With $4 billion in capital raised in ICOs, and very little utility value to show for it, it’s tempting to call token offerings a bubble.
However, the more likely truth is that the same forces that gave rise to today’s paradigm-shifting technologies (see: Carlota Perez’s definitive book) are at play in the world of crypto. And that while we may be entering bubble territory, the key difference between tulips and crypto is how speculative capital was deployed – the former into manufacturing an asset and the latter into technology development.
Still, money is no guarantee of success, which is why I’ve been spending a lot of time thinking about capital deployment into crypto, a topic deserving of more attention because it will be a major proof point for the ecosystem’s long-term trajectory.
It is also an area of competitive advantage for crypto projects in the next five years.
That’s because unlike the centralized technology companies we’re used to, entrepreneurs building decentralized projects cannot scale their efforts by hiring an executive team and then recruiting VPs of each function who then all report into them, in some pyramidal structure.
Every dollar and ounce of energy spent should maximize value for the network rather than the organization.
Not only does this have implications on what kind of entrepreneurial mindset will be successful in this paradigm, but allocating capital to grow a decentralized network is unexplored territory. Luckily, tokens have proven to be very effective motivators, and even better, they aren’t constrained to people who are directly affiliated with the organization like equities are with employees.
It makes the most sense that the network should reward participants proportional to how much work they do for the network.
If we look at the growth of bitcoin and ethereum, mining was an elegant capital distribution mechanism in the early days. However, there are still some tweaks to be made to this model in that it doesn’t fully incentivize smaller players to join-in at scale. That, however, is a topic to be saved for a separate blog post…
I will preface this post by saying that this is just a hypothesis on my part, not backed by any data except for a few projects that seemed to have executed this well.
I have long believed that token offerings shouldn’t be used as capital raising mechanisms beyond after the point at which the network the team is building still benefits more from being mostly centralized, and that is perhaps only in the product development stage.
Afterwards, a well-designed mass incentive system (airdrops, mining or perhaps some other new mechanism) is more efficient for getting builders to contribute to the network. At that point, they directly benefit from the value created in the token.
In other words, if we oversimplify the value growth in a network, excluding speculative effects (in the chart below) any excess funding raised by the early team past the inflection point (especially at a premium) should represent some dead weight loss to the future network participants.
In this case, the team benefits from the token’s early price appreciation rather than the network, and the team also has to figure out how to redistribute it the capital in an efficient, decentralized way while generating returns on any undeployed capital.
One way for teams who have already gone down that path is to minimize the deadweight loss is to think of rewarding builders in terms of percentage of network rather than the value in fiat to simulate a token reward.
But, this is a little harder for pre-product networks already valued in the billions.
Still, my hypothesis does not factor in other ways to deploy cash such as pursuing biz-dev opportunities and investing in applications on top of the network.
I might argue that is potentially distracting for the early development team, though I’ll leave it as an open question whether an independent entity made wealthy from the early token price appreciation (and who might most easily specialize in these activities), might be the best entity to execute biz-dev and investing.
If we take bitcoin and ethereum again as examples, these independent entities exist and have contributed significantly to the growth of the two ecosystems.
Perhaps, I am operating with a huge VC bias, but this hypothesis seems to be playing out in the market where accredited investors continue to fund the early team and take product risk, with the public joining in later.
This is very different from even six months ago, and some of it is due to regulatory risk, while some of it is due to the market self-correcting. More so, I am seeing airdropping as a norm for the next phase of development to bootstrap an early community post-product.
Airdropping is interesting because it can represent the first stage of the mass-incentive mechanism I discussed above. The best airdropping mechanisms should both attract the highest potential value creators for the network and should be earned by its recipients.
The first point is a bit more obvious, but the latter point relates to the psychology of “free” product. Giving things away for free is good for generating trial behavior because the notion of “freeness” exciting beyond the marginal value delivered by that good.
However, it has the potential to makes people think they should get it for free forever if they didn’t do anything to earn it.
Economists have long studied the notion of freeness and endowment effects, which show us that the more work you do for something, the more you feel ownership towards it, thus the more you value it.
This is perhaps another argument for airdrops that simulate “mining” and only to a small group of hardcore HODLers who commit to doing work, rather than airdropping to every crypto-influencer in the world.
Speed on our side
A point I want to end with is that in crypto, we generally want to use financial incentives to govern what previously was governed by social incentives. I think most teams underestimate the difficulty of building a perfect financial incentive model as the possibilities for gaming the system are seemingly endless.
As soon as we introduce a financial incentive mechanism into the equation, people quickly abandon the social governance mechanism, and it is very hard to rebuild. Therefore, we should experiment but understand the risks that by adding financial incentives, some models may be broken beyond recognition.
Perhaps, we shouldn’t abandon social incentives altogether but think about how we can supplement them with financial incentives to grow the market.
Overall, I am very bullish on these experiments, because in only very recent human history, we’ve managed to build a monetary and financial system to govern most of the business world and we’ve grown our economy dramatically as a result.
Blockchain technologies will no doubt allow us to experiment and prototype new coordination mechanisms at an even faster pace.