A Growth Model for the Decentralized Economy
Overview. Traditional models of personal income growth can be distributed along an exponential earnings potential curve: from a salaried employee at the lowest end of the curve, to owning or becoming a significant shareholder of a larger corporation. This paper examines the challenges to progression along the curve, and how blockchain technologies such as smart contracts and cryptocurrencies hold the potential to reduce the barriers to scale.
Background. Traditionally, the sale of smaller enterprises to larger ones via Mergers & Acquisitions (M&As) have been, and are presently the most common means for small business owners to achieve significant returns. A 17-year long study conducted by the IRS looked at the top 400 individuals by annual gross income. The study found that on average, “Partnerships and corporations” accounted for 19.9% of their income. This was second only to capital gains (45.8%), but significantly outmatched the contributions of wages and salaries (8.6%), interest (6.6%), dividends (13%). However, while the highest-earning individuals made most of their money through owning and selling companies, most small businesses remain small, and unable to achieve significant scale.
Scale & Earnings Potential of Self-Employment. Self-employment exists on a continuum of scale (typically measured by the output of goods & services provided), which is positively correlated to earnings potential (Fig. 1). The vertical lines illustrate the upper-bounds of the scale and earnings potential of each category of employment — from being a salaried employee, to owning either the whole (nearly impossible) or (more commonly), a significant share of a large enterprise.
Among the self-employed, at the very smallest unit of scale lies the individual freelancer. The freelancer is usually a sole proprietor, typically owning very little capital goods, and is both the sole employee and owner of the brand. In fact, for this reason, we observe on the curve that salaried employees can and often do earn more than freelancers.
But freelancers can earn more than salaried workers owing to their ability to command a larger proportion of the value they create in the marketplace due to the absence of middlemen like the firm. Examples of this include independent consultants, and medical specialists.
However, the upper bound of freelancers’ scale — and hence earnings potential — are severely constrained by their ability to trade time for money, commonly expressed in a standard labor supply curve. And while evidence from earnings research by freelancing firms suggests that the average freelancer can and does earn more than a typical salaried employee, freelancers also tend to work longer hours, albeit on their own schedule.
As any given self-employed individual moves along the curve, they have to acquire more capital (K), and hire more service providers (L) in order to increase their productive capacity, or scale.
For instance, a freelance baker might start selling her cakes out of her own home kitchen. But she realizes that her earnings cease as soon as she goes on holiday, or falls ill. She then decides to move to becoming a small business by hiring and training her friends to continue production for her even when she isn’t baking. As she grows, she reaches a point where she realizes that her home oven is no longer enough, and she has to purchase expensive, energy-intensive industrial-capacity ovens. Not only that, now she has to rent a small commercial kitchen large enough for the bigger ovens. But to make the investment worth it, she also has to increase demand (customer orders) by spending more on marketing her cakes online, and then hiring more bakers, and delivery boys, to meet that level of production.
However, not only can taking this next step to achieve a higher level of scale (and potential earnings) be extremely costly, and time-consuming for her, but also eventually faces diminishing returns to scale — requiring a new round of investment expenditure. For this reason, the shape of the curve closely resembles generic Cobb-Douglas production functions.
There are also hidden costs to achieving scale in self-employment, which may explain why most freelancers and small businesses never achieve much scale, and hence, face low caps on their earnings potential. In more recent times, a new kind of online platform has emerged to:
- Quickly match freelancers to customers; ensuring a steady stream of work,
- Arbitrate disputes when they arise to ensure freelancers are paid fairly, and
- Standardize interactions to reduce the hassle of drawing up contractual agreements between freelancers and customers.
- Provide reputation ratings to facilitate trust and lower screening costs.
Examples of these gig-economy platforms include Uber, AirBnB, Fiverr & TaskRabbit. However, these platforms can impose onerous commission fees on their freelancers (Fig. 2), acting like employers, yet avoiding the need to pay employment benefits like paid time off, medical insurance, or sick leave.
Acquiring customers outside of these centralized gig-economy platforms is also costly (Fig. 3), as the market for digital marketing channels is also controlled by a few dominant, centralized search engine companies and social media platforms such as Google and Facebook.
If through a combination of skill, persistence and funding, a small business successfully surmounts these successive hurdles, evidence suggest that there are two ways to progress along the earnings potential-to- scale curve. Either continue to grow the scale of business this way until it becomes a giant in its own right, or to be acquired through M&A by a larger company at a high exit valuation.
