Levelling the playing field
April 2022
Introduction
We are all familiar with the current format of token issuance from nearly every project these days. Tokens are allocated across various buckets (team, partnerships, marketing…) with inexplicable lock-ups and vesting periods. This is presented succinctly in a pie chart and crunched down into 2D graph to reassure tokenholders that they are suitably protected from insiders and founders.
There are several flaws in this approach, which need to be addressed if token capital is to be taken seriously by projects and investors more accustomed to professional (ex-crypto) capital raising.
By comparison with securities or equities, the mispricing of token rounds has far more significant consequences. A severe misalignment between utility-driven stakeholders and financial investors can destroy the project itself.
In this paper we deal specifically with:
Alignment of allocations between principals
Lock-ups and vesting
Investment round pricing
In this paper we suggest a generalised approach to find a standard and logical issuance process. Each project can then calibrate parameters and distributions with respect to their specific business model.
Allocations
We view token capital as being analogous to the Revenue line of a business. In a corporate example, Expenses (e.g. CapEx and OpEx) are deducted from Revenue leaving an Income line for Equity. In the case of token capital, we can simplify the allocation buckets by sweeping all the expense buckets into Expenses leaving the Equity equivalent line for its Principals (Founders, Team, Investors).
For the purposes of this paper we are not concerned as to the composition of Expenses but there are some obvious observations that we can make:
The formal allocation of capital to distinct expense buckets is restrictive and counter-productive. With dynamic markets and token price volatility, it is impossible to predict the correct allocation of tokens for the expense budget. These allocations are a best-guess and in reality this whole bucket should be a discretionary treasury. In that regard, a better approach would be to label this whole bucket Expenses coupled with an equalisation event for all token holders in the event the tokens are not used (such as a burn mechanism). This also protects the project from retrospective allegations of investor misrepresentation.
We would include liquidity and single staking incentives in the Expenses portion. These should be used as a cost of business and accretive to token holders (reward economic contributions, pay for services, acquire users and so on).
If we take a very simple approach that Expenses total 50% of the token capital (an implied 50% equity margin), we can now look at the relationship between the Principals, i.e. “Team” and “Investors”.
There should be an equal allocation of tokens between Team and Investors reflecting the passive capital vs. active execution relationship
Therefore, we arrive at a simple allocation as follows:
Lock Ups and Vesting
This is a contentious section, but possibly the most important part of analysis, since the current market approach is riddled with conflict and unintentional special (undisclosed) terms. Investors demand individual preference on price and liquidity with projects being held to ransom for capital and brand association. Conversely, projects blame “Dumpers” for ruining their token markets, which is equally unfair since, if you give someone liquidity, you cannot complain if they use it.
Liquidity changes an investor’s risk profile and therefore affects, on a risk-adjusted basis, their entry price. For example, an investor at $2 per token, with immediate liquidity, is much better off than an investor at $1 with a 5 year lock up (in crypto terms at least). Having multiple lock-ups, within and across different rounds, creates an impossible pricing model for investors and makes it extremely hard for a project to genuinely price their cost of capital.
All investors have identical liquidity
This allows the fundraising rounds to be much simpler and removes preferences and misalignments. If there are special terms, these can be dealt with by modelling an in specie capital contribution. (For example, incubation or marketing services), but in any event should be disclosed.
The Team unlock should occur at the point where the Investor vesting ends.
This is common sense and ensures the Team delivers for the Investors. For this paper we assume that the Team unlock occurs at Year 2 and therefore Investors should be 100% vested by this point.
Investors can unlock at any time post TGE, based on a Liquidity Curve that determines the proportion of tokens they are eligible to receive.
The S-curve is a Sine wave (translated, scaled, restricted) that makes the general assumption that there is a standard growth / development pattern for the project.
Investors unlocking early receive this proportion from the curve and no more.
As noted on the graph, an investor unlocking at 6 months would receive c. 15% of their token allocation. To state the obvious, this is very different from an unlocking schedule as the investor, in this case, forfeits 85% of their allocation.
Forfeited tokens are sent to a pool and allocated to Investors that are left at the end of the locking period, subject to a burn that is equal to the proportion of Investors that unlocked early.
If 80% of Investors have unlocked early, 80% of the Forfeit pool is burned, leaving 20% Forfeit tokens allocated to 20% of Investors who stayed the course.
As a result, if investors acted independently, this would create a “Last man standing” bonus structure for those that stayed for the 2 years. More sophisticated investors will generate liquidity optimisation models spreading their unlocking across the curve as there will be arbitrage opportunities. Whether it is arbitrage or investor collusion, the outcome is a known liquidity profile for all token holders with investors treated equally in proportion to their capital. Gamification is limited to the intra-investor bucket.
Investment Round Pricing
Since lock-ups and vesting are now the same for all investors, we can look at the relative price entry point for the different rounds based on the relative time each investor spent waiting for TGE.
The price difference between rounds is calculated from time to price-visibility (TGE) adjusted by a development curve
The Risk Curve is created from fitting an S-curve around the Sqrt (Time) to capture volatility and development from Seed to TGE.
This will always require careful planning from the token issuer with regards to a realistic TGE and their capital raise requirements. We can see on the graph that post-seed rounds 2,3,4 should be priced a 2x, 5x and 11x seed round, assuming timings at 0.25, 0.50 and 0.65 of the seed to TGE period.
In the event that TGE slips, the ratio between the timings changes in favour of the later rounds. Compensation for these subsequent rounds can be made by simply rolling back the curve. In addition, if a round is priced at a lower multiple than the curve implies, prior rounds can be compensated with extra tokens to recalibrate the curve.
This approach carries an in-built risk-adjusted “Down-round” mechanism between non-public investors.
There are of course practical limitations to the approach:
Issuance too close to TGE would demand a large premium to seed (due to the exponential curve). This would most likely trigger a compensation payment for prior rounds or a shift in TGE anyway since the requirement for funding at that point would be abnormal.
Compensation tokens would be limited by the project (since tokens are not infinite) and too much compensation would disrupt the capital structure or kill the project itself.
These limitations or edge cases should force greater focus from projects on their capital raising requirements and deliverables.
Importantly, this is not a reference to TGE pricing, but the TGE timing. It deals with the price-unknown period for private investor relative pricing and not the outcome of TGE price.
Finally, models such as these can easily be turned into smart contract form for programmatic issuance.
Conclusion
This is a high-level approach towards standardising the structure and issuance of token capital. There is no one size fits all and, as we see in traditional finance, special terms such as “Right of first refusal” will still exist.
However, a transparent risk-capital based framework, such as this, enforces alignment across the capital structure, removes lumpy or disproportionate liquidity events and incentivises investors to model their capital correctly which stabilises the capital system.
This ensures the survival of a project will be on its commercial merit alone as opposed to a poorly managed capital structure.
As a result, we believe this approach will remove the lower quality capital providers and projects and allow increasingly sophisticated funders and issuers to enter the space which is critical for growth and adoption.
About 0rigin
0rigin designs and builds blockchain and decentralised models that will have a profound impact on the global economy, by fusing traditional disciplines from finance and technology with cutting edge techniques and product innovation.
Learn more about 0rigin on our website, tag us on Twitter, or speak directly at info@0rigin.one
