Meaningful ICO’s?

Photo by Cris DiNoto on Unsplash

Cryptocurrencies, coins, tokens, ICO’s, decentralization. This space is very hard to wrap your head around, and separating good opportunities from opportunistic, spammy, or outright fraudulent ones is quite difficult. Here we build a strategy framework around Systems of Controls that provides a lens into the ecosystem that may help to visualize the space and separate the wheat from the chaff.

It should be unnecessary to state that ICO’s, by definition being built on top of decentralized infrastructure, are better when they encapsulate a value proposition that also leverages and relies upon decentralization — from a trust, storage, payments, control and/or governance perspective. Those that are simply a substitute for other means of fundraising are not that interesting or disruptive through this lens (although they may still be lucrative). So, how do we judge how disruptive a decentralized value proposition is?

In our view, centralization and decentralization have to do with the amount of personal autonomy stakeholders have in the system. The more authority that can be distributed, the more decentralized the system.

We begin by capturing that very simple structure, where we can plot systems against how decentralized they are relative to other systems, something we call the Systems of Controls axis. Much like Systems of Engagement or Systems of Intelligence, where you position yourself on the Systems of Controls is a large part of your value proposition, differentiation, and potential to build a moat. We use the circle to represent ‘equal, democratized control’ while the triangle represents ‘top-down, centralized’ control.

The power of a compelling decentralized economic system, as encoded in a token structure and possibly an ICO, is to change the balance of power, control, rewards, and evolution/governance of a system. You would expect to see a meaningful ICO map out a new and specific space on this spectrum in relation to incumbent and competing solutions.

This can be looked at in (at least) two ways. One is around the overall value proposition that a company is bringing to bear, and the second is around the structure and incentives — the economics and governance — that underlie the company.

Starting at the macro level, you can define a vertical position on the Systems of Controls axis that separates companies that operate under The Theory of the Firm from those that operate under The Theory of the Ecosystem — a term we propose here specifically to contrast it with the Firm. The Theory of the Firm is a well studied area, and applies to most of our recent corporate experience. It elucidates how firms grow, and centralize, until the cost of internal transactions exceed the cost of external transactions and/or anti-trust rules kick in (current models of the Firm are much more complicated and refined than this, but this simple view will serve our needs). The point is that Firms get stronger by centralizing, until they reach a point of equilibrium where they can’t grow efficiently any more. They then settle into that spot on the Systems of Controls axis. The “gravity” of Firms, encoded in how they are set up and incentivized, pulls to the right. They thrive on economies of scale and efficiencies.

Decentralized efforts have a different goal. Their goal is to build around more autonomy and more equal distribution of control, power, learnings, and proceeds to all active participants— The Theory of the Ecosystem. It is, at least in theory, a more meritocratic and inclusive model; more democratic. Open source software is an example of an Ecosystem approach. Contributors add value to the system, are often driven by a desire to ‘lift all ships’, and benefit in reputation and status which may lead them to better opportunities within the industry.

The Theory of the Ecosystem can be seen as both very old — this is how many parts of the world worked before city states, industrialization, and the formation of Firms — and very recent; a reinvigoration based on emerging technologies such as block chains. There is not as much relevant academic work or theory yet around a general theory of Ecosystems, although a lot has been written about open source. [ A search for Theory of the Ecosystem will, unsurprisingly, return many results pertaining to ecological systems; there are obvious parallels.]

The incentives, community, and organization in an Ecosystem design are quite different from those in a Firm. The Ecosystem thrives and survives if autonomy and contribution are properly rewarded. The idea of internal transaction costs almost does not make sense — people work on an Ecosystem because it provides them value through contribution, reputation, meaningful engagement, as well as rewards. The gravity for Ecosystems is to maintain transparency, reputation, and equitable division of work and proceeds. In this case, “gravity” pulls to the left.

Despite the diagram, there is not a well defined line between a Firm and an Ecosystem; it is a grey area at best. However, this is the division that we will use between a ‘meaningful’ ICO and simply using an ICO as an ‘optional’ way to finance or bootstrap a Firm. In a ‘meaningful’ ICO, the underlying crypto-infrastructure is truly used to decentralize the system. There are other advantages to ICO structures (less, or no, dilution for example) that may cross this boundary.

As an example we can look at taxis vs Uber vs a ride sharing company that operates under a coin economy where both drivers and users participate in the full economics, and have some say in the operations (governance) of the effort. Uber, while giving users more autonomy than taxis, is still a centralized entity that makes many decisions for users, and more importantly, for drivers. There is definitely room ‘to the left’ for a new competitor in the ride sharing space. Uber has no need for a token or an ICO; a decentralized ride sharing company will.

