The True Cost of Tokens
Let’s talk about Cost of Capital.
Capital has a price, and it is often expensive.
Gary Vaynerchuck is a boss hog you should read, start with this piece. Gary is not an industrial magnate like Elon Musk, husking through science books while recruiting top minds to reinvent engineering disciplines, nor is he a design maven like Steve Jobs, lulling us into the gripping allure of his fascist, sleek skuemorphism. He’s just a hard working New York guy who really gets money and disciplined compound return, who played it frugal and then balled deep on shares of Twitter et al. He’s got good common sense, and it’s about damn time we applied that to the ICO markets.
By the way, the SEC called, they want their jurisdiction back.
The game theory of rushing out ICOs was, why the hell not, everyone else has 8 or 9 figures you’d better get at least 7, the bar’s so low, just raise in ETH. That’s over now. To cash in massively on what may be considered, in an accounting sense, free money, neither tied to debt or borne with legal governance powers from shareholders, was the black hole temptation of this industry for a while, with the bar lowering until during the mania of a bubble, we have our second proper ICO window (the first was in 2013–1st half 2014).
The legal changes the game theory. Now there is reason to wait to do an ICO. But before we get into that, let’s consider the sheer economic consequences of different decisions a project can make for itself, with two little anecdotes, because this is Medium and you’d better expect literary color mixed in with your technical ideation.
Last May I was bummed out because my girlfriend moved out, so I forced myself to go out for a night on the town, went to Venezuelan dancing night, ratio was bad, met one Korean girl I should have asked to add me on Facebook, came home at 5am, whole thing cost me fifty bucks. A week later a friend who owns a business retrofitting trucks and other value-added services for the transport industry taps me for help with his MBA homework. I do not have an MBA, but multiple people have at times asked me for help anyway, and I always smash it in about 3–5 hours of study and modeling. He offered me about 50 bucks, so I got up early on a Monday morning and cranked out the spreadsheet in time for his class — basically a lot of being up early in the mornings to break even.
What he tasked me with understanding and calculating were a few metrics on balance sheet performance, particularly Cost-of-Capital.
What I learned is that if you borrow money, cost of capital is close to what your interest rate is plus a bit of swerve for compound opportunity cost of that interest-diverted cashflow relative to your internal rate of return for investing said cashflow back in your business — bottom line, is if you’re doing fine, debt is the cheapest way to finance, just inflexibly so. But if you sell equity, god help you, because your cost of capital is higher the better you do. To put it in lay terms, if you sold 40% of your equity before the thing went up 20x, you missed out on a heck of a lot of money there, which your investors instead enjoyed. The best businesses paying higher costs of capital has made a lot of ordinary people much wealthier, particularly in the convex-payoff Schumpeterian melee of the last 40 years since the early days of Silicon Valley.
Second anecdote:
Later in 2016 I am back together with the girlfriend, worrying about making payroll for myself and several others. If it’s not one thing it’s another right. As a consequence I was selling OMNI that was held by the foundation I worked for, and then after Bitfinex was hacked and there was speculation that they would issue 8-figures worth of their debt as a free-floating Omni Layer token (they didn’t), and another friend who flips a lot of coin decided to buy in to the token with his crew of syndicated co-investors, but without calling me first to negotiate over the counter, and we got a perfect storm that took the price from $2.50 to briefly over $10. I had sold enough in July to pad up a payroll or two, but what I sold then in early August was enough to pad several payrolls. Ergo, if I had staggered my sales to go for the higher price, or even negotiated $5.50 over the counter and made a better deal for everyone, then we’d have had more money for the same sales.
Later OMNI would trade at over $100, in the midst of the mania mentioned at the top of the article. If I could have timed my trading better to have totally sold out above $5 and re-buy a lot of OMNI back around $3, while still servicing payrolls until other sponsorship came in to relieve the burden, and then held those tokens another 10 months, the difference would have been dramatic. I was just too conservative about the near-term cashflow expenses to have traded more aggressively.
So yeah… this is what success looks like, unless you’ve massively sold down your position in your own token. To be fair, the other board members still control a fair amount to fund future dev. Across the board, so to speak, the cost of capital was balanced enough to keep funding things for years, mission accomplished, to some degree of efficacy.
Also, OMNI is an example fraught with late 2013’s, 2014’s and 2015’s activity with other actors, prior leadership, huge overhangs of illiquid tokens inefficiently priced — but I did do an article for Bitcoin Magazine that they never published last year where I analyzed a bunch of other coins that had been issued as ICOs, and the astonishing finding I made then (which needs to be re-checked by post-bubble valuations to be sure) is that in the non-bubble valuation days of long-term ranges in BTC pricing of coins, it was the coins who raised less money that had the best overall performance, relative to bitcoin or in dollars. Also their performance reflected this difference in non-linear terms.
Regardless of the legal designation on your token in a given jurisdiction, you’re still hurting yourself by issuing a huge overhang of tokens to investors.
Raised less :: performed better ->Convex function
Got that?
