Tokenomics Primer Part 1
Level 3 - Virgin DeFi Analyst
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Tokens are the core driver of the entire crypto ecosystem’s value.
And yet, despite their importance for raising capital, fueling investor demand, and acquiring customers, tokens often seem like an afterthought for projects.
Unlike stocks, tokens have a lot of flexibility in how they facilitate exchanges of value.
Rather than being independent of a product like stocks are to companies, tokens can become an *essential component* of a crypto application.
We have put out our thoughts on token economics a few times over the years.
One of our more popular takes has been this thread by Owl.
We’ve given consultations on tokenomics for new projects and have been in dozens of positions that have further advanced our views on tokenomics.
Today we’ll cover part 1 of our primer on tokenomics. This post will give you the lay of the land and the specific set of principles that we use to gauge the quality of tokens.
**If you are a paid subscriber: In part 2 we will cover specific examples for paid subs only. If there are projects whose tokenomics you want us to review and provide an opinion on, leave them in the comments. We’ll do a deep dive on the tokenomics of 3-5 tokens with a mix of our picks and reader picks!
Let’s dive in.
Understanding Tokenomics
Tokenomics, or token economics, are a component of mechanism design for crypto protocols that involve the supply, demand and value distribution dynamics of a token.
Traditional businesses have access to equity and debt financing, whereas crypto protocols have access to token financing. The term “token equity” is thrown around the ecosystem, but tokens have the power to represent all kinds of agreements on value exchange, not just equity.
When combined with a regulatory framework, tokens can be designed to mimic equity. A token standard could be developed that receives support from lawmakers and is recognized as equity.
Debt instruments are no different. A bond issuer could easily use smart contracts to manage payments to bondholders without the need for middlemen. Bondholders can buy and sell bonds seamlessly with tokenized bonds. Just like equity, a token standard could be developed to create a set of rules that allow tokenized bonds to be legally recognized.
Equity is a representation of value. Bonds are an agreement to transfer value. Tokens are units of value that can represent either of these traditional “legal tokens” and much more.
Key Takeaway: tokens are a transferrable representation of underlying value.
What is value?
“Value” in the corporate finance sense of the word means how much a company is worth. A company’s “intrinsic value” is the present value of its future cash flows. A company’s cash flows also determine the debt the company can take on. A company’s value minus the debt it takes on is its equity. This is a “fundamental value” approach to finance.
When operating in meme / narrative driven markets like crypto it’s easy to fall into the trap of thinking “everything is a meme” in all markets. This is simply not true.
If you were planning to acquire 100% of a company, what would you care about? You would care about customer growth, the relevant metrics to gauge its performance, its revenues, profit margins, customer concentration, cash flows, and much more. You would then want to try and get the business for a good price based on these fundamentals.
Unless you like lighting money on fire, you probably don’t care too much about what Twitter and Reddit were saying about your target, especially if you are a subject matter expert in the industry you’re acquiring in. Fundamental value is a real driver of price.
In traditional markets if a company’s stock becomes really cheap relative to its fundamental value, another company (such as a competitor) or private equity investor may step in to buy it out. Public markets investors may step in well before then and bid up the price. In traditional markets, fundamental value has avenues to be “realized.”
Crypto protocols and tokens generally do not work on a fundamental value basis - at least not today - in part because there is no concept of acquisition. Yes there have been some cases of attempted M&A with crypto protocols and their tokens but these were uneconomical. Tokens don’t trade on the expectation that there are acquirers waiting on the sidelines. If no one is going to step in to buyout a protocol, you’re reliant entirely on hedge funds and retail to support its price.
The crypto holder base is short-term in nature and they aren’t given enough reason to operate otherwise.
Crypto Token Challenges
In crypto, no one is stepping in to acquire a token as it trends to zero. There’s no “fundamental floor” on the price of the token. Even tokens with large treasuries find themselves trading below the value of their assets because there’s no realistic way for the value of those assets to be realized.
Tokens end up trading on the stories people tell each other.
What matters far more when it comes to tokens is supply and demand. When there’s no fundamental demand, you have to operate on the assumption that the supply will be sold as it becomes available.
Dumpy’s Law: Anything that can be sold, will be sold.
Tokenomics today aim to gamify the process to reduce or eliminate the ability for people to sell. Various lockup mechanisms (vote escrow) or memes (3, 3) have been concocted over the years towards this goal.
