Tokenomics: when tokens beat equity
By: Andreas Park
Tags: Cryptocurrency Investment, Blockchain, Initial Coin Offering, Cypto Assets, Crypto

The last two years have witnessed an extraordinary development in the financing of early-stage firms. In 2018, over 900 early-stage entities have raised an estimated 21.7 billion U.S. dollars by issuing blockchain-based tokens or coins, while bypassing most of the traditional financial industry.

To understand just how extraordinary this boom in the blockchain-based capital market is, let’s look at the Canadian TSX Venture (TSXV), an established, very successful market for early-stage firms. The 1,400 firms that have listed on this public market have a total market capitalization of 41 billion US dollars — built in over 20 years. In 2018, the TSXV saw only 8 IPOs with a total raised of around 0.04 billion US dollars.

Despite the remarkable amount of funding raised and the clear interest of people who are willing to put money into these tokens, most financial industry insiders are deeply skeptical about tokens and coins as a financing tool. There is much fraud, shady business, firms that throw money out the window — it’s a genuinely chaotic environment. What’s missing or what gets drowned out by the noise, is a serious debate on the economic viability of the concept of a token. The big question is: Does token financing have economic merit and do tokens solve a problem other than regulatory arbitrage?

In this piece, I want to provide a brief summary (well, as brief as an academic can be — as my 8-year old says: Daddy, I asked you a simple question, don’t give me a full lecture for an answer!) of a recent paper that my co-author Katya Malinova and I wrote to answer these questions.

Some background: In an initial coin offering (ICO), investors transfer funds, typically in the form of cryptocurrencies, to the issuer in exchange for blockchain-based tokens or coins. These tokens are pieces of code, “smart contracts” that are stored in a decentralized form on bespoke blockchain or that run on an established one, like Ethereum.

In principle, blockchain- or crypto-tokens can assume many economic functions. For instance, they may represent traditional assets such a debt or equity claim on the issuer, or claims on physical assets (that’s the latest thing: security tokens — but that’s not what I’m writing about here!). What we study is the more common form where tokens provide their holders with access to an application or service, by means of a blockchain-based infrastructure, and where there is no transfer of ownership rights. Let’s broadly define them as utility tokens.

Token sales raise billions, and they have some appealing secondary features like tradability on secondary markets. And yet everyone I’ve talked to struggles to understand what these tokens really are economically and whether there is any intrinsic economic merit of selling them (over and beyond regulatory and transaction cost arbitrage). When a new investment product comes along, the key question is: does this product have economic functions that enable investments that are otherwise not possible?

Before we start, let me stress that this is a question that requires a theory — I know everyone likes data and is excited about AI and machine learning. But this is a fundamental question — a computer won’t give us the answer!

Our paper: Katya and I develop a theoretical model and show that a well-designed token issuance contract can lower very standard, intrinsic agency costs that stem from the conflicts of interest between the issuer and the investors. As a consequence, tokens can be used to successfully finance projects that will not receive equity-based funding.

Our work does not exist in a vacuum — we build and expand on some very insightful work by our colleagues. Christian Catelini from MIT and Josh Gans from Rotman circulated a very insightful piece earlier this year in which they argue that a typical token sale constitutes a pre-sale of future revenue. They provide the first framework that shows how tokens can be used to issue funds, and how token issuers’ “monetary policy” — the issuance of future tokens — affect investors’ willingness to provide funds. Cool stuff, I highly recommend reading it.

Another great piece comes from Jiri Chod and Evgeny Lyandres from Boston College and Boston University: they model a token sale as a pre-sale of a fraction of a firm’s future revenue, and they show that this method of ICO financing leads to underinvestment relative to the venture capital financing.

We build on Josh’s, Christian’s, Jiri’s and Evgeny’s work, and model token-issuance as an alternative tool to equity financing that is available to a profit-maximizing entrepreneur. There are other things one could be interested in, but we are not (well, not in this paper at least): for instance, we don’t look at the possible role of cryptocurrencies in platform adoption.

In our model, a monopolist entrepreneur has an idea for a venture that would offer a particular good or service, and she requires set-up funds to build the platform that would provide this good or service. The demand for this good is uncertain, and it will only be realized after the set-up cost has been incurred and the platform has been set up. In our baseline model, the demand distribution is exogenous; specifically, we assume a linear inverse demand with an uncertain intercept. (I know this sounds too simple, but the key to good economic theory is parsimony — include only what you must and keep it as simple as possible without being simplistic.)

The entrepreneur may raise funds from investors, in exchange for equity, or in exchange for tokens that entitle the tokenholders to a pre-specified share of the future output. As is common with early-stage firms, we assume that the issuer cannot access credit markets (show me the start-up that can get a bank loan!).

Investors in our model do not have a preference for a financing method, and they will finance the venture as long as they break-even in expectation. (That’s just for simplicity: you can include a required rate of return, and it wouldn’t change anything, but it would make matters messier to write and solve.)

At time zero, the entrepreneur decides on the choice of financing, and at time one, once the initial investment has been made, she learns the demand function and chooses the profit maximizing quantity. In our baseline model, the issuer picks the profit-maximizing production the equity financing, and all profitable projects can be financed by equity.

With ICO financing, the issuer has a choice of how to structure the offering, and we show that this choice is critical in that it affects the venture’s profitability. First, the entrepreneur can issue tokens in exchange for a fraction a of the future revenue. Mechanically, the entrepreneur will issue T tokens at time zero, pre-production, sell t=a*T of these to the investors, and commit not to issue tokens in the future. Investors will then receive exactly the fraction a of the revenue and each unit of goods or services requires T/q tokens when a total of q units of output is produced.

This method of financing, which we refer to as revenue sharing, leads to “under-production”, relative to the profit-maximizing quantity (similarly to under-investment in Jiri Chod’s and Evgeny Lyandre’s work). Why? The production incentives are distorted because the entrepreneur produces a quantity such that her share of the marginal revenue equals the entire marginal cost, and that quantity is below the optimal one.

Revenue sharing is not the only way to arrange a token sale: the second, alternative option is to pre-sell a certain amount of output. That’s actually quite common with crowdfunding — think of Kickstarter where you pre-pay for your quadcopter. Mechanically, the entrepreneur will issue t tokens at time zero, before production starts, sell these to investors and pre-commit to a fixed token-to-output exchange rate.

In this case, the entrepreneur does not commit ex ante to the total number of tokens that will be issued, and will issue q-t tokens to herself after the production decision q has been made. This method of financing, which we refer to as an output presale, generically leads to a very different type of agency conflict. When choosing the optimal output quantity, the entrepreneur fails to internalize the price impact that the production of an extra unit of output has on the tokenholders. “Failure to internalize” is economics-speak for “whoops — sorry I caused you some pain but it’s better for me!” (and it implies that by not being able to commit, I’m ultimately harmed, too). This externality leads to “over-production”, relative to the quantity that maximizes the venture’s aggregate profits.

So what have we learned? Our discussion so far illustrates that the choice of ICO financing is critical to the success of the financing round. The two types of ICO financing methods both result in production quantities that do not maximize the project’s expected net present value. Consequently, there will be profitable projects that cannot be financed by either of these two token methods, even if the absence of other frictions.

Now what? Well, intuitively, if one method causes over-production, and the other under-production, can we not just combine the two and do better? You guessed it, we can, and the right combination brings us back to the optimum. How and why? Well, many people will not like the sound of it, but the basic idea is to impose a tax — not a government tax, but a contract payment that works like a tax. Here’s how.

When we pre-sell of a fixed amount of the future product to the token-holders, the token-holders suffer from an “externality” (the whoops-sorry-effect). A traditional solution to correct for externalities is a tax. In this case, the optimal tax is imposed on the entrepreneur’s revenue through an appropriate dynamic token monetary policy: in addition to selling a set of initial tokens (which represent a claim to the units of output) to the investors, the issuer also commits to offer investors a share in the revenues from the additional tokens that are issued after the production decision (=the tax).

In other words, the optimal outcome is a dynamic token contract that cleverly combines the output presale with future revenue sharing. In our model, that’s always possible, and there’s a unique way to do it. When done correctly, this optimal contract ensures that the entrepreneur’s choice of the production quantity maximizes the venture’s total profits, and then all projects that can be financed by equity can also be financed by an ICO offering, and vice versa.

Can this be done in reality? I can’t see why not — what are smart contracts for if not this?!

There’s one additional thing to mention. Early token issuances restricted the number of tokens and touted this as a virtue. It isn’t because the issuer may well and needlessly have passed on profitable opportunities ( and deprive interested customers/platform users!). Again, our model provides guidance on how to do it right: pre-sell some tokens and share the gains later when you produce more.

Although we think that the equivalence of tokens and equity itself is pretty cool (so tokens aren’t intrinsically inferior to equity), it gets really interesting when we think of situations where the success of the firm depends on the entrepreneur’s unobservable, unverifiable, and un-contractable efforts. Yes, entrepreneurs want to do well and are self-motivated. But do investor really know? Can investors monitor what the CEO is doing? Traditional VCs and angels probably do a good job at helping firms navigate the “normal” tech world, but in this new economy, they are likely out of their depth, in particular when the issuer itself is “decentralized.” Who can monitor teams of developers that are scattered around the globe? (Most VCs don’t like to even deal with founders that are not in the Bay area.) This type of moral hazard certainly should be a first-order concern.

It turns out that in this entrepreneurial moral hazard scenario, tokens are superior to equity! We show that with entrepreneurial moral hazard, the profit equivalence between token financing and equity financing breaks down and that tokens, not equity, offer the stronger incentives for the entrepreneur to exert effort!

How does this work? The key mechanism is that under the optimal dynamic contract, issuers earn positive profits only if the demand is sufficiently high (more effort => more demand). When moral hazard is weak, anything that can be financed with equity can also be financed by tokens. But when moral hazard is severe, the issuer only puts in the effort under the token contract (without effort she gets nothing), she wouldn’t do it with equity (where she gets something either way). Consequently, all profitable projects that can be financed by equity can also be financed with tokens, but some profitable ventures that can be financed with tokens cannot be funded by equity.

I’d like to think that this result is pretty neat, but admittedly, the mechanism has a deja-vu character. The thing is that the optimal token issuance contract has a flavor of debt-financing in the sense that when a company has debt, the issuer doesn’t get paid when the demand is lower and therefore has a strong incentive to exert effort. That debt is good at counteracting moral hazard is an insight that has been made in the 70s already, in the seminal work of Jensen and Meckling. In fact, much of the business of leveraged buyouts is based on this idea.

What’s next? Personally, I hope that regulators take a step back. There are clearly people who are willing to put money into these entities’ tokens. Buying blockchain tokens is cumbersome and it requires many steps — it’s not like you get them on your TD Ameritrade screen. These investors cannot possibly be duped into believing that this is your average NYSE-listed firm. Your financial institutions, in fact, make it hard for you to get engaged. So what’s with the babysitting? (As a proudly humble Canadian I’d like to say that I get the impression that the OSC is much more open-minded than some other regulators!)

There is a role for policymakers and regulators: they should seek to develop rules and mechanisms that allow issuers and investors to come together and interact in a safe environment, and that ensure that investors have the right information about the economic functioning of tokens when they engage financially. My sense is that the current laws are insufficient. As we argue in our paper, tokens have a role to play in venture financing that equity cannot. Imposing IPO-level hurdles for token issuances, which are simply unsurmountable for early-stage firms, may damage otherwise economically viable entities and harm economic growth.

In summary, token offerings are conceptually probably the biggest innovation in the financing of firms of the past decade. Our work provides a blueprint for future revenue-based token offerings: the optimal compensation to token-holders should consist of both a presale of output units and of a commitment to share revenues in the future. With an optimal token contract, tokens can finance the same projects as traditional equity. In the context of our model, tokens are even superior because they can finance some profitable projects that can’t be financed with equity.

The full paper can be found here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3286825

Update (Nov 24): I’ve created a narrated version of presentation slides (~19min) on YouTube: https://www.youtube.com/watch?v=52giUWmgxN0&t=6s and the slides are visible here: https://slides.com/ap248/tokenomics

I’ve also made minor changes to the structure of the text.