The economics of ICO issuances, increasingly known as tokenomics, involve all decisions around the issuing and implementation of a token within an ICO ecosystem, and the way holders of tokens are able to use these to exchange goods and services on the platform. Such decisions include structuring of the offering, sale models, pricing of tokens and allocation mechanisms.
Parallels have been drawn between central bank currency issuance and ICOs. Many industry participants refer to a “monetary policy” in token issuance, as issuers need to manage expectations of tokenholders and ensure price stability for the token.
Structuring of ICO offerings
Structuring of ICO offerings varies across projects in regards to the number of tokens issued; the proportion maintained as compared to the one distributed to investors; the allocation mechanisms; the future supply of tokens; and the sale model used. As this financing mechanism is new and innovative, the structuring of the offerings tends to evolve as the mechanism matures, in part as a response to failures experienced.
Most ICO offerings are capped, placing a ceiling on the amount they wish to raise which is in turn translated into a cap in the number of tokens that will be issued. Uncapped ICOs run the risk of token “inflation”, with the value of existing tokens being eroded with every new token issuance. This effect is similar to the dilution to which equity-holders are subjected to.8
The schedule of token issuance, if tokens are not issued in a single issuance, needs to be clarified by the issuer upfront. Given potential token “inflation” and the fact that the price of tokens is affected by the supply of tokens, initial token-holders are sometimes negatively surprised when the issuer decides to issue more tokens than initially announced.
Having a full and accurate schedule of the medium-term financing needs of a start-up upfront can be a very difficult task, as their financing needs depend on the success of the business, the speed of its development and other unpredictable factors. This can be a real challenge for SMEs who may realise after the ICO that their initial issuance did not sufficiently cover their financing needs; the issuers will have to deal with a trade-off between depriving themselves of further token-based funding rounds so as not to negatively surprise their existing token-holders or issue further unscheduled rounds of tokens and dilute them.
This is why many issuers decide to hold part of the tokens issued as reserves that are not yet sold. Such reserves effectively serve as a safety net in case the company needs to raise further funding in the future. These can also be used to incentivise miners or developers contributing to the project by serving as compensation,9 or can be given to a market maker
tasked with preserving the price stability of tokens if these get listed on a trading platform. Deciding how many tokens to keep as reserves is a delicate balancing act for the entrepreneur who does not wish to deprive the ecosystem of tokens.
A mechanism that can help issuing companies foster a thriving ecosystem is placing caps on individual contributions.10 Such maximum limits on investment per individual investor promote the diversification of platform participants, helping the development of the network, with a significant impact on value creation (see Section 2.2). At the same time, caps can impede the hoarding of tokens by speculators who accumulate tokens expecting their value to appreciate. Such hoarding is, in turn, detrimental to the functioning of secondary markets for tokens, stripping the market of valuable free floating tokens. Conversely, minimum contributions can be imposed in case the issuer wishes to restrict participation to institutional investors. This, however, can be counter-productive on the creation of positive network externalities.
In addition to fostering a more vibrant network, caps on individual contributions promote KYC/AML activities by issuers, as it effectively requires a KYC process to be undertaken by the issuer. In such cases, issuers verify that the address of each tokenholder represents a unique individual and can create whitelists with users’ addresses and verifications, similar to shareholder registries.
A portion of the tokens issued is, in many cases, set aside for the founding team of the project11. When the tokens issued do not incorporate any ownership rights, allocating part of the token issuance to the founders, who continue to hold full ownership of the company, could be seen as counter-intuitive or even conflicting. Such cases could give rise to misalignments of interest when founders have interest in inflating the token price artificially, only to “flip” the token to new buyers for large profits (so-called “pump and dump” schemes). Lock-up periods for tokens reserved for founders should therefore be used as a tool to align the interests of founders with those of other tokenholders.
Extra tokens are allocated to those undertaking the mining process through which nodes validate transactions. Mining nodes try to solve complex mathematical calculations in order to verify transactions, and are rewarded with new tokens for every validated transaction.
The case of Filecoin can be a good illustration of token allocation12. Thirty per cent of the tokens created would be disbursed “at genesis”: 15% to the development team, 10% to investors, and 5% to the “Filecoin Foundation” that will ensure the future development of the project. The 15% team allocation, together with the 5% to the Filecoin Foundation was considered by the industry as rather high. The remaining 70% of tokens would be reserved for mining rewards, and miners will be able to earn those tokens as reward for every block in exchange for replicating files on the network.
The issuance can be contingent to the achievement of a minimum threshold, the “soft cap”. If the pre-defined target of proceeds set by the imposition of the soft cap is not met, investor contributions are returned and the platform is not launched. Such soft caps are also customary in crowdfunding campaigns.
When it comes to sales models, sales at a fixed price, auctions, reverse auctions and hybrid forms of the above or other innovative mechanisms are being used. To date, no single structure or sale model has proved to combine all the desired properties that would render it an industry standard.
The technology underpinning ICOs allows issuers to include in the code a pre-specified algorithm or schedule for the issuance of tokens, as well as terms and conditions for the supply of tokens (prices, thresholds, caps, etc.), which are then automatically executed on the blockchain (e.g. through smart contracts). This improves the credibility and trust of potential token holders, but reduces flexibility of the company to adjust to fluctuating market conditions.