Even Ethereum raised only 10M (after the 5M loss on their BTC dropping with no hedge). That was a scale project, a lot of developers, multiple teams, the most expensive countries chosen, they should have held onto the 5M in unrealized BTC $ value and had a cash cushion instead of coming down to 3 payrolls of runway before the ETH bull market got going. But the point is, even with their ICO issue hang, and their Proof-of-Work high inflation rate, it wasn’t such a massive shelf that it couldn’t be surmounted by the eventual value manifestation of the underlying network. Now ETH is 10B or something, it seems like if they had raised 100M it wouldn’t have mattered, but it would have mattered — you would not be seeing the three and a half orders of magnitude gain, you might be seeing two and a half at best, more likely two.
It wasn’t Jesse Livermore’s thinking that made him the big money, it was his sitting tight. And it’s not raising the big money that will make you the big money — it’s your thinking! Following that, your token hodlers will make their big money sitting tight.
Are you a talented developer or designer? Are your co-founders also? How confident are you in your ability to bring in novel work to a level of testing that befits financial protocols with a modest-sized team? How much money does that cost?
Probably a lot less than 150M or 33M or even 5M. Probably 1–2M is plenty.
If your token is so good, why don’t you hoard it mercilessly?
Commodities vs. Securities
So now that we’ve established the mathematical reality of token issuance, i.e. there is no free lunch, and just because token holders don’t have preferred stock where you could walk out of an acquisition with nothing because the valuation was below par, doesn’t mean there aren’t other traps to set by raising too large or at too high a valuation, now that we’ve established that, let’s talk about the fun part — securities laws!
An Australian made a comment that tokens seem like they’re legitimately software licenses that grant use of service, hence not securities. Clearly, this is a position that some jurisdictions will take on the matter. The US has the Howey test which boils down to “common enterprise” in the horizontal and vertical senses, a crypto-hedge fund whose token tracks NAV would be horizontally common, but even something that is issued to fund a protocol or something could have vertical commonality. So then, what is not a security in SEC parlance? Well, Bitcoin for one, the Commodity Futures Trading Comission has already classified Bitcoin derivatives as coming under their jurisdiction (multilaterally cleared) so ergo, Bitcoin is a commodity. Why is that? Also Bitcoin is the best performing coin of all time considering it’s sub-penny initial pricing. How was Bitcoin ever priced at sub-penny levels?
Because it’s mined, not issued. Or rather, it’s issued by an algorithm, the protocol itself, not a foundation or what-have-you.
Ethers are a hybrid because they ICO’ed but they also are mined.
Given the DAO message, the subtext from the SEC’s judgement is that Ethers are a “currency” and therefore, if the SEC isn’t making action against the DAO perpetuators (since they apparently liked the fork and rescission that resulted) they also aren’t making action against the Ethereum Foundation. So, is ETH a commodity? It would seem so but this is more of a maybe.
Then take something like Factoids, which is a non-enforced revenue corral for Factom Inc’s IP which they also derived revenue from by just billing clients, which benefits equity holders but not token holders, this looks like it probably is a security anyway, but it haz the use-case redemption model and it could perhaps squeak by.
One key difference from those tokens to the recent batch of ICOs, is that they all had some working code. Not working-working though… ETH took another year to have the network functioning and able to execute basic smart contracts gas’ed with ETH.
But that seems to be a major pro in favor of a commodity designation.
Bottom line:
- If you are going for the commodity designation, try raising privately or doing a Reg CF in the US for a company that holds whatever IP, pays the devs ect. and perhaps has some tokens in treasury. There could be a holding company outside the US that holds a lot of the stock in the US entity. Or skip the US, block it.
- The token should be earned by the company for providing the work that gets the token issued in an algorithmic manner, the way Satoshi was a decent chunk of the mining network when it was a handful of laptops. An initial ICO when it’s working that shelves a big chunk of money supply to inflate off of, with 10% going to some special address you control, may still be permissible in a “commodity”. It’s like allowing farmers to sell experimental seeds and allocate themselves 10% of that amount as treasury, so they can have funding to finish developing the new type of crop — a tortured analogy but the distinction is the readiness state of the thing being sold. A promise of experimental seeds on the other hand would be a security perhaps. Zero Cash looks like a good recent example, fully running as a protocol/blockchain at ICO — we just need Ledger X offering ZC options and its commodity status will be locked in.
- There are systematic ways to harvest the value of a token that would otherwise be some investors’ unrealized capital gain, through seignorage a.k.a. inflation: issuing the token to those who are doing work that makes the network valuable. So consider baking inflation into your token economics as a way of massively reducing cost of acquiring customer, or subsidizing the work, or subsidizing the user’s service experience, instead of raising big sooner. Because part of the cost of a huge token overhang, or even a medium-sized one, is limiting the ability of an inflation model to co-exist with an up-trending price, killing its utility. Inflation in a coin has the potential to be an *off balance sheet* form of perpetual financing for network growth, this is the new thing.
Probably the hard-money conservatives will come at me for advocating inflation but face it, crypto is fiat money more than gold is, there are no supernovas powering these proof-of-work algorithms just dead dinosaurs being burned. Low, predictable inflation is what kept fiat going and if you look at it closely, it’s what got Bitcoin and Ether where it is today.
3. Some business models need a lot of capital to get going, BANCOR might be a decent example, but look at the damn chart:
What if you were such a fanatic for your own coin because you believed in its commodity value beyond just corporate expenses, corporate ops, corporate partnerships and acquisition campaigns, what it you had an almost mystical passion for the potential of your big open-source organically money supplied thing, like those Bitcoin Maximalists, but innovative.
What if you created the coin that you deserved to HODL?
