execution. As we’ve seen this summer — going live is difficult. These projects are working to solve hard problems using state of the art cryptography. It takes a long time and a lot of trial and error. Assuming, though, that the teams are indeed working on the problems, you could probably apply some sort of discount rate to whatever token valuation methodology you choose to price in the delays.
The second is moral hazard. Because pre-network tokens come with no rights, you can’t just assume that the project team is cranking away. As I mentioned above, they’ve already got your money and don’t owe you anything in return. Before you invest, it’s impossible to measure this risk. Impossible. You can make guesses about the character of the founding teams, and look at their LinkedIn profiles, and talk to their former colleagues, but truthfully there is no diligence that would fully satisfy my inclination to distrust most people. (Note: I’d be interested to hear about any vesting schedules or treasury token rules that might mitigate this risk). After the fact, you can look at Github repos, and follow their IR people, and bug them on Twitter but really you shouldn’t have invested in the first place.
There are many ways to think critically about the possible future value of a crypto-economic network, as cited above. And doing so might make an investor comfortable with the potential use case and addressable market of a given utility token. However, I firmly believe the the risks to a project are impossible to quantify using a utility token whose incentive structure is coupled to the network itself rather than the company that’s building it. And without a clear picture of that risk, it’s impossible to value the potential reward.