Tokenomics Guide #1: Do I need a token?

What are tokens?

Crypto gave the world the ability to tokenise assets, complete cross border payments and raise money in ways that were unimaginable before. This has led to many narratives emerging and created quite a distorted view around tokens. Just ask your non-web3 family members what they think crypto is. The answer would generally be a currency used for payments.

Since the ICO era of 2017, tokens have seen multiple narratives surrounding them ranging from payments token, a fundraising mechanism, governance tokens used to incentivise user actions and revenue generating utility tokens.

This multitude of use cases have left the majority of people confused around the purpose of a token and if their project they are building needs one.

Similarly to the bear market in 2018, the bear market in 2022 is looking like another cycle of tokens being the enemy. This article will look at if your product needs a token, some benefits and drawbacks of tokens and one of the most common questions we get asked, “can i launch my token later?”.

Does your product need a token?

As tokens fall out of favor (again) investors and builders alike are asking the same question, does this product really need a token? In some cases, tokens may be essential to the functional operation of the product being built. In other cases a token may complement the product and enhance the user experience for those using the product, but not be essential to its operation. Finally the token may add no additional value to the product and will likely not be required.

In all cases, the token is not the product and cannot replace it. The quality of the product is the most important factor, along with a clear revenue generation model, plan on scaling and target market. When all of these areas align, the question of “does my product need a token” will become much clearer.

The key things to think about when building a product and deciding if a token is required are; will the token assist in helping the business reach its goals, will the token add extra friction for the user and can the same goals be achieved via another method. These other methods could be fiat or stablecoin payments for the product or an NFT with governance rights instead of a governance only token.

Below will focus on some sectors of web3 and give an overview of if a token could be useful or not:

1. SaaS model (Web3 Tooling) — In the case of a B2B SaaS model, a token may not be necessary to the usage of the product. In most cases a token adds extra friction and complexity for the company building the product. If this is the case it is advised to raise via a SAFE and pursue capturing value via equity. An example of this model is Infura, the world’s largest blockchain API which connects applications to the blockchain. Infura utilised a subscription revenue model and does not have a token. Usually payment for these services are taken in fiat or potentially alternative cryptocurrencies such as stablecoins or Ether. Occasionally exceptions are made for companies that plan to decentralise even though the token does not have any utility within their product. The governance only token model does have its limitations but if decentralisation is a core concept a token can be utilised to achieve this.
2. DApps — With most decentralized applications (dApps), a token can be incorporated to gain the many benefits that a token can provide (listed below). Usually these tokens aren’t critical for the operation of the application, however they should aim to increase the user experience and share the success of the application with the token holders over its lifecycle. An example of this is GMX, although the token isn’t required to use the product, as a GMX staker you are rewarded with a share of the platform fees (paid in ETH) along with governance rights. The GMX governance token is also utilised to bootstrap liquidity to provide a superior on-chain trading experience, decentralisation of governance and marketing around the product.
3. Infrastructure projects (Layer 1s) — Infrastructure projects in the web3 space are the most likely to require a token for the product to function. In the case of layer 1 blockchains, the token is used to secure the network and pay validators who are running the consensus algorithms of the blockchains. The token is usually utilised as a unit of account and is required as a means of payment for each transaction that is validated to the blockchain. In the case of a PoW blockchain such as Bitcoin, the token is essential to pay the miners for their work. The two biggest examples of requiring a token to function are Bitcoin and Ethereum. This is also true for digital resource networks such as Filecoin.

Benefits of a token

• Allows bootstrapping a product. This enables the product to overcome the “cold start” problem which is aided by token incentives attracting liquidity providers or users to a new protocol. The aim here is to have a nice product and use the token to draw the potential users in, hoping once they have used the product they will stay.
• Marketing and awareness of the business — especially applicable if combined with an airdrop or marketing campaign. Along with bootstrapping, a token public sale, launch, airdrop and IFO (initial farm offering) can work as excellent marketing tools to gain the eyes of potential users.
• Potentially easier fundraising for the project and easier distribution to investors. Easier fundraising is especially common when the crypto markets are in a bull market. As shown in this tweet by Defiignas, the web3 fundraising landscape is tightly correlated with the BTC price. Showing that when Bitcoin is increasing in value, funding is easier to come by.

