Capitalism and Investing
The unique, historical innovation of Capitalism has been its take on ownership of capital. Capitalism is built on a system of property rights that allows capital to be accumulated, owned and deployed by individuals or corporations for profit. This combination of capital, property rights and animal spirits has unleashed tremendous productive energies that have reshaped the world in the last 300 years.
In the 1960s Venture Capital emerged as a new asset class designed to find entrepreneurs building big businesses and give them the capital they needed to get there — and make a healthy return for everyone in the process. Venture Capital has been focused on equity investing historically. Investors make investments in return for equity in the company — a percentage ownership of the company. Equity investments — through preferred shares — afford investors several important rights including:
- Information Rights
- Liquidation Preference
- Board Seats
- Pro Rata Rights
These rights help both protect an investor and their capital and entitle them to a say in the company’s trajectory. An investment creates a partnership between entrepreneur and investor, and ideally, a partnership where they are both aligned on the goals and mission of the company.
But are token holders entitled to rights as well? If so, what might those rights look like? ICOs usually happen at the earliest stages of the company, and while in many ways they resemble going public, ICO fundraising is similar in function to pre-seed to Series A fundraising in enabling a company to build out the core product and team. One of the main differences is that in traditional pre-seed and seed rounds entrepreneurs sell anywhere from 15% to 25% of their company. In contrast, ICOs involve selling 50% — 75% of the tokens on the network.
Tokens are distinct from equity shares in two important ways: utility and liquidity. Most tokens are so-called ‘utility’ or ‘platform’ tokens which means they are designed for use on a specific platform offering a specific good/service. Thus, a token enables its owners to access a good/service it otherwise would not be able to (or would not be able to at that price point). Equity shares don’t really have an equivalent function. Similarly, tokens are highly liquid. Post-ICO a market is immediately created for the tokens and you can flip them immediately if you like. Equity from venture capital investments don’t become liquid till a company goes public on the stock exchange, and even then, there is a holding period.
What is particularly interesting about tokens is that they are “basket securities.” Most protocols that are released are designed to allow other developers to build applications on top of them. Thus, the value of the token that corresponds with that protocol will in part depend on the popularity and usage of all the applications built on the protocol layer, not just the application built by the company that released the protocol. Tokens then operate similarly to index funds in that they track the “overall value” of the economic activity on that protocol.
While 2017 was the Wild West of ICOs, 2018 looks likely to be the year that regulation is put into force. According to the SEC — and now most regulators worldwide — tokens for the most part look and feel like securities.
“A change in the structure of a securities offering does not change the fundamental point that when a security is being offered, our securities laws must be followed.”
“By and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”
Part of the maturation of the ICO as a fundraising mechanism will be the establishment of frameworks for what rights token ownership should afford investors. Ideally the market will self-regulate and create these frameworks, but if the market fails to do so then regulators will step in.
Governance in the world of Blockchains has two senses: the incentive structure and design of the protocol and the mechanisms for coordinating change and evolution of the protocol once it is out in the world. The following rights span both senses of governance. The design of the protocol and its future mechanisms for coordination are deeply interrelated.
Models for Token Rights
Utility rights by themselves are insufficient to justify a token’s existence. It also seems counterproductive from a business sense. Why create a token that intentionally adds friction to accessing your good or service, when accepting USD would operate equally well? While companies can stand to gain from the appreciation in token value, this is far from guaranteed. Instead, here are some preliminary token rights that justify a token’s existence.
Block Creation Rights
Much has been written on how expensive proof-of-work systems are for achieving consensus in terms of electricity. A switch to proof-of-stake is a logical improvement but doing so requires that a protocol has tokens. The DFINITY protocol for example is designed in this way. A holder of 10% of the tokens is able to validate transactions on the network in proportion to this stake.
An interesting variant on this model is the Komodo Protocol. On the Komodo protocol 64 Notary nodes handle Bitcoin blockchain notarization. These 64 nodes are elected by Komodo coin holders. Token ownership thus grants holders the right to play an active role as a validator in the network.
A second model could offer investors information rights once they hit a certain threshold of token ownership. How this threshold could be calculated is open to different approaches. This right aims to supply major investors during or post an ICO with additional information around the state of their investment. Over time these major holders would likely liquidate their positions and fall under the threshold, which would likely lead to no token holders eventually holding enough of a position to entitle them to information rights.
A different approach would be to grant every investor in the ICO information rights for a limited period of time post-ICO.
Blockchains have enabled digital autonomous organizations to be created and tested for the first time. But, as with any decentralized community, governance is a crucial factor in determining the long-term health of the community. As decentralized communities, the long-term health of a protocol depends on the strength and engagement of its network of users. Such governance rights are a basic feature of Distributed Autonomous organizations. While few successful examples exists to-date, governance is something that will increasingly become important as protocols mature and seek to evolve.
The networks of users around a protocol are analogous to opensource communities in their function, and the most successful opensource projects are usually the best governed. Tokens offer not only a potential reward mechanism for contributions, but also a potential voting mechanism.
Pro Rata Rights
Investors in an ICO could also be entitled to pro rata rights in a follow-on token sales. This could be structured like traditional pro rata rights for equity investments — which allows investors to invest an amount that maintains their ownership — or perhaps allowing ICO investors to invest the same amount of dollars they put into the initial ICO.
Potentially such pro rata rights could be expanded to include other applications built on the protocol, which would make it an extremely powerful right for investors — especially for protocols that are successful.
2017 showed the tremendous enthusiasm for ICOs from both the entrepreneurial and investing communities. It is a disruptive alternative to private markets and public markets and a hybrid that could potentially bring together the best of both worlds. But the ICOs after regulation comes into place may look dramatically different from what we saw in 2017.
It is in the best interest of the protocols as well as investors for frameworks around token rights to begin to emerge — both for the long-term health of the protocols and the long-term viability of ICOs and a fundraising mechanism.