One of the most important questions in evaluating a token sale is “What is the role of the token being sold?”
Often, answering this question is not easy. Tokens can be designed to perform a variety of different functions or grant holders a wide array of privileges. This diversity distinguishes investing in token sales from buying more traditional stocks and shares. Understanding token function is an important prerequisite to understand blockchain products, assess potential investment opportunities, and evaluate the sustainability of token economies.
In this memo, we propose a framework for characterizing tokens in token sales.
Tokens are not like company shares: they are much weirder
Investors familiar with traditional financial markets think of investing as acquiring a share in a company: shares provide holders rights to dividends and (usually) voting rights on major company decisions.
Given the language around ‘market capitalization’ and ‘token price,’ the comparison between tokens and shares is understandable. It is also wrong.
Tokens sold in crowdsales are different from company shares in a number of ways. First, most provide no voting rights at all. Even when tokens do entitle holders to a portion of profits, the amount distributed is calculated via algorithm: token holders don’t debate whether to distribute dividends and how much. Additionally, unlike shareholders, token holders have no legal rights and no obvious avenues for legal recourse. Finally, many tokens don’t involve profit distribution or group decision-making at all.
Even “app-coins” and “utility tokens” vary widely in their purpose
The industry has begun adopting the terms “utility tokens,” “app coin,” and “protocol tokens” to describe tokens that are particular to a certain application or platform. While these ‘utility tokens’ share similar characteristics, their use in practice can be extremely diverse.
Here is a list of tokens that have been called “app coins” in one place or another.
In many ways, it does make sense to group these tokens into one category. Launching an app-specific token presents a challenge shared by all the app developers: how to design a sustainable token economy. It certainly isn’t easy. It also presents a challenge shared by all users: how to manage a portfolio of tokens specific to one or a set of applications.
The “app-coin” nomenclature also also groups together tokens that themselves do many different things--things investors themselves often don’t realize.
Tokens give different types of (non-legal) rights or functions
Instead of categorizing tokens into mutually exclusive groups, Smith + Crown finds that tokens tend to confer holders with different rights, and individual tokens can confer multiple types of rights. These rights aren’t legal rights, though there may be enforcement mechanisms depending on the situation, but they are rights on the platform itself. One can also think of them as ‘functions.’
Tokens with this right entitle holders to a portion of fees or profits from using the network. This is similar to a company stock, though these do not necessarily give voting rights: for example, token holders of ICONOMI can’t fire the ICONOMI CEO or demand different kinds of dividends. Holding the token simply gives the owner a portion of fees.
Advantages: The token value is easy to understand, easy to estimate, and doesn’t require the design of a token economy. There is also a clear relationship between growth of the platform and growth of the token’s value.
Disadvantages: Such a token design usually builds a community of investors but not necessarily of users. In addition, such tokens seem in need of regulatory guidance regarding prevailing securities laws (in
Tokens with this right entitle holders to influence the direction of the platform or protocol: vendor selection, additional features, even some basic protocol decisions. This is a basic feature of Distributed Autonomous Organizations (DAOs), like DigixDAO and TheDAO. (However, there are reasons to exclude The DAO as an “ICO,” since tokenholders technically still had control over their tokens: they were not given to a third party who independently spent them.)
Advantages: Governance rights can help build community, because token holders can be participants in the governance process.
Disadvantages: There are few working examples of governance tokens. The effort suffers from poor UX and low levels of engagement among token holders. There are also few guidelines about how, how often, and about what decisions to consult token holders. Developers risk expending precious resources managing this community or being accused of deceiving token holders if there are no opportunities to exercise these rights.
The most common type of token with this right is any token in a proof-of-stake system: tokenholders can become block validators with their chances roughly equal to the balance of tokens. Participating in this type of consensus process involves running software of some kind. Ethereum is currently secured via proof-of-work, but in the future, it plans to shift to proof-of-stake. We define this right broadly to include not just when the token itself gives the holder the right to create blocks but also when the holder can pick who makes the blocks. Lisk, for example, has a delegated proof of stake system in which token holders can vote on consensus nodes, and their vote is weighted by their Lisk balance.
