Utility token market cap and equity market cap are not comparable
In our work on token economics, and in talking with investors, we are frequently asked about the difference between the valuation of equity, and the valuation of tokens. How should a utility token issuance be valued, and how does it compare to the value of an equity offering?
This is incredibly important for the blockchain community to understand.
Token and equity valuations differ significantly in what they represent, and a misunderstanding can result in an investor dramatically overpaying for a token, or an entrepreneur not receiving the fair value of the tokens that they are offering.
Christian Catalini of MIT and Joshua Gans of the University of Toronto address this question in their paper, Initial Coin Offerings and the Value of Crypto Tokens. They analyze a situation in which an entrepreneur is starting a business that will start offering a service in the near future and will operate over time; the authors model this as several discrete time periods (e.g. quarters). During each period, the entrepreneur will offer a product or service to users that can only be bought using the platform’s utility token.
In the time period before the platform’s launch, the entrepreneur must decide whether to raise funding by selling equity, or by raising funds using a utility token sale. There is no speculation — the amount that can be raised from investors will be equal to the fundamental valuation of the equity or of the tokens.
Catalini and Gans demonstrate that both the equity and the token pool can be valued using similar reasoning. The value of both the equity and the tokens depend on two factors:
- The value of the rights (goods, services, cash flows, etc.) that are bestowed from owning the shares or tokens.
- The timing at which these rights will be delivered.*
We start with the value of the equity. Equity ownership gives the shareholder the rights to a share of a company’s profits. Assuming the company has no debt, and that 100% of equity is issued to investors, the value of the equity issuance is equal to the discounted sum of the company’s expected profits, over the entire life of the business.
If investors are paying for equity based on its fundamental value, an entrepreneur raising money via an equity sale will be able to raise at most the discounted sum of the business’s future profits.
Now consider the value of the token. Catalini and Gans show two critical results in their paper that allow them to derive the value of the token:
- The dollar value of the total pool of tokens in a given period of platform operations is equal to the dollar value of the products or services that that token pool can buy.
- Token holders will spend all their tokens in a single period of platform operations: they will save them until the period in which they have most value, and then will cash them in for platform goods and services.**
For the details behind both of these results, see their paper.
These results imply that the value of the total pool of tokens sold during a token sale is equal to the total platform revenues from a single period of operation. Catalini and Gans show that the choice of monetary policy — i.e. whether the entrepreneur plans to let the total supply of tokens grow after platform launch — can impact the spending decisions of platform users, and therefore which period of revenues this is.
What do these results imply about comparing an equity sale and a token sale?
First: A simple but important point is that the value of equity and the value of utility tokens are functions of different things.
- The value of the equity is a function of the profits of the business over the life of the business.
- The value of a utility token is the value of the goods or services the token can buy in a single period.
This is worth reiterating. A utility token is redeemed in exchange for platform goods and services. A utility token holder cannot receive benefits from the token until that token is spent, at which point the token holder no longer owns that token. This all means that a utility token’s fundamental value depends on the value of the goods or services on a single occasion at which it is spent. In contrast, equity bestows rights to a flow of profits for the duration of token ownership.
Second: Either option can raise more funds. Equity’s value is based on profits, or revenues minus costs, while utility token values are based on revenues. A business with very high per-unit costs and low margins may raise more from a utility token sale than from an equity sale, whereas a business with low per-unit costs and large margins may raise more from an equity sale than from a token sale.
Third: The market cap of the total circulating utility token supply cannot be worth more than the total revenue of the platform in a single period of operation. This is critical, and provides a natural heuristic for investors. If the business cannot possibly have revenues in a single period (for example, a quarter) equal to the market cap of the circulating token supply, the token may be overvalued.
As token design continues to evolve, the industry will need to evolve its approach to token valuation. Security tokens, for example, may grant rights to equity, dividends, interest payments, governance input, and other assets that will require more complex valuation schemes.
But for utility tokens, which continue to be the predominant tokens used in token sales, the Catalini and Gans framework provides a compelling method for evaluating fundraising options and investment decisions.
*The value of both also depends on factors such as the temporal discount rate, which we don’t discuss here.
**In reality, the result is more complex. The token holders will either spend all their tokens in the first period of platform operations, or they will be indifferent about when they are spent. For ease of exposition, we present a simplification that obtains equivalent valuation results. This result also assumes that tokens are re-sold after they are used to purchase goods and services, and that they are not burned.