In the absence of lock-in periods for entrepreneurs issuing ICOs, one way to protect investors could be the allocation of issuance funds to custodians who will only hand out funds to the issuer upon achievement of pre-defined milestones. Such milestones in the development of the project and the lifetime of the company would need to be disclosed ahead of the issuance.
In any and all cases, transparency around ICO terms and conditions is of paramount importance for participants and increases the credibility of the issuance. As ICOs are, for the most part, unregulated, disclosure requirements do not apply and in many cases investors do not receive the level of information necessary for them to make informed investment decisions.
Before the actual ICO, some issuers choose to undertake a private offering of tokens or token “pre-sale” to a small number of identified parties, in most cases insiders or cornerstone investors such as VC funds. Tokens in such pre-sales enjoy a discounted price for the tokens and in most cases proceeds raised are used to cover the set-up and expenses of undertaking the ICO transaction (marketing expenses, advisory fees, etc.).
Private sales of tokens ahead of ICOs raise a number of issues, as they tend to favour insiders by offering heavy discounts on the tokens that hold exactly the same risk as the ones purchased by investors during the offering. Issuers who use pre-sales to cover the expenses of undertaking an ICO offering do not take on any personal risk at all.
Not having any “skin-in-the-game” is another source of potential conflicts, as the founders carry no personal financial risk in the transaction besides reputational risk. Having some personal capital at risk assists founders of start-ups in convincing investors of their involvement and can act as a tool for the alignment of interests between entrepreneurs and investors.
Token valuation and pricing
The application of standard corporate finance valuation frameworks to tokens issued in ICOs is challenging. Most ICO offerings do not fit the standard investment paradigm given the underlying economic relationships involved in such offerings, as well as the novelty and complexity of the structures13 used.
The difficulty valuing ICO tokens is very much linked to the difficulty in defining tokens. If tokens were to be defined as currency, their valuation could be somehow similar to cash or cash alternatives; if defined based on their utility value, they would represent the price of the service at any point in time; if considered equity securities, the company’s enterprise value would need to be modelled and the price of the security derived from such model.
The economics of the issuance (number of tokens, offering price, structure of the token offering) need to be defined and disclosed to potential participants upfront, to allow for the valuation of the tokens, however, this is not always assured given the absence of disclosure requirements in most ICOs. The full schedule of tokens to be issued at the initial and future stages need to be known with accuracy for an investor to be able to make an informed decision about the value of the token, as existing tokenholders are diluted by subsequent issuances (what is defined as “token inflation”).14
Pre-defining the token schedule of issuance may reduce the flexibility of an SME to quickly respond to changing market conditions, reducing the agility of the company. Entrepreneurs themselves are faced with the challenging task of having to decide, with accuracy, their total financing needs that their venture will face in the future, so as to determine the total supply of tokens, before the platform is even built – or impose a dilution for their initial tokenholders at a later stage.
Another level of difficulty in valuation and pricing relates to the way value is (i) created and (ii) shared within the network. As mentioned above, network effects represent an important value creator for blockchain-enabled projects, and the expected monetised value of such positive externalities needs to be accounted for in valuation.
Sharing and allocation of the value created by tokens may not always be straightforward in the case of an ICO. In cases where tokens are considered securities, token-holders get their fair share of value derived from the appreciation in the value of the platform. But the duality in the function of a token, both as a means to represent the future value of the company (similar to an equity share) but also as a means to transact on the platform or get access to the platform (usage or utility), needs to be priced in.
In the absence of ownership rights, as is often the case in ICOs, and if the tokens issued are not considered securities, an expected upside in the value of the company will only be shared by traditional equity-holders/owners of the company (if these exist) and not by token-holders. Conversely, any upside from the appreciation in the value of tokens will be
attributed to token-holders. A potential dichotomy of value attribution may arise between token-holders and traditional equity-holders in case an initial investment round with traditional equity has taken place before the ICO (VC/business angel or other) or in a follow-on financing round with traditional equity.
In its simplest form, pricing of a capped ICO offering a fixed number or tokens would result in a fixed price per token and a valuation reflecting the target or cap of the offering. This would be the case even for a regulated offering with no uncertainty about the regulatory framework or the stability of the market. In practice, given that many offerings occur in unregulated markets, and/or some of the trading or exchange platforms involved are in grey regulatory zone, uncertainty around the credibility of the trading or exchange platforms needs to be priced in the token.
Interestingly, if the platform does not have any other revenues after its token offering and no revenue is generated from the sale of services/products to token-holders or non-token- holders, the value of the company can be assumed to be only based on token appreciation. In such cases, the value of the company will be equal to the number of tokens in issuance times the price of the token, similar to the market capitalization metric.
It can be argued that the pricing of ICO tokens is linked to, and therefore may be dependent on, the pricing of the prominent cryptocurrency used to buy it and to which it will be converted when sold. As tokens are in most cases exchanged against one of the prominent cryptocurrencies (e.g. Bitcoin or Ether) in primary or secondary markets, the price of the reference cryptocurrency will not be dissociated from the price of these coins. This exposes tokens offered to increased volatility given the extreme volatility witnessed in such reference cryptocurrencies. In terms of pricing, ICO tokens may also carry a premium linked to regulatory uncertainty and an illiquidity premium until the token is listed on an exchange.
The difficulty in assigning a fair value to tokens issued in ICOs at their current form may therefore be a limitation for the wider use of ICOs as a financing mechanism for SMEs and participating investors.