A few months ago, we analyzed Initial Coin Offering (ICO), a new way for companies to raise capital mainly in the technology sector which surged in 2013, and compared the new financial instrument with traditional financial instruments. In this article, we want to dig deeper into ICO and present a new scientific concept which derived from it: Tokenomics.
The word “tokenomics” is a compound of the words “token” and “economics”. This term raised popularity in the middle of 2017 due to the high numbers of ICOs and different project models. Tokenomics contains all decisions around the implementation of a token within an ICO ecosystem. A token represents a digitally, cryptographically-secured unit of value which is created by distributed ledger technology such as blockchain. The token can be built on a new blockchain (native token) or on the top of another blockchain such as the ERC20 standard on the Ethereum platform.
A token gives the owner a right which differs from one ICO project to another. You can have a right to
- Access a platform
- Purchase a product or service
- Future profit-sharing
- Approval of changes in the code
Example: Why are companies creating tokens?
Imagine you found a hostel chain that should accept in future cryptocurrency as payment by the guests to avoid international banking fees as most of the guests come from abroad. As the founder doesn´t have any access to funds from friends & family, credit or venture capital, he decides to raise capital via an ICO to create its cryptocurrency and to finance its expansion and all related expenses (salary, advertising, rents, etc.) in the next five years. Hence the company offers a service which can be paid by a token.
In practice, a project-specific token will be developed by programmers like for example the Primal Base Token, Ethereum or Filecoin which can be purchased via other cryptocurrencies or sometimes via fiat in an ICO.
According to William Mougayar, author of the Business Blockchain (Wiley, 2016) a token in a business sense can be defined as:
“A unit of value that an organization creates to self-govern its business model, and empower its users to interact with its products while facilitating the distribution and sharing of rewards and benefits to all of its stakeholders.”
Apart from the technical design (smart contract, webwallet etc.), the hostel owner has to design a particular ecosystem in order to sell the token. This is called a token model which differ depending on the project from each other, but It includes the key following elements:
- Token Classification: Utility or Security
A token is classified into different categories depending on functionality or legal requirements. The Swiss Financial Market Authority classifies tokens into payment tokens, utility tokens or asset tokens whereas the U.S. Security and Exchange Commission (SEC) published a guide in April 2019 which determines when a token fall under a security classification.
A utility token is a digital asset that gives the owner the right to access a service or product of the platform. It is not an investment nor gives shares of the company. The price of the token can increase over time when the demand for the product or services is increasing. By contrast, the security token is an investment tool when it fulfills certain requirements which are tested by the Howey test. A token is a security token if it is a financial investment with an expectation of profit in a common enterprise and the profit is generated by a third party. If the token meets all the points, it must comply with the requirements of a traditional security (debt, equity, derivatives) by the SEC.
- Token Sales Model
To mitigate risks and increase trust and transparency to future investors it is necessary to define a token sales structure. In this model, the details about the token, its economics, and the terms of the sale have to be clear. There are different token sales models and project owners constantly find new models to distribute the tokens. The most common ones are:
– Uncapped token sale
In the uncapped token model where an unknown number of tokens will be issued for a fixed rate. Early buyers can receive a promotion in the first weeks and the ICO has a specific distribution time. The most famous uncapped token sale was Ethereum in 2014 which ran for 42 days. The sale price started at 2000 Ethereum/Bitcoin in the first two weeks and increased after it linear to 1337 Ethereums/Bitcoin. There is a lot of critics regarding the uncapped token sale because of the high uncertainty of valuation and the fear of a dilution effect.
– Capped token sale
In a capped token sale, the token quantity is limited. In this model a soft cap, hard cap and hidden cap can be set. In a soft cap, after the cap is reached there is a certain time extension until the full closure whereas at a hard cap, the token sale stops once the cap is reached. In a hidden cap, the investors don´t know when the token distribution is finished. The capped token sales were more popular in the last years as it gives more transparency and trust to the investors regarding the valuation. In the first capped sales, the sale finished after a few hours and was accelerating with the time. For example, First Blood finished their 5.5 million USD sale in two minutes whereas BAT raised 35 million USD in 30 seconds.
– Dutch auction
The Dutch auction model is already known in Initial Public Offerings (IPO). The price is set after taking in all bids to determine the highest price at which the total offer can be sold. In July 2019, Alogrand raised more than 60 million USD in its Dutch auction mechanism. The 25 million tokens were sold at a price of 2.40 USD/Algo token. The foundation told that it will around 600 million Algos per year.
– Reserve Dutch Auction
In a reserve Dutch auction, the token sale is capped and the amount of the token distributed depends on how long the sales take to finish. Gnosis set a cap at 12.5 million USD and finished on the first day. Approximately 5 % of the tokens have been distributed to the purchasers and other 10 % to the Gnosis team. At this strategy, the buyer decides which is the highest price the buyer wants to buy at. The sale starts, the buyer waits a while and once the valuation drops to the desired level and executes the transaction. There can be two possible outcomes: First, the sale finishes before the price is at this level and the buyer stayed out. Second, the sale finishes after the valuation dropped to the desired level and the transaction get executed. Due to the “fear of missing out”, the sale finished after a few hours with the cap reached and 5 % of the tokens sold.
- Token Allocation
Another important aspect in the tokenomic model is the token allocation which informs about the token distribution in its environment. The distribution of Filecoin was as followed:
- 70% to Filecoin miners as reward for providing storage service, maintaining the blockchain,
- 30 % to the genesis block which is divided as followed
- 15 % to the development team
- 5 % to the Filecoin foundation
- 10 % to investors (Partnership)
the token allocation has to be clear. It will answer the question: Who gets what? The ICO project developer has to publish information like how many tokens are public to sale, percentage of token going to team member and number of tokens sold to private investors (preICO). Furthermore, the project team has to define what to do with the funds used.
- Token Valuation and Pricing
The token valuation is quite challenging as most of the ICOs do not fit in the standard investment paradigm. Another difficulty is that the valuation difficulty is linked to the token definition: If a token is defined as a currency it can be valued similarly to cash and in case of utility value, the service price could be adequate. To have a value, a token consists of an intrinsic (functional) and speculative value. Bitcoin, the first cryptocurrency, has no intrinsic value as there is only the technology behind. When you buy a Bitcoin, you don´t own the technology. A lot of banks like Morgan Stanley forecasts the death of Bitcoin, but it is still there and with a high market capitalization. In finance, intrinsic value is the value of an asset, company or investment and can be calculated by a fundamental analysis with qualitative and quantitative aspects. In cryptocurrencies, intrinsic value can be defined as the actual value of the cryptocurrency based on the underlying perception of its true value including tangible and intangible factors. The intrinsic value is quite subjective as it depends on the capacity of the team to execute the idea into a reality. Thus, other factors like functionality, a potential market and community and funding have high importance. The intrinsic value can be a service, a commodity such as gold or silver or digital certificates such as carbon credits.
Summarizing, tokenomics can be seen as the fuel of a blockchain ecosystem. Tokenomics presents only a part of a whole technically and economically designed project. Although it promises another way to raise capital for small-and-midsize companies, it is quite complex and risky as investors are investing mostly in an idea and not in a finished project. The team members can tackle this issue by being transparent and offer a trustful token sales model.
Written by Marco Blanke