Frameworks for Funding and Token Distribution — Part 1: Utility Token Sale

As of now, various funding models for crypto networks have been tried out, but there is still a lack of a clear taxonomy for those. Due to the recent shortcomings of Initial Coin Offerings (ICOs), this term has established itself as somewhat of a dirty word, which some crypto marketers are trying to avoid at all costs. For some, the ICO has become synonymous with scams, fraud and unwanted attention from regulators.

Yet, the need for crypto entrepreneurs to fund their operations is as strong as ever. This is the first in a series of blog posts that outline some of the current models for the capital generation and token distribution, as well as their implications on investors and regulators.

Despite some of the recent failures, utility tokens still seem to be the gold standard. When you have already launched your mainnet or DApp and you have implemented token functionality, you are set to publicly sell your tokens and, hopefully, they will pass as utility tokens to regulators and not be classified as securities. Unfortunately, you are still operating in a legal grey area and the rules for this are the same as in soccer: It’s always offside when the ref blows the whistle.

Also, you want to make sure that your tokens have actual utility, as this will greatly affect how investors and traders valuate them. This means that you need to design tokens around your business model and they must offer a functionality that is not yet provided by an already established cryptocurrency. As a rule of thumb, if the services you offer could be paid for in ETH instead of your native token, you have designed yourself a veritable shitcoin.

Investors are becoming increasingly aware that there are many tokens out there that are simply meant to fund a network, rather than provide utility.

If your project is one of those, your ICO will likely not succeed. If it does succeed, your token value will plummet in the months afterwards, as there is no practical use case for your tokens. This is what makes or breaks utility tokens and a significant portion of your whitepaper will consist of describing the problems you are trying to solve and how your tokens are going to help in doing so.

Advantages and Disadvantages

In terms of practicality, this approach takes somewhat of a middle ground between keeping costs low and providing regulatory safety. Also, when launching a utility token sale, you already have an MVP that you can present to potential investors and thus show that your project is serious business.

The biggest advantage of utility tokens above classical business models is that it allows you to reap network effects without having to keep shareholder value in mind, as the shareholders (so to say) are your active users. The benefits of network effects and rising demand for your tokens are thus directly and fairly distributed to your community. Much of the disruptive nature of tokenization comes from this ability alone.

The drawback, of course, is that you have to develop an MVP beforehand, without any funds (unless you have been endowed with venture capital). This means that you have to pay your team members with your own native tokens until the end of the token sale. Keep in mind that your team members take a great risk by committing to the project because if you fail to reach the soft cap, their work was all for nought. Therefore, you should pay them well, but don’t overpay them either. Your tokens are meant to be distributed to the community and you want to avoid having token balances centralized in the hands of your team.

Token Vesting

Beware of the dump! Even if you blindly trust your team members, always anticipate that they will immediately sell their tokens once they get a chance to do so. They are not to blame for this. Remember that your team has worked hard in order to make your token sale a success and at some point, your team members want to get paid.

Many aspiring projects have failed in the past as there was no real incentive for the team to keep improving the network. Therefore, make sure that team tokens are properly vested. Ideally, vesting is governed by a smart contract like this one, where tokens are gradually vested over time and your team members can release their vested tokens at any time during the vesting period. Thus you decrease the likelihood of massive price dumps.

One decision that you have to make is how long you want the vesting period to be. On one hand, a long vesting period creates a strong for the team to stick with the project, but on the other hand, you will probably have to pay your team more tokens in total, to make the waiting worthwhile for them. It is up to you to find a good balance here.

After the Token Sale

You need to have a plan on what you are going to do with the proceeds of the token sale. Of course, you want to put the money to good use in order to improve your project, but you have to keep the money somewhere in the meanwhile. Since utility tokens often operate under a non-profit business model, it is usually a good idea to transfer the proceeds to a foundation.

This gives investors some reassurance that you are going to invest the proceeds for the specific purposes outlined in your whitepaper. However, you are not as free in your operations as you are with a company, so it might be helpful to set up a company to conduct the token sale and additionally a foundation to manage the proceeds.

Finding the right jurisdiction to incorporate your legal structure in is an important step as well. Naturally, you want to incorporate in a crypto-friendly country. You might as well consider picking two different countries, for example a country with a good regulatory framework such as Malta, Switzerland, or Estonia to set up your company and a tax haven such as Liechtenstein or the Caymans for your foundation.

Picking the right legal structure and the right jurisdictions are some of the most important and complex decisions you have to make early on and there are many different factors to consider. If you want to read more about this, check out this article.

Conclusion

A good utility token is a wonderful, disruptive technology that allows skilled entrepreneurs to solve existing problems in the classical economy, without a large upfront cost. However, setting up a utility token is a complex and tedious task and not to be taken lightly, as there are many pitfalls that may lead to failure either during, or after the token sale. The most important thing to consider is that your token actually solves a problem and that you don’t merely create yet another cryptocurrency.

In part 2 of this article series, we will tackle funding STOs and SAFTs as funding models with higher regulatory standards.

Tobias W. Kaiser is a Research Associate at a-Qube specialized on Tokenomics, decentralized business models, and Game Theory.