The potential to succeed in an Ecosystem has been enhanced with recent technologies, from the Blockchain to Ethereum and smart contracts. These make it possible for decentralized solutions to be as efficient as centralized ones.

We can also look at the Systems of Controls axis at the micro level — at the level of a single Firm. A typical public company is shown in blue below.

This is fairly abstract, and requires some explanation. The X axis is our usual Systems of Controls with Decentralized on the left, and Centralized on the right. The Y axis is a view of how proceeds, incentives and economics work within the Firm. At the bottom we have Labor which is typically paid for (past) work in a fiat currency — dollars. At the top we have Equity which is typically valued on a multiple of the future potential of the Firm. The Firm is structured to maximize that future potential by optimizing how work is provisioned, and how customers are treated and integrated. The business model — that optimal balancing of dollars and equity value — is shown by the dotted horizontal line.

The blue area represents the direct stakeholders in the Firm. In terms of the position of the Firm along the X axis:

• Shareholders have a relatively flexible and self-controlled relationship with the Firm. They can buy and sell at will, and have independent control from the Firm itself. They are the leftmost — the most decentralized — players. Their interest is fully equity based; they are not typically compensated any other way. They can pay relatively low tax on capital gains.
• The CEO is typically compensated with both equity (options and stock) and for labor (with a salary and bonus). The CEO can set the direction of the company, within certain bounds, and has the most power / autonomy of the direct employees of the Firm.
• Individual contributor employees have very little autonomy or say in the direction of the firm (in a typical hierarchical structure). They have set goals and set work processes and essentially do as they are directed from mid and upper management. They are the most centralized, least empowered, members of the Firm. Most of their compensation is in dollars, and they pay tax at income rates.

This is why the Firm is angled from the top left to the bottom right. How about the teardrop shape of the Firm? This represents how late stage capitalism rewards the stakeholders:

• Shareholders often rank before employees in preferential treatment and in strategic importance. As equity is leveraged, missing a quarterly projection or overestimating growth rates punishes the stock and may result in the removal of the CEO or management. Shareholders hold more power, and see more of the proceeds (while potentially also holding more risk). Companies often bend towards shareholders by maximizing profit above all else; a recent example is the amount of effort put into ‘optimizing’ corporate tax through complex off-shore structures.
• Individual contributor employees are typically paid only in dollars, and do not participate meaningfully in the equity upside of the firm. They benefit the least from an increase in the value of the Firm. (Of course, in downside scenarios, they are protected from losses, so they also have lower risk).
• Customers interact with the Firm by either buying product ($) or contributing other assets (i.e. user data or attention) in exchange for the product. Outside of product lock-in, customers can engage or disengage with a Firm fairly easily. There is a clear delineation between the Firm and its customers.

That is the ‘shape’ of the modern Firm.

Now, if we map an idealized decentralized Ecosystem into our graph, it would appear to the left of the Firm, to the left of our Firm/Ecosystem line, and represent a different allocation of assets:

All participants in the Ecosystem have more equal control, more equal opportunity, and more equal participation. Customers participate in the Ecosystem by contributing and using the system, and benefiting when the entire Ecosystem does better. In this view, the governance of the ecosystem is also part of the Ecosystem — at the extreme with a Decentralized Autonomous Organization (DAO).

A token or coin, along with smart contracts, can be seen as a means of defining and managing the economy of an Ecosystem, and ensuring that participants are treated equitably and that governance is decentralized yet fair. It may measure contribution and commitment to the ‘now’ instead of leveraging too far into the future or simply rewarding labor with dollars. (This ecosystem level economy is different than the underlying crypto-economics which rewards participants for maintaining the decentralized infrastructure — such as a blockchain or Ethereum; both types of economics are required for a successful ICO).

This economy can be ‘structured’ or ‘designed’ while still maintaining utility throughout the ecosystem. Parts can be more like equity, and parts more like dollars. For example Steemit, an Ecosystem approach to user generated content, has three components to their economy: Steem Power which rewards users for being ‘long’ on the ecosystem and gives Power users more governance rights; Steem which is transactional within the ecosystem (i.e. used for ongoing payments / recognition); and Steem Dollars which allow you to convert to other currencies. BAT is another good example of Ecosystem thinking, applied to digital advertising.

Based on the Steemit example, if we zoom in on the Ecosystem bubble, it would look like the diagram below, although both simpler and more complex models are possible. The governance of the Ecosystem may be fully decentralized and run by the community, as is shown here. Governance may not be open to all participants, but rather those who are dedicated to the ecosystem (are ‘long’, for example) or who have put in a threshold of effort or earned a threshold of coins. However, governance should be transparent, and anyone in the Ecosystem should have the ability to earn their place in the governance structure. Much of the ecosystem may be simply ‘regular business’ and there may be structures that allow one to enter or exit the ecosystem easily, particularly for customers.

Of course this is highly abstracted and reality will be much messier. Many great Ecosystems will be hybrids; they may still have a co-Firm, a CEO setting the overall vision, a management team driving for results, and some employees who choose to take the safety of a salary over the higher risk / higher reward option of being paid in coins. Their governance may be completely in the Firm, or a combination of the Firm (with some type of super-voting rights) along with input from the Ecosystem. Customers may directly participate in the Ecosystem for some products or services, but may also use more traditional direct buying for other parts.

Such a hybrid may be balanced between the Firm and the Ecosystem, or may tilt slightly in one direction or the other. Those that tilt left are better ICO candidates. Sometimes governance may include a non-profit component to help lean left, and to separate the Firm’s forces from those of the Ecosystem it is trying to enable. (Kin is a good example of this).

[Aside: A hybrid is different than a virtual currency that is completely controlled by a Firm, such as many gaming companies that use virtual currencies or rewards programs. Those look more like this:

The virtual currency is a feature of the product and it runs completely within the Firm; the Firm maintains control of the governance of that currency. While often productive and compelling, this is not a decentralized model. ]

We led off by stating that a meaningful ICO — one that is built on a core decentralization thesis — is one where gravity is towards the Ecosystem instead of the Firm, and we have attempted to visualize that here. Of course, every opportunity is different and there is a lot of grey space in the middle. However, an opportunity with an Ecosystem will typically:

1. Provide more equitable distribution of proceeds throughout the ecosystem, based on a cryptocurrency backed economic model.
2. Enable some (or full) decentralized governance structure, where the evolution of the Ecosystem has input from many participants.
3. Provide more autonomy for participants than a Firm would.

ICO’s that don’t meet these criteria — that are subject to centralized Firm gravity — may still be compelling and have great ROI’s, but they could also be financed with more traditional methods without dramatically changing their outcomes. In this case the ICO may be a lower friction method, but is not essential.

This is all still capitalism. The healthier an ecosystem is, the more it will be valued, and the more demand there will be to buy into the system. It is simply that some ICO’s (more accurately, their economic model) will encourage more transparency and democracy in governance, more equitable and measurable division of proceeds, and more active participation than being a pure equity holder (for example, the inflation rate of the coin, along with other structures, may penalize short term speculative trading and encourage active participation in adding value to the ecosystem).

With one final look at our visualization, money has almost no restrictions on it; it exists at the far left on the Decentralization spectrum. It is free to flow into a Firm or an Ecosystem as supply and demand evolve. Thus, Firms and Ecosystems will compete for dollars and Ecosystems must prove that they can provide as much, or more, overall value (which hopefully is more than just a measure of financial returns) to investors and participants. This flow is obvious in today’s listed coin markets, although many of those ICO’s have not yet provided the transparent governance and participation that we would expect. It is early days, and there is lots of room for improvement (as well as gaming by bad actors).

This is, perhaps, one of the less understood impacts of the block chain and crypto currencies. The addition of low overhead transactions combined with trust-less decentralized ledgers allow Ecosystem models to operate effectively and compete with Firm economics. The space of ‘viable’ capitalism is extending further into the decentralized spectrum.

What does this mean for investors and venture capital? There are opportunities for VCs on both sides — continued investment in Firms, where venture capital has typically been deployed, and investment in Ecosystems, where the potential value of the economy can be large, but where more active participation (or staying ‘long’ on the ecosystem) may be required by the economic model. In hybrid models it may be possible to play both sides — the Firm may hold significant amounts of the underlying token, but may be valued on more than just the token alone. Owning equity in the Firm and holding coin in the Ecosystem may both be valuable. A warning sign would be a Firm that is solely valued on the coin economy, but where equity is not fully aligned with that Ecosystem — in that case the equity may end up with marginal value.

In hybrid models it is often possible for a Firm to establish product-market fit before it launches its ICO. It may then (partially) transfer equity into coins, and move customers to be ecosystem partners. In these cases, establishing product-market fit before launching the ICO may be advantageous, if only to separate from the crowd. For pure Ecosystem plays, the ICO — the coin economy — may be so central to the operation of the product that the two must occur in concert.

In summary, we hope that Systems of Controls is a useful way to visualize and think about decentralized models, and a way to separate out meaningful ICO’s from others. Over the next few years we will see the Theory of the Ecosystems mature and be compared and contrasted with the Theory of the Firm in more detail.

If Systems of Controls interests you, this post explores how decentralization intersects with existing strategy frameworks. If history is a guide, incumbents will be so entrenched in being Firms that exploring even a touch of Ecosystem will be too much of an innovators dilemma for them. If so, startups that ‘lean to the left’ may be our best hope to disrupt the oligarchy that have centralized the Web.