The first option, as explained, is not only costly to finance via retained revenues, but also fraught with risk in forecasting demand, supply chain, and other forms of market risk as the business grows. The second option relieves the self-employed person from having to deal with these risks alone, but comes at the cost of sacrificing control over the brand, culture, and the enterprise. This prospect can be highly unpalatable for both the self-employed business owners, and the employees with whom they may have spent a considerable amount of time building the company with. A contemporary example of the possible fallout from M&As can be found in the aftermath of Etsy’s IPO — which had similar effects to being acquired by a larger company as corporate raiders acquired significant shareholdings to wrest control of managerial direction.
Decentralized M&A (DMA). The combination of blockchain, and cryptocurrencies as a fund-raising mechanism, holds the potential to enable small businesses to achieve scale, without sacrificing equity, or control over the brand and business decisions. Additionally, the proposed framework for this is DMA architecture presented here also holds the potential to provide freelancers on the entire network with a mechanism that allows for the provision of employment benefits, traditionally possible only under salaried employment arrangements.
Consider a blockchain network which replaces the 4 functions currently provided by gig-economy platforms (above Fig. 2). Smart contracts allow functions #1 and #3 to be automated quite easily and securely. Consensus mechanisms allow #2, and #4 to be also to be automated in a decentralized manner, combined with incentives for work done.
What this means is that it is possible to shift the business model away from charging individual freelancers and small business owners to be discovered via digital marketing, and instead create incentives which reward organic, peer-to-peer referrals throughout the network.
Also, suppose that such a blockchain network would collect an extremely small percentage of earnings made through the platform (far lower than any tax rate in the world), to be accrued into a collective fund, whose growth (and hence interest rate) is managed by asset management partners. Individuals can draw upon their contributions to the fund in cases such as sick leave, paid-time-off, and other employee benefits traditionally only reserved for salaried employees. This fund also serves as a pension fund to facilitate consumption smoothing via lifetime-permanent income, or in cases of unemployment spells.
This protocol underlying the blockchain can then be white-labelled to small businesses and freelancers, allowing small businesses to acquire service providers like freelancers, as well as customers at low acquisition costs. In so doing, small businesses can achieve scale not only quickly, but at significantly lower marginal costs than before. Additionally, it enables the businesses to provide to their own sub-networks (subnets) the employment benefits of the protocol.
Small businesses who come on board the network to form their own subnets can also turn to Initial Coin Offerings (ICOs) as a fund-raising vehicle. This obviates the need for them to relinquish equity and dilute existing shareholders’ ownership of the company in order to raise the capital needed to acquire capital and labor to expand productive capacity.
In exchange, the subnet entities will enter into a decentralized federal economic arrangement with the mainnet entity — commonly referred to as a “DAO”, by holding mutual currency reserves of their value at the time of ICO. If they choose not to ICO to raise funds, the entity operating the subnet will hold a reserve of the mainnet’s currency equal to 10% of its firm value (EBITDA).
This enables two things:
- Firstly, mutual foreign exchange reserve holdings enables frictionless transactions between users on the various subnets, as well as the mainnet. This ensures that a newly-minted coin on a new subnet also has utility in being able to purchase goods and services on other subnets without having to face significant transaction costs in exchanging currencies.
- Secondly, mutual foreign exchange reserve holdings also allow smaller, less-established businesses who come on board the mainnet to ride on the value of the currency of the larger, established mainnet’s currency, as well as the reputation of the mainnet’s protocol. All things being equal, this should enable smaller businesses to raise funding through ICOs, and other means much quicker, and thus finance their progression along the curve (Fig. 1).
The DMA structure and mechanics described here are conceptually similar to “white-label” franchise models. Unlike traditional M&As, DMAs do not wrest control of management, intellectual property, or capital from the smaller businesses being acquired. Nor do DMAs result in existing shareholders’ suffering dilutions in their ownership of the enterprise.
Conclusion. The advent of the internet age held the promise of enabling self-employment by removing middlemen such as employers or distributors. However, the peer-to-peer revolution still leaves much to be desired as large centralized giants have come to dominate the search engines, social media platforms and online marketplaces and matching apps which address fundamental frictions of trust and information, hampering the conducting of economic activity among peers.
This paper outlines and explains how blockchain technology can be used to create a new growth model for the self-employed to move up the earnings potential-to-scale curve: whether as an individual freelancer, or as a small businesses. Not only can the DMA structure help the self-employed achieve scale at drastically lower marginal costs by fulfilling those crucial marketplace functions (see above Fig. 2), but can also fill the yawning gap of employment benefits and social security that is currently left in the wake of the burgeoning freelance economy as a percentage of the labor force all across the developed world.
To check out how the Blue Whale Foundation is trying to pioneer the application of Decentralized M&As, visit: https://www.bluewhale.foundation/
