Michael Kogan

@mkogan4

ICO Analysis: Shitcoins or Real Investments?

ICOs have quickly grown to rival early stage venture financing in 2017. How should investors think about this new asset class is a question I personally find fascinating. My fascination stems from the fact that this phenomenon is both a real revolution with enormous potential and an irrational bubble, a kind of “irrational exuberance of shitcoins”, to paraphrase Mr. Greenspan’s famous reference to the 90s stock bubble.

The theory behind investing in tokens goes something like this: in the past, developers of protocols, such as TCP/IP, UDP or HTTP had no direct way to monetize their inventions and no direct economic incentive to innovate on their creations. Cryptocurrencies, such as Ethereum, which support creation of smart contracts, change this paradigm. By issuing a token which fuels the protocol, developers can monetize their creations through the appreciation in the value of the token, which happens as a result of increased usage of the protocol. Ethereum itself can be thought of as an example of this thesis playing out in the real world. Bitcoin can be thought of as analogous to gold in terms of its place in financial portfolios, meaning, it is a reliable and efficient store of value uncorrelated to traditional equity and fixed income investments. Ethereum then can be thought of as oil — the fuel that underpins the smart contract ecosystem. The question is, how do we value this ecosystem. How should investors separate wheat from the chaff or real tokens with serious upside potential from shitcoins? What follows is not a legal analysis of whether or not tokens are securities or should be treated as such. As an example, one can analyze whether or not rare Swiss watches are a good investment from economic point of view, but they are clearly not securities in a legal sense.

Let’s examine token value from the point of view of token issuers. Startups often run out of money and need multiple rounds of financing. Every equity financing round dilutes the percentage ownership of the founders. Therefore, ceteris paribus, it is clearly in the founders’ interest, at least at the earliest stages, to either raise money from friends and family on less onerous terms than traditional VC rounds, or subsist using their own resources, be it credit card debt, personal funds, loans or other means. Issuing tokens, in this context, creates an appealing alternative. Since tokens, at least in the form they are currently being issued, are not equity ( one could certainly do equity issuance using blockchain, but that is a separate discussion ), the ownership dilution does not take place. Therefore, startups that have a reasonable chance at raising financing through tokens, should at the very least give the possibility some serious thought.

Startups should issue tokens, if they can and when it makes sense, but why should investors buy tokens? What are investors buying, when they do, not in name, but in substance? Let’s assume that a token is necessary in order to power some sort of network or protocol, or a decentralized system. The entity issuing the token in expectation will earn revenue either directly from the token facilitating transactions on the network, and collecting fees for those transactions, or, indirectly, from the appreciation of the token. Therefore, the token can be thought of as an option on the future value of the network, or an option on the revenue of the entity issuing the token. Clearly, this option value is also an idiosyncratic bet on the team behind the project. From the point of view of users of the network, the token should represent value which could not be easily converted into a liquid asset by means other than token creation. Since introducing another currency increases overall transaction costs ( due to the necessity of two way conversion from the new currency to major currencies), it must be the case that efficiency gains clearly outweigh this increase. This is important because the value of the network is a function of how valuable it is for the users of the network.

Using the above principles, we can examine whether specific tokens make sense as investments. Let’s take Filecoin, one of the most successful recent ICOs. Participants in the Filecoin ICO ( or, more specifically, SAFT ), purchased an option on the value of decentralized storage plus some additional optionality embedded in the technology behind filecoin that could theoretically power a different compute resource network. This option has a high chance of expiring worthless, but it also has reasonably high potential upside, making it a reasonable addition to a well diversified portfolio of assets. While it is possible to trade storage using existing currencies, the filecoin token creates, at least in theory, a liquid commodity that explicitly reflects value of storage.

In contrast, KIN token, issued by the company behind the KIK messenger, has no such properties. Specifically, it is entirely unclear why the same objectives, as outlined in the KIN whitepaper, could not be accomplished more efficiently with one of the existing crypto or fiat currencies. Therefore, it is not likely that there are any advantages in introducing a new KIN currency, which can make up for the expected increase in transaction costs.

To summarize, tokens are effectively options on the future value of the network and also options on the future revenue of the entity issuing tokens and should be valued accordingly. Metcalfe’s law states that the value of a network is proportional to the square of the number of connected users. In order to maximize the value of the network, startups should consider airdropping free tokens in order to immediately seed the network with as many users as possible, or at the very least ensuring as wide as possible participation in the token sale, to maximize initial network size.

In conclusion, it is possible to price tokens using tools available to us from traditional finance and systematically distinguish shitcoins from tokens which can have real value.

please go to www.mtoken.io to register for a free ERC-20 token airdrop.

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