Protocol Tokens — Good for Investors, Bad for Business

Knowing When to Build a Protocol Token

If you’ve been making the rounds pitching your upcoming ICO, chances are you’ve been rejected and labeled as not a protocol token. The protocol token thesis, outlined in USV’s blog title Fat Protocols, states that 90% of the value of the network is captured in the protocol layer which is accessible by a token native to that network. Investors love protocol tokens as they can buy in early and experience gains similar to what was seen with Bitcoin and Ethereum.

We’ve been approached frequently by large, successful startups as well as publicly traded companies seeking to undergo token sales. In conversations with these companies, we’ve found that protocol tokens are a good deal for the investor and a really bad deal for the company itself.

Fat protocols require a very deep level of expertise that makes sense for highly technical teams to undergo and are not for everyone. Here’s why:

  1. Technical Risk — Creating a protocol requires a very deep level of expertise in open-source software, applied cryptography, game theory, and economics.
  2. Business Risk — Protocol tokens can take over five to ten years for the market cap to reach expectations
  3. Execution Risk (for emphasis) — Gathering the team necessary for executing such a project can be a challenge.

Based on these risks, established businesses should not be deterred by not having a protocol token. Instead they should look at the opportunity involved in rewards style tokens that can accentuate existing business models. This provides a solution that keeps existing stakeholders, company founders, and investors aligned around common goals with satisfiable expectations.

Technical Risk

Most blockchain developers that have been in the space for over a few years started out from the bottom up. With no development courses, bootcamps, or textbooks; it was necessary for developers to interact with the various blockchains with very archaic tooling over many years. The fact that the subject matter was taboo for quite sometime, resulted in a few, highly skilled experts in the field. These developers have built up the abstraction layers necessary for developing on blockchains as they’ve attempted to build the applications that matched their vision.

Expecting a team in-house or one that was located on Elance the week prior to build a protocol relevant to the line of business is quite simply not possible. In order to build a protocol relevant to the line of business, the inner protocol of the business must first be synthesized finely. This inner protocol is comprised of the various parties that interact with one-another, the network resources involved in the line of business, as well as the mechanism design that ties it all together. Again, it is simply impossible for the C-Suite of a company to understand the inner workings of their business within a blockchain context and then to have their middle management correspond with a team overseas to build this. Even internally, expecting to be able to communicate at a high level to middle management and to expect quality output is unreasonable.

The tokenized economy requires abstraction, and standardization of concepts before the ICO-in-a-box concept is possible.

Business Risk

For a business to hop on the token hype train, it requires significant diversion of resources and attention from the core business model. Developing a protocol in-house requires full attention and a full dedication of resources. Most of the attention is coming down from C-Suite execs which are primarily concerned with the marketing, branding, and business angle of the protocol. A protocol needs to be carefully executed from a technical angle.

All of the successful businesses (based on technical solutions), altcoins, and tokens that came out of blockchain 1.0 (pre-ICO era), have been founded by teams with deep technical expertise. We can see that those that were non-technical have spun out of the businesses by referencing Tony Gallippi from BitPay, Will O’Brien from BitGo, and Circle which has become a prominent trading firm vs. technical solution. The impact of non-technical involvement in protocol development is still relatively low compared to that of a hands on, technical developer.

Rewards Token?

The fact remains, crypto investors don’t care about rewards style tokens. Crypto investors are still chasing the Bitcoin style 100,000x gains. The fat protocol thesis is focused around investors trying to figure out how these unfathomable gains were generated in the first place. An established business does not need 100,000x gains built into their company. If there is such a keen interest, company founders should simply invest their own money.

The inherent value in a protocol token is that it can incentivize parties to provide resources to a network that they otherwise would not have the incentive to do. As an example, Bitcoin miners are incentivized to provide computational power to the network in return for Bitcoin. Bitcoin users are incentivized to use and hold the token due to the low fees and increasing price respectively.

Overlaying an existing business model with a closed-loop tokenization layer can be a low risk, high return way to accelerate revenue from existing business models without risking relationships with investors or existing business models. Performing this through a centralized platform model can provide a company with the control necessary today, to ensure the business remains in tact. Additionally, this leaves the door open to later list the token on an open exchange. If the token continues to do well, then developing a protocol is also something possible for the company to undergo at a later time. Providing the company with the best of both worlds, a convenient technical implementation and roadmap, as well as a low-impact initiative which can generate positive press and provide shareholder value.

If you have revenue and investors, do yourself a favor. Don’t make a protocol.

-Mason

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