Advantages: People understand staking and can make estimates of their return.
Disadvantages: People don’t always stake their tokens, stakers aren’t necessarily users and excessive staking could reduce transaction volume on the network. It also requires the launching and maintenance of a new blockchain.
Many tokens allow holders to play some kind of role in maintaining the network that doesn’t involve creating blocks for a blockchain. These rights are also not ‘governance’ rights: they don’t determine the overall direction of the platform or features of the protocol itself but instead are actions on the platform about specific users.
Exercising these rights often involves human decisions not just background software. In First Blood, for example, token holders can serve as Witnesses; instead of creating blocks, they run software to support the network. They also serve as Jury Members to adjudicate in the case of disputes—manually reviewing evidence and making a human decision in the process. Token holders are usually entitled to either a portion of token inflation, a portion of network transaction fees, or both.
Advantages: The token sale distributes tokens directly to users, and as a result, the token sale / ICO builds the community at the same time. It is also easy to understand how value generated on the platform flows back to people holding the rights to earn it.
Disadvantages: Raises the barrier to participation and could centralize core network maintenance activities in a small group of dedicated people with the time/resources to participate.
Some tokens are simply the sole means of payment for a platform or service. In short, to pay for any services on the platform, one needs the native currency.
Advantages: Creates a clear use case for the token and seeming more like a currency than an ‘investment contract.’ It’s also very very easy to do and requires no crypto-economic design.
Disadvantages: Creates balkanized services each with native currencies that can wildly fluctuate in value—people often criticize this with the rhetorical question, “what if we needed a different volatile currency for each company we purchased from?” Projects also open themselves up to competition from projects that offer exactly what they are offering but also allow other forms of payment: in order words, competitors can compete solely on means of payment. In most cases, having a native means of payment doesn’t introduce meaningful features beyond simply accepting ETH or BTC.
Tokens can also play a role of being needed to access the network and pay transaction fees. It’s not the sole means of payment—other currencies can be used—but small amounts are needed to use the platform at all. In some ways, Ethereum and all platform blockchains are like this: the native cryptocurrency is just needed to pay gas fees, but people can still transfer (and pay with) meta-tokens. Another example is Melon, which accepts multiple forms of tokens as payment across the network but which also requires that transaction fees be paid in Melon tokens.
Advantages: Gives maximum flexibility to the platform to accept multiple means of payment..
Disadvantages: The sum total of transaction fees is generally much less than the sum total of payments that flow through the platform, and it seems unlikely that the need to purchase the token in order to pay fees will add up to much fundamental token demand.
There are other rights that we looked at that didn’t quite fit into the above typology but also weren’t quite a category on their own. For example, Synereo’s AMP token will be used to amplify content across the network. It doesn’t give profits to holders. Holders don’t have a say in governance. It’s unrelated to maintaining the network or creating blocks. It’s not a necessary transaction fee, and it’s not the only way to transfer value in the network. It is in its own category. Smith + Crown will be exploring these other tokens in future publications.
Rights in Token Sales
We evaluated every major token sale in our database before March 2017 and coded the tokens into their respective rights.
Source: Smith + Crown analysis. Includes all ICOs that ended between 2013 and March 1, 2017, and that raised over $30,000 USD. Tokens can have more than one right.
- Perhaps unsurprisingly, the most common rights that tokens confer are access and payment rights. These rights provide an easy and obvious use case for a new currency.
- Block creation rights come third. This speaks to the rise in the popularity of Proof-of-Stake consensus mechanisms, even while meta-tokens are also becoming more popular.
- Governance and contribution rights are the least common. These rights are typically connected to complicated organizational structures and nuanced token economies. Projects that have these types of rights are difficult to design and harder for ICO participants to understand.
Moving forward, we will distinguish in our ICO profiles what rights the token actually confers. We will also be publishing some analysis looking at the relationship between different token rights and the success of their sale.