• Generally faster liquidity for the team and investors. In traditional markets, the average time from seed investment to IPO is around 10 years. In the crypto currency markets the average time from seed investment to liquidity can be as short as 12–24 months. This is a huge incentive for investors and team members to launch a token to reach liquidity faster.
• Incentivisation of the community via:
• User rewards
• Rewards for actors providing a service, i.e. liquidity providers
• Grants
• Community building rewards
• DAO contribution rewards
• The community is incentivised to help create additional products, tooling or awareness through marketing for the project, which decentralizes the workforce.
• Allows for a company to be decentralized. This can be done for ideological reasons or legal reasons. Either are achievable via the user of a token and governance process.
• Aligns users, stakeholders and the team’s interests. This can be done via revenue share captured by the token. This aligns all users and stakeholders of the protocol to act in the best interests of the company.
• Ideally increases user experience for product users.
• Allows value to be captured and realised by all stakeholders.
• Allows curation of data. This mechanism is especially common in products that need to crowdsource the correct answers from the community. For example, curating medical data in a DeSci protocol.
• Allows stakers to take on an important function in securing the protocol. For example, the Aave Safety Module utilised the AAVE token as a liquidity backstop in the case of bad debt on the protocol.

Drawbacks of a token

• Unclear regulatory landscape regarding tokens, especially in the US. This may lead to US users being geo-blocked or teams remaining anonymous.
• Risks of value accrual to either the token or equity. This must be made clear to investors when fundraising as issues can arise between stakeholders if the value accrual mechanisms aren’t clear.
• Complexity around token allocations, once allocated into buckets, distribution amounts are generally hard to alter. Alterations may be achieved via governance (if decentralized) at a later stage but it is best to get allocations correct from the beginning.
• Extra complexity in relation to token utility and providing a balance between token supply and demand. If a token is not necessary for the product to operate, utility must be given to it to ensure there is sufficient demand for the token. Without sufficient utility and no demand the token price will likely suffer.
• Potential friction and complexity for users. This is usually common with the token being used as a ‘payment token’. Requiring all transaction fees or marketplace costs to be paid in the governance token adds extra friction to the user experience as the user may have to go and purchase this governance token prior to completing their desired transaction. This adds extra cost and time to the process for little added benefit.
• Complexity around governance. Some companies may not want to be decentralized and others may face governance attacks. Steps must be put in place to mitigate these risks.
• Added costs to the company to gain liquidity, exchange listings, market makers and user rewards
• Association with token market price and quality of product. This can cause a solid product to be tarnished by an underperforming token price due to association.
• Generally retail community members are more sensitive to token price movements, this can cause demands or explanations from the team.

Can you launch first, then release a token?

It is becoming increasingly common that companies launch their product prior to launching a token. This allows them to try to find product market fit whilst also remaining flexible if a pivot to a new focus is required. By launching first, the added complexity and cost associated with ensuring the token is liquid enough, has enough utility and the community members are satisfied with the tokens performance are removed and allows the team to focus on building out their product.

Another advantage of launching the product first is it allows the user base to grow (which can be used for a retroactive airdrop) and allows for the company to address any pain points and incentivise beneficial actions and disincentivise harmful actions by users.

Ideally the product will have a solid user base and PMF prior to launching the token, which when live accelerates the adoption of the product, acts as a marketing tool and allows the team, investors and community to all benefit from its success.

This also allows potential token holders to evaluate the business model instead of betting on a theoretical future construct, opening up the business to value-adding fundamental value investors rather than value-extractive speculators.

Conclusion

As outlined above there are many aspects to think about when deciding if a token is right for your project. The first step is to have a clear understanding of your product, how it will generate revenues and what actions (if any) you want to incentivise/disincentivise with a token. It is also imperative to understand who your users will be, what their web3 experience is and if they have the desire to interact with a token.

One cover all approach is to raise on a SAFE/SAFT and gather advice on how a token could look and complement your product. This will give you the time to launch the product, find PMF and then launch the token at a later stage.

One final thing to remember is, a token is not the product. The two things should compliment one another and align all stakeholders. A strong token design won’t save a weak product and a strong product won’t save a weak token design.

If you are looking for token advisory please reach out to us here at Deus Ex DAO and our advisors would be happy to advise you with any token related questions and modelling.