Valuing Productive Cryptoassets
This post focuses on productive cryptoassets and their respective valuation frameworks. These assets can be modeled similarly to real estate, equity, and bonds. They are distinct from non-productive cryptoassets like medium of exchange tokens and candidates for store of value.
Productive cryptoassets in this context include discount tokens, native profit sharing tokens, work tokens, burn and mint tokens, and governance tokens.
Productive vs. Non-Productive Cryptoassets
Without the influence of broad speculation, token value in the aforementioned models should grow linearly with respect to cash flow generated atop the network. Generally, the goal in token design is to implement mechanisms that create financially productive digital assets that align incentives of stakeholders. Such productive assets (covered in more detail herein) can then generate cash flows to their holders.
The equation of exchange, MV=PQ, is a semi-useful heuristic for identifying poorly constructed cryptoassets (those that are susceptible to infinite velocity and limited economic growth). However, this equation is often mis-applied when evaluating productive assets. Rather than treating all digital assets as money, some should be evaluated as businesses. Discounting future cash flows to their net present values is one example of a sufficient valuation approach. The more things change, the more they stay the same.
Native Profit Sharing Tokens
Native profit sharing tokens are ones that would fail the Howey Test. These tokens are native to their respective applications. Similar to a classic security, ownership of the profit sharing token programmatically gives access to scheduled dividends.
A good example, is Siafund. The Sia blockchain allows users to connect with storage hosts through a decentralized marketplace. Miners are rewarded through Siacoin (Sia’s payment currency), which can then be used to buy and sell storage space. Siacoin is the network’s payment currency. Siafunds are the equity. Siafund holders earn a proportion of transaction fees paid by network users.
Some argue that this model is fundamentally rent seeking — that the network does not need fees to survive. On the contrary, profit sharing tokens properly align incentives — essential for building a great product and cultivating a strong community. However, if margins on a network are excessive, expect rational participants to fork and create lower cost options. This optionality, inherent to open-source, is a key distinction between fees and rent-seeking.
Profit sharing through a token is easy to understand; it’s how most businesses incentivize performance. Consequently, calculating a network’s fair market value can be done by simply applying an NPV model using earned fees over a defined timeframe. See attached model.
Work tokens offer network service providers the right to perform work through a lock-up or staking mechanism. This ensures that service providers are rewarded or penalized in proportion to the quantity of tokens staked. The work performed should be of commodity form whereby the only differentiating characteristic among providers is the number of tokens each stakes.
Through the work token model, token holders are afforded the possibility of future cash rewards. Similar to discount tokens and profit sharing tokens, the work tokens model creates productive digital assets whereby the holder can expect a certain return on investment. The value of the asset should also theoretically increase linearly with network usage. The most prominent example of this model is Augur.
A subset of work tokens, token curated registries (TCR), intend to function similarly to work tokens in that validators and curators can receive a proportional amount of contract revenue based on the amount they stake in order to do work for the network. Given this model, the more tokens one owns, the more potential revenue can be received.
Because participants earn revenue in proportion to the tokens staked, it’s straightforward to apply a net present value calculation to the token.
Discount Token Models
Discount tokens grant to their holders the right to receive discounts on services offered from the issuing network. These tokens are often paired with a project-specific stablecoin, utilizing a dual token model. However, a network that utilizes a discount token can use any medium of exchange for its services. See the attached model valuing the discount token, Sweetcoin.
If the price of the token exceeds the value of the discount, users will logically avoid the purchase. Using this model, one can determine price elasticity based on the value of the discount.
As an example, Alice borrows $100 from “BlockchainBank” intending to repay the loan in one year. She is charged .5% interest annually. If she purchases and activates enough DiscountToken (DT), she can eliminate the .5% annual interest. In this case, she would be willing to pay up to $0.50 (.5% on the $100) for an amount of DT that would eliminate the interest fees over the one-year period. Note, this does not give the price per DT as we don’t know the total outstanding supply. This only tells us the maximum price Alice is willing to pay for an amount of DiscountToken over a one-year period.
The token’s value in this example, should theoretically increase linearly with network use. As users desire discounts, more DTs become activated. The network value should be equal to the total expected reduction in fees over a given time interval.
Burn and Mint
In the burn and mint model, tokens are used as a payment currency for the network, but users do not pay service providers directly. Instead, users burn tokens in the name of their specific service provider. Tokens are then minted on a predetermined schedule and distributed to service providers. Service providers are rewarded in proportion to the number of tokens burned in their name.
Importantly, the number of minted tokens is not a function of the number of tokens burned. This would create circularity and eliminate value accrual.
Service fees must be linked to an external unit of value such as the dollar. If burn rate (demand) exceeds the predetermined mint rate (e.g., “net burn”), token price should grow based on supply and demand dynamics.
The burn and mint mechanism for accumulating value is contrived. A basic profit sharing model would properly align incentives and promote value accrual in the token.
Governance tokens are indirectly productive assets because they don’t produce cash flow for holders but may serve as a protection on future cash flows. They allow holders to vote for changes in the network in which they belong. Typically, the number of tokens one holds is proportional to the number of votes they have. In a system that can be copied, what is the value of a governance token?
The network value of a governance token is bound by the net cost of forking or creating a new copy of the network. Using a decentralized social network as an example, the code can be copied but the network effects that have been created as a result of peer-to-peer communications may be lost. In this scenario, there is a substantial cost or moat developed around the network. The users and businesses have an incentive to participate in the decision making.
Using 0x as an example, the maximum price a network participant (e.g., a relayer) will pay for 51% of governance tokens is bound by the estimated cost associated with a network fork. Cost is equal to the difference between the net present value of the pre-fork and post-fork business. This serves as a starting point for determining fair value of the network. See the attached model and previous post for additional detail.
It’s worth noting that the value of a governance token is not equal to the value of governance. It is equal to the delta between the value of tightly coupled governance and the value of loosely coupled governance. That delta is not necessarily positive.
MV=PQ is generally not suitable for valuing productive assets. Rather, it demonstrates a semi-useful way to understand how a medium of exchange token behaves relative to the economic activity it generates.
The profit sharing model is an easy-to-understand mechanism for aligning incentives within a network. The promise of dividends allows participants to estimate present value of the token. With increased regulatory clarity, expect more profit sharing tokens to emerge.
Burn and mint effectively aligns incentives but is a contrived mechanism to avoid security status. Generally, a profit sharing model can replace burn and mint.
Work tokens are integral to the security and functionality of their respective networks. Their designs attempt to align incentives of all stakeholders. An owner of work tokens can reasonably estimate the value of their tokens based on the future cash flows made possible through token ownership.
Discount tokens provide a mechanism through which users can estimate the present value of tokens based on potential savings over a specified timeframe.
Tightly coupled governance tokens are an interesting experiment in coordination. The value of governance is driven by the cost to fork the network.
It’s striking how similarly most “good” token models operate. They are fundamentally productive assets, some of which resemble securities. Discount tokens, profit sharing tokens, work tokens, and burn and mint tokens are built on an assumed margin or fee that is distributed to the service provider or token holder. With these value accretive tokens, simple net present value formulas can be used to reasonably estimate a token price.