Early-stage Crypto Investors Must Evaluate “Token Risk”

In this post I introduce a new concept, “Token Risk”, which is a kind of risk present in early-stage investments into crypto projects. I then analyze the implications of Token Risk for early-stage crypto investors.

Token Risk is the risk that the company will succeed but the token will fail.

Specifically: Token Risk is the risk that the company and team will create new value and succeed in their goals, and yet the token investor will lose money on the investment because the success of the project will not cause the token value to increase.

To dive deeper, we need a primer on types of risk in tech investing: VCs and other early-stage investors make high-risk-high-reward investments, and must always try to estimate the risk and the reward. Over the years, VCs have developed a typology of kinds of risks: standard types include “tech risk”, “market risk”, ”product-market-fit risk”, “team risk”, and others. Before a VC decides to make an investment, they evaluate the risks. They also evaluate the reward, i.e. the potential profit that will be generated if the investment succeeds. They then offer a valuation that is correlated to the reward and inversely correlated to the risk. The higher the risk — the lower the valuation.

To the types of risks I list above, I claim we must now add another kind of risk, “Token Risk”. Token Risk is the risk that the company and founders will succeed wonderfully, but that this success will be reflected solely in the company’s balance sheet or in some other token or asset, and not in the token that the investor bought. This type of risk is relevant mostly to VCs and other early-stage investors that invest in tokens, and particularly to value investors that aim to buy and hold tokens for a long time based on their evaluation of the long-term market potential of the company. The common myth of token investing is that when companies issue tokens, the value of the company’s market potential accrues in the token. I claim this is not the case, and that there is substantial Token Risk that the value created by the company will accrue outside of the token. Token Risk is relevant to value investors, but much less relevant to investors who aim to speculate with the token. Speculators plan to profit from market sentiments about the token increasing; these are shorter-term strategies that are closer in spirit to “sentiment investing”, and are less subject to Token Risk.

I claim that Token Risk is quite substantial for many of the last years’ token-issuing companies. This claim arises from a combination of three observations:

1. Successful businesses typically take 10+ years to achieve market saturation or to satisfy the potential that the early-stage investor saw in them. Specifically, token-issuing companies have many years to go before achieving their potential.
2. When a business has not yet achieved their potential or market saturation, a great way to increase its success is to pivot or to expand the business model. (e.g. because new customer types respond to new business models).
3. Using current token design methodology, a token usually represents only one possible business model, and cannot be pivoted or expanded. (Excellent token governance might change this in the future; but pre-2018 token models are rarely subject to effective governance that is aligned with both the token holders’ interests and the business’s interests.)

Combining these three observations, we see that the token is actually tied to a single business model, which is likely to become invalidated when the business model is pivoted. This creates substantial Token Risk: a chance that the company will succeed but that the token will fail.

So let’s get down to brass tacks. What will Token Risk look like on the ground? Unfortunately, we don’t know yet: Token Risk only exposes itself in the long term once the business needs to pivot, so we haven’t seen dramatic real-life cases of it yet. One preliminary test case is SingularityNET’s recent announcement that it will start a Venture Studio as a spinoff alongside its main business, thus expanding its business scope. SingularityNET is currently exploring how to combine this into their token model; we need to follow and see how this expansion will affect the value accrual into its token. In general, to understand how future token risk looks like, we must guess. Here are some example scenarios where token risk might come up in an company that raised funding using tokens:

1. In five years, the company finds that its technology is better suited to offer services in another currency rather than services in its own tokenized economy. Thus, to maximize success, it must pivot to a non-tokenized business model.
2. In five years, the company finds that its token does not represent its business USP very well and has created a flawed economy. Thus, to maximize success, the company must redesign its token.
3. In five years, the state of the art of cryptoeconomic research has improved, and we no longer rely on tokens to represent business value: rather we rely on other cryptoeconomic systems that define economies where tokens are the “wrong metaphor” for value. These economic systems might be based on smart contracts, but not on a single fungible representation of value (i.e. a token). Thus, the company must redesign its decentralized economy and drop support for tokens.

When such pivots happen, the founders will naturally want to be fair to their early-stage investors. However, they will have other priorities that I think are more important: such as maximizing the success of their company. These priorities will often conflict because the token-based investment model did not do a good enough job at aligning the incentives of the early stage investor with those of the company. Thus, there will be a conflict: maximizing the success of the company requires hurting the success of the investor. In contrast, equity-based investment are much better at aligning these incentives (although they are by no means perfect). Equity-based investments enjoy humanity’s hundreds of years of experience in developing financial instrumentation for high-risk-high-reward investing, and 40 years of intensive trial-and-error in aligning incentives for VC-based tech investing

The existence of Token Risk does not mean that tokens are useless. Quite the contrary, they are a highly promising way of running a business where the “rules of engagement” are set in advance; tokens can build open-garden ecosystems which attract a wide tent of stakeholders, who create positive-sum network value.

But tokens as a funding model do create an incentive-misalignment between the investor and the company and founders: the company and founders hold both tokens and equity, while the investor holds only tokens. Equity is relatively stable under pivots of the business model (because equity represents ownership of the intellectual property created by the company, some commitment by the founders, some legal restrictions, and more). Tokens, on the other hand, seem unstable under pivots of the business model. Thus, when a business model pivot is needed in the future, the best thing for the success of the project might be to pivot the model and do away with the tokens, while the best thing for the investor would be to avoid pivoting. As an investor, I want to ensure in advance that my incentives are maximally aligned with those of the company’s success and with those of the founders. I am embarking on a 10-year relationship with the founders, where the company experiences both ups and downs, and I want to make sure we’re all in the same boat. Thus, I am wary of token investments: when I make a token investment I am setting myself up to finding myself in a future situation where I’d have to choose between the good of the company and my own financial interests: never a good place to be.

I suspect that in the last few years, the market has under-estimated and under-accounted for Token Risk, and I predict that it will continue to under-account for Token Risk in the coming years. I think VCs, founders, and other financial engineers must develop effective ways of enabling VC investment into crypto companies that allow these companies to have the benefits of issuing tokens, while keeping the investors incentives aligned with the incentives of the company and the founders. Such models might combine equity with tokens, or be entirely new creations. My rule of thumb is to make sure that the investor is “in the same boat” as the company and as the founders: this maximizes the chances that they are aligned for the years to come.

Acknowledgements.

I’d like to thank Artur Safaryan for useful discussions that led to this post.

Image credit: rawpixel on Unsplash.