Token design innovations over the years have centered around the idea of preventing selling rather than promoting buying. Buying is promoted by marketing / narratives / influencer distribution.
In other words, the value proposition for buying most tokens isn’t compelling. Incentives are also misaligned, often favoring one stakeholder group with insider access at the expense of all other stakeholders.
If the creators of a project aren’t interested in holding their own token, they’re going to have a hard time convincing others to buy or hold (especially if news of their sale leaks). The more tokens the team sells, the less of an incentive they have to care about the long-term outcome of the project.
Even the ones who are earnestly building for the long-term find their hands tied by regulatory pressure. U.S. regulators have yet to put forward a framework that tokens can comply with, instead opting to remain ambiguous about how the technology can be used. Tokens provide creative ways to confer value to their holders and can be valuable additions to the tools available in existing capital markets. We’re confident that well intentioned regulators will come to understand this in time.
We digress.
Key takeaway: tokens that are not tied to any aspect of fundamental value, or where fundamental value doesn’t exist, are doomed to go to zero. Since regulations prevent many tokens from comfortably distributing profits, tokens with fulfill any measures of traditional fundamental value are sparsely found in the ecosystem.
The Principles of Good Tokenomics
We have now established that fundamental value helps an asset’s price. Crypto protocols often do not have a good mechanism to realize fundamental value, so tokenomics are extremely important in ascribing value to tokens.
The primary method for conferring fundamental value to holders in traditional markets is distributing cash flows, but regulations make this a challenge for many tokens.
Not only that, but distributing cash flows as an early-stage startup seems like a bad idea if you want to remain competitive (competitors that don’t give distributions will have more resources).
In an ideal world, we want to look for ways to link the values of tokens to fundamental performance without paying cash dividends until we’re flush with profits and have a defensible moat.
Over the last year since our tokenomics thread, one thing hasn’t changed: we continue to believe that good tokenomics are directly linked to the growth of the underlying protocol.
Governance tokens reflect poor tokenomics, unless governance involves actively directing the flow of capital.
Why is this so important?
It all comes down to incentives. If the team and investors get paid on marketing their token (only reason for there to be demand for a token with no value), they don’t have to build a successful product that solves a real problem for customers. They just have to game whatever aspects of the project the market is looking at (roadmap, wallet addresses, attention, memes, etc.) to drive buyers to their token.
When you hire an executive in the real world, you make them responsible for achieving certain targets and performance metrics. You want to make sure the executive is focused on driving results in the right areas, which ultimately creates value for shareholders.
What you don’t want is people getting paid outsized amounts when the business is failing (while being mindful that they are not overly penalized for things outside their control to the point where they leave).
Most tokens are not linked to performance whatsoever. How do teams get paid? They wait until the tokens are done vesting (or sell them in advance at a discount to market). The cold hard truth is there is little incentive to build anything that lasts long-term in crypto. Success begets failure.
To sum up the key points so far:
Fundamental value is an important component of asset prices everywhere
Crypto protocols generally do not distribute or align tokens with fundamental value
Lack of ability to realize fundamental value results in tokens trending to zero
Tokens often have misaligned incentives, benefitting insiders over all others
Tokens are an essential component of the business model for crypto protocols, acting as a substitute for equity and debt financing as well as a tool for customer acquisition
It’s easy to give tokens away, hard to convince people to hold
We conclude, based on the above facts, that tokens should be purpose built with specific goals and behaviors in mind unique to the product / business model. There is no uniform model for tokens that will work across crypto, and both teams and market participants should not expect otherwise.
Demand
We classify demand as having two sources: organic and inorganic.
Organic demand comes from token utility and speculation
Inorganic demand is token demand the protocol pays for (token buybacks, burns, etc.)
Giving tokens away is not difficult. The value of a token comes from the demand for its use cases, actions that remove supply, and the desire for people to speculate on its performance.
Both organic and inorganic demand are key to a token’s value.
Let’s go over an example of a token that we consider to have done a good job on the organic demand side - Arweave’s AR token (Arweave deep dive here).
The AR token is central to the Arweave protocol - it’s used to reward miners, and used as a currency for users looking for storage. Anyone looking to store data has to pay for 200 years of storage *upfront* with AR. This upfront payment is then used to pay miners in the future. Over time, storage costs decline, so the amount paid upfront is theoretically less than what needs to be paid out.
Most of the transaction fee for storage goes to an endowment fund, which is then distributed to miners over a long period of time. Remember that miners operate a business, and they will have to sell their rewards to cover their operating costs. This creates selling pressure. However, since most of the transaction fee goes to the endowment fund, the growth of Arweave actually creates a supply sink.
That means the AR token is directly rewarded for the growth of the Arweave protocol. All of this demand is *organic* as it is user driven. If Arweave doesn’t grow, the token doesn’t perform well. That’s a good thing, not a bad thing.
Autist note: The goal of a protocol is not to expend its resources on eliminating price risk for buyers. Resources should be spent on growth, and the token should benefit from this growth. If a protocol fails, the token should fail.
Inorganic demand, where the protocol pays for the demand, has risks. Buybacks can be front run, either by outsiders who know when they’re coming, or insiders who can decide on a whim to do buybacks. In most cases we consider buybacks to be a worse version of cash flow distributions due to the principal-agent problem.
A good example of inorganic demand would be if a protocol were to offer a service or benefit in exchange for tokens. Instead of paying in cash upfront, users could deposit tokens to be burned today in exchange for lower fees for 6 months (just an example). Protocols can play with the timing to better manage their cash position, drive up the token price and foster platform loyalty.
Staking is also a good example of inorganic demand but once again it depends what is provided in return for staking. More tokens is just rewarding farmers with no benefit to the protocol. A high ROI version could be that stakers above a certain amount of tokens could have direct access to the founders. This helps align incentives as those with the most tokens have the largest economic stake. Users with fewer tokens could join forces and assign a delegate to speak on their behalf and represent their interests. This creates additional friction for selling in a *positive way* by improving communications between founders and investors.
The options are unlimited. Tokenomics have to account for the unique situation and business model of every protocol / application.
Supply
Supply dynamics generally seem to be well understood and have been covered ad nauseum in crypto so we will keep it brief.
Max supply: This is largely irrelevant for niche coins but if a coin goes mainstream, there is “unit bias” where people want to “own one coin for cheap.” Can make sense to have high max supply for this purpose but the actual number of tokens does not matter.
Allocation: Very important. This determines who controls governance in most cases. Generally speaking 20% is a good number for core team and 10% for investors. 30-40% for team is a bit aggressive, and anything above 40% for the team we wouldn’t touch with a ten foot pole. If the total team, VC, and DAO allocation combined is greater than 50% it’s not decentralized.
Vesting: Also important - this determines how much supply will circulate at a given time. Don’t forget Dumpy’s Law.
Incentive programs: Usually necessary, and one of the key benefits of tokens. These programs, if used effectively, can be essential in driving initial use growth. However, it can be challenging to avoid farmers and pure value extractors. Whether or not incentive programs give crypto startups a long-term advantage is up in the air, but at this point users have grown to expect to get paid to use a protocol (with some rare exceptions).
Liquidity: Beyond the scope of this primer but a crucial topic. Where does the protocol support price? Where does the market? And how do you avoid having to pay for liquidity forever? Important considerations.
Token Risks & Considerations
The key risks to consider with tokenomics are:
Regulatory: Due to regulatory uncertainty, paying dividends and potentially even issuing a token at all can be a risk
Mitigant: Have some or all members of the team operating outside of the U.S. and avoid jurisdictions that are not crypto friendly. Legal advice along the way is strongly advised
Runway: With fixed supply tokenomics, the risk is that a project runs out of tokens before reaching critical mass
Applying rewards to achieve real adoption as well as managing the quantity of rewards issued can mitigate some of this risk
If there is significant runway concern, governance can have the rights to vote on inflation once max supply is hit
Managing the treasury properly early on when there aren’t runway concerns can help mitigate some of this risk
Exploiting Economic Models: If bad actors can find a way to exploit reward systems to drain the protocol of tokens, they will. Token models must be resilient to these types of attacks including avoiding “wash trading” activities for tokens that drain tokens without rewarding the protocol with loyal users
*If you are a project that wants us to advise on your tokenomics and better align incentives with holders DM owl on Twitter. We’re interested in improving the space if you are.
**If you are a paid subscriber: In part 2 we will cover specific examples for paid subs only. If there are projects whose tokenomics you want us to review and provide an opinion on, leave them in the comments. We’ll do a deep dive on the tokenomics of 3-5 tokens with a mix of our picks and reader picks!
You can sign up to be a paid subscriber below.
Until next time..
Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.
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