Cryptoeconomics for the Long-Term: Founder Lockups and Second ICOs — Part I
This article was born from several recent discussions I had with Stanford friends around the sustainability of cryptoeconomic models. Thanks in particular go to Michael Longoria and Kevin Xu for sharing many of their thoughts around the space, as well as several other friends with whom I have discussed this topic at length. In this article, I will lay out several long-term challenges for the Cryptoeconomy, focusing on incentive design, founder lockups, and post-ICO fundraising. I will also propose improvements and solutions that I believe would be helpful for solving these problems. It is my hope that these ideas will encourage both investors and developers to think critically about the incentive systems currently in place, as well as the long-term success and viability of their projects beyond the first few years.
n.b. I will use “company” to refer to the founding entity responsible for creating a blockchain ecosystem, while I will use “project” to refer more broadly to that ecosystem. This is an important distinction, since, as outlined in Scott Kupor’s and Sonal Chokshi’s article Analogies, the Big Picture, and Considerations for Regulating Crypto, blockchain networks can and will evolve beyond the control of the founding company.
Back to the Future
Imagine: The year is 2021. Bitcoin has died over 800 times by now; reincarnated, of course, as Bitcoin. Vitalik is finally able to grow a beard. Filecoin is finally launching soon. Donald Trump narrowly lost re-election as president to Stephen Colbert. Ripple still has not been added to Coinbase. McAfee joins the church as a eunuch. Verge prepares for its 50th 51% attack ahead of its next major partnership announcement. I will be 25 (oh god).
Also by 2021, nearly all of the founders of ICOs from the current 2017–2018 craze will have their founder and foundation token lock-up periods expire. This will increase circulating supply, encourage downward pressure on token prices and valuations, and create meaningful doubts about the long-term sustainability of the cryptocurrency ecosystem.
We saw a particularly notable case of this last year, when Charlie Lee sold most of his Litecoin before announcing it to the public. While he no longer has a personal stake in the project, he does want to continue development — the price of Litecoin and the Litecoin ecosystem certainly took a hit from this announcement, and only time will tell whether it will continue to survive and thrive.
As token lock-up periods expire, founders will be faced with very real dilemmas about the success and profitability of their company, and their continued participation in their project’s growth. Is their company or foundation profitable? Do they believe their efforts can continue to increase their token holdings’ value? Are there more lucrative or attractive options? Is the project unable to meet its key goals? Do they have other sources of income that allow them to hold a substantial amount of tokens? Can they string people along for long enough to achieve their own token liquidity?
A Fork in the Road: Misaligned Incentives and the Three Paths
There has been a great deal of recent discussion about how to classify ICOs from regulatory perspectives, in addition to discussion around the investment perspectives and frameworks necessary to evaluate ICOs: Are they startups? Are they ecosystems? Are they foundations? In fact, all may be true. In my article on Developing Frameworks for ICO Investing, I outline useful ways to structure thinking about ICOs, treating them from a startup perspective. While ICOs are their own set of businesses, the startup landscape is the closest analogy, and one that we can use to derive meaningful conclusions from a business type that remains in its infancy. I believe this is the most helpful approach in many cases, because ICOs are, in fact, startups with added challenges, considerations, and key stakeholders.
As a decentralized project develops, however, the project’s ecosystem and the founding team become separate entities. In many cases, the founders may look to benefit from the ongoing growth and expansion of their ecosystem. This should result in a business or foundation which captures some of the value created by the decentralized network, and recycles the value to create additional growth, fund additional development, and support the maintenance of the ecosystem. DASH has led the way with this approach, creating a fund for ongoing development driven by their community.
Regardless of the final business model, at the end of the day, a positive cash-flow or continual increase in token valuation is essential for ensuring that its leadership remains committed to success. Without this, there is little economic incentive to continue development on a given project.
For the scope of this article, I see three important scenarios to consider throughout this process of evaluating founder lockups. I will walk through each scenario, how the current structuring of incentives will encourage founders and companies to act, and how each situation is broken.
The First Scenario: Happily Ever After
The first scenario is the one that everyone dreams of: Everything is going well, the company/foundation is profitable, and the founders believe that their continued work is not only profitable, but the best usage of their time and resources. Even though the founders may have newfound liquidity, they do not sell because they believe their efforts will continue to cause the value of their tokens to appreciate. They may hedge by selling small amounts, but ultimately, nothing much will change from the current landscape.
This can quickly and easily be broken, however, by any sort of negative event which would transform the company’s long-term outlook. Moreover, new competitors, black swan events, or personal changes in founders’ lives could all shift this balance toward a less optimistic outcome.
The Second Scenario: The FUD Flood and Treading Water
The second scenario is the one everyone has nightmares about: The company is barely staying afloat, they are running out of funding, the founders want to move on, and they believe that the experiment has run its course. Here, in fact, the founders have strong incentives to sell their tokens (and minimal incentives not to!). Their work obeys the law of diminishing returns, and the network itself receives less utility from each developer-hour after several years than it did in its inception. Even if the project may be doing OK, it may not be thriving enough to justify sinking additional time, effort, and money.
While some may be quick to classify this as an exit scam, why should it be? The founders made a genuine effort for several years, and they failed. Maybe the idea was too ambitious, maybe the community support was lacking, or maybe it was vaporware all along — it doesn’t matter now. Not only that, but everyone involved in participating in the ecosystem, purchasing the tokens, and supporting the project had complete information: The founder unlock should hardly be a surprise, and nor should the sell-off if the project fails. If this is an exit scam, it is a fully consensual one.
In fact, to make matters worse, to encourage market liquidity for when they unload their tokens, the founders may attempt to pump up the price and buying interest for their project shortly before dumping. This would allow them to unload their holdings without crashing the price as substantially. This possibility should hardly be a surprise to anyone, and already occurs on a semi-regular basis, but will become more pronounced over time as larger market-cap coins also begin going the way of the dodo.
In a similar vein to manufacturing hype, team members may also prolong a failing project’s lifespan until they reach their unlock time — rather than announce they are moving on 3 years into the project, if 1 additional year will yield large token dividends, why quit early? Folding a project prematurely, rather than treading water for an additional period of time, is against the economic and rational incentives for any founder.
Clearly the incentive structures here are broken, such that founders (who are intimately familiar with the details of their project’s operations) could choose to leave and sell their entire stake in the project. This will happen if and when they feel it is no longer economically in their best interest to continue their work, even when they have not accomplished goals warranting such a large payout in unlocked tokens. The model of locked fixed token payouts is problematic. We should not make a habit out of subsidizing failed project teams’ exits, which the current token unlock philosophy endorses.
The Third Scenario: Promising Future, Bleak Present — Series B ICOs
The third and final scenario is an interesting juxtaposition of the prior two, and for many projects, may be the most likely outcome: Their “burn rate” — a startup’s spending in excess of their income — eats through the amount of capital raised via ICO, and leaves the project nearly broke after several years. If they are not yet out of money, they will begin to feel the pinch of several years of questionable funding, operational bloat, and inefficient budgeting — all side-effects of the ICO craze leading companies to begin overcapitalized rather than starting lean. Even if the network is set into motion, money and time are still required to acquire users, improve, and maintain the network.
These bloated projects will face new challenges as they are forced to scale back and optimize their operations to match their dwindling budgets. Without additional funding, even promising projects may be forced to reconsider their long-term sustainability, leaving them with a difficult problem: They need to raise additional money. How could this play out? While I believe the last option, a security token offering, is most likely, I will run through the other three alternative fundraising scenarios in order from least to most likely.
- Second ICO
With a fixed token supply, the project cannot mint additional tokens to sell, thus they likely cannot perform a traditional “second ICO.” Creating additional tokens would require diluting existing supply, and should be impossible anyhow, since a fundamental principle of cryptoeconomic design is that coins cannot merely be minted as anyone pleases. Since this is the case, and selling existing tokens owned by the team should be considered bootstrapping, we can rule out the traditional ICO model as a solution for this funding predicament.
This may seem obvious, but in line with the second scenario above, the team and/or foundation could sell a portion of their tokens to provide additional funding beyond their initial raise. This would not be new money flowing into the company ecosystem, and thus would need to be weighed heavily against the opportunity cost of using these funds for general operations rather than their intended purposes (or profit-taking for founders). The only cases where this may make sense for either party is when there is a near-term expectation of a turnaround and profit — much like any other investment, it would not merely be done as goodwill.
- Sell Equity (to VCs)
Just as traditional companies can sell equity, so can blockchain-based companies. This is, however, only possible if the company exists beyond the blockchain ecosystem it sets into motion. Owning equity in a network is far more difficult. This fundraising strategy would align with the traditional VC and startup fundraising model, where a new company’s primary asset is their future earning potential. Rather than selling tokens, a company would choose to sell equity. This most likely would be done through the traditional VC model, and would enable them to receive both validation and support from more established firms. Just as many token-sales for VCs today include a portion of equity, this could become diluted or capitalized upon by future equity rounds with higher valuations. In this way, an equity offering would look a lot like a traditional Series B round today.
This is a concept similar to the Second ICO, but with a very different nuance: Rather than selling tokens to the public, a blockchain community could decide to increase the circulating supply of tokens to provide the necessary funding for project innovations. Of course, in the current fixed-token models, this would be difficult to implement; still, it remains more attractive to the ecosystem than running a second ICO: No additional money is sunk into the project, but value is created through creation of additional tokens. This would only take place (and only make sense) in cases where the proposed inflation would be offset or outweighed by the value of the improvements. This would not solve general funding problems, but could be used to provide more meaningful incentives for innovation. This is discussed further in Fred Ehrsam’s post on Funding the Evolution of Blockchains.
- Security Token Offering
The final, and in my opinion, most attractive option, is to hold a security token offering, selling fractional shares of future revenue and assets generated by the network or company. The valuation, share of revenue generated, future revenue projections, and overall success and promise of the project thus far will all be factored into the sale. Only projects with a genuinely promising future will succeed at raising funds in this manner, and a clear revenue stream is necessary to justify this approach — whether through the network or through a company responsible for maintaining it. These STOs could represent either tokenized equity, or a variant wherein investors are only entitled to revenue generated by the network independent of the issuing company or foundation.
A Better Way Forward
Now that we have established that the current models are flawed, and that there are a lot of possibilities we need to account for in the future, the question becomes, can we do better?
In my next article, Part II, I will discuss potential solutions to this problem of misaligned incentives. While there will always be faults and challenges with any model, I believe that we can significantly improve the current approaches and best-practices. It is my hope that in the coming months and years, these solutions will become more commonplace and help to avoid many of the pitfalls seen in our current models. Part II can be found here.