Is fundraising with both equity and tokens fundamentally flawed?

Intro

In the ever-evolving world of crypto, fundraising methods have adapted. The most prominent emerging trends, SAFTE (Signed Agreement for Token and Equity) and SAFEs (Simple Agreements for Future Equity) combined with Token Warrants have become the go-to choices for investors.

However, a challenging dilemma arises when projects aim to appease two distinct sets of investors who have invested in different financial instruments: tokens and equity. These investors expect value accrual from the company, but ensuring both equity and tokens accrue value, without the other being impacted is no easy feat.

In response, Simplicity Group has had a number of requests from projects wanting us to create a token economy that can foster token value accrual without adversely impacting the equity valuation of the company. This presents a complex and intricate challenge, particularly as the means for the token's value appreciation cannot rely on conventional fee structures or buyback mechanisms, thereby safeguarding the equity's strength.

In this article, we will delve into this conundrum, scrutinising the viability of projects raising funds through both tokens and equity, and exploring how to balance the value accrual between these instruments.

Before we can dive deeper we must first understand tokens and equity in more detail. Namely the purpose of each financial instrument, and how they accrue value. 

Equity purpose and value capture

Equity investment involves purchasing shares in a company, representing ownership. Businesses issue shares to raise capital for various purposes, such as research and development, expansion, or growth opportunities. These shares encapsulate the overall value of the company.

Token purpose and value capture

In contrast, a token serves as a vehicle for transferring value. Tokens have multiple use cases, but at Simplicity Group we categorise their purposes into four key areas*:

• Decentralisation: Tokens can facilitate the decentralisation of a company from third-party influences, mitigate counterparty risk, and offer greater fiscal and monetary policy control.

• Web3 and Community Control: Tokens can empower community control and align incentives for users, fostering a sense of ownership within the ecosystem.

• Derivation: Tokens can represent various financial instruments, making it easier to tokenise assets, provide liquidity, and streamline administrative processes.

• Transfer of Data Tokens can share data much easier, and the possibility of zero knowledge data sharing

_{*there are exceptions}

Whilst the purposes of a token define why a token should be created, they do not define how a token can capture value, at Simplicity Group we’ve found 5 clear routes for a token to capture value, as shown in the table below:

Possible Solution

The first proposed approach appears to present an easy solution. It involves tokens being issued directly by the company, here the tokens would be considered the property of the company, and their value would be integrated into the overall equity valuation. However, implementation of such a solution is unviable due to the legal risks with issuing a token. As such most tokens are issued by a token issuance company. 

Another key challenge with this approach is that as the token supply becomes more decentralised, the tokens transition from being owned by the company to being held by token holders. This shift in ownership dynamics complicates the relationship between token value and equity value. If the token captures value in a manner that overlaps with the traditional mechanisms for equity valuation, it could potentially lead to a situation where equity holders miss out on the appreciation in token value.

Therefore, this can be considered an inadequate solution, and we must find a better solution.

Token Economy Design Solution

Designing a token economy that enhances value without undermining a company's equity valuation poses distinct challenges. Some traditional utilities must be reconsidered:

• Tokens shouldn't be used to cover fees; this can lead to potential revenue loss for the company.

• The company's revenue must not be channelled to repurchase tokens or distributed to token holders.

• Tokens shouldn't grant governance rights affecting the company's day-to-day operations.

Despite these constraints, there are still innovative ways to craft a thriving token economy. One promising avenue is the creation of a derivative market centred on the token, running parallel to the main business. Let's say your primary business revolves around verifying the authenticity of luxury watches. Imagine a complementary market where users invest in a pool, forming an index of authenticated watches. Here, token holders can partake in governance, selecting watches for the index or determining which pools earn rewards. Users would require tokens to participate in this pool.

Through this structure, the token garners value from the derivative market, while the core business retains its inherent value proposition, ensuring that the equity continues to reflect its true worth.

Once you have a functional business, it is easier to implement a token that either improves the core business proposition or creates a parallel value proposition that does not reflect on the core business.

Spanner in the works: price vs value

We have discussed how to design an economy that allows for token value accrual without impacting equity value, but does this actually resolve the problem? The heart of the challenge lies in the imperative to satisfy two distinct groups of investors. But what do investors truly desire? The simple answer is a return on their investments. The measure of return on investment (ROI) hinges on the price of both shares and tokens. So the question at the root of the problem is how is price determined?

In the realm of traditional equity, the process of assigning a price to shares aligns closely with the actual underlying value via arbitrage - users buy and sell shares when they see the price mismatching the value. Various valuation methodologies, such as Price to Earnings (P/E) ratios, Discounted Cash Flows (DCF), and the Discounted Dividend Model, offer robust frameworks for determining the value of shares. Due to this arbitrage occurs to ensure value is reflected in price.

Conversely, in the landscape of cryptocurrencies, valuing tokens presents a challenge. Notably, there are no universally accepted industry standards for appraising tokens, amplifying the complexity of the task.

Furthermore, the market value of tokens often deviates significantly from their intrinsic value, introducing a substantial disparity. A multitude of factors, including liquidity manipulation, the influence of market makers, and strategic token lockups to control supply, all contribute to this divergence between the perceived value and the actual price of tokens when compared to equity.

Arbitrage still occurs over time to bring the price closer to the perceived value, but in crypto this is a process that’s easy to manipulate due to the factors mentioned above.

In essence, the goal of the projects facing the conundrum isn’t to allow tokens to accrue value but instead to ensure the price of the token goes up.  

Token economy design to increase price

From an economy design perspective, there are four main ways we can increase price.

1. Contractionary Monetary Policy:
a. Reduce Unlocks: Implement dynamic or variable vesting schedules to slow the release of tokens into the market, reducing the supply over time.
b. Limit Tranche Selling: Implement measures to limit the volume of tokens sold at any given time, preventing oversupply in the market.
c. Buybacks (and Burn): Employ a mechanism where the project buys tokens from the market and subsequently burns them, reducing the circulating supply and potentially driving up the price.
d. Increase Interest Rates: Create opportunities for token holders to earn higher returns through staking, lending, mining, or other mechanisms, which can incentivise holding and reduce selling pressure.

2. Contractionary Fiscal Policy:
a. Increase Taxes/Fees: Introduce higher fees or taxes on transactions or actions within the ecosystem, reducing token circulation and potentially increasing scarcity.
b. Locked Actions: Encourage token holders to lock their tokens for specific actions, such as governance participation or lending, restricting the available supply for trading. 

3. Marketing:
Effective marketing strategies can stimulate demand for the token. This includes building a strong brand presence, conducting targeted promotional campaigns, and fostering a sense of community and utility around the token.

4. Increase Pair Liquidity:
Enhancing liquidity by pairing the token with other assets on popular exchanges can facilitate easier trading and potentially reduce price volatility. A more liquid market often attracts more participants, which can positively impact the token's price.

To safeguard the equity value from potential dilution by the token, certain measures such as initiating buyback and burns or elevating taxes/fees are not viable options. However, through astute economic design, it is possible to enhance the token's price without compromising the equity valuation, ensuring a balanced approach.

Conclusion

Overall, it is feasible to design a token economy that promotes the appreciation of token value without negatively affecting the company's equity valuation. From an investor's perspective, this makes dual investment avenue structures appealing, risk is mitigated for those confident in the company's operational prowess. Furthermore, it grants investors the flexibility of a liquid asset through the token, paired with the opportunity to hold a share in the company's equity, striking a balance between liquidity and ownership.