I’ve been at a few events recently where people talk about the “market cap(italisation)” of utility tokens issued in ICOs, and comparing them to the market cap of cryptocurrencies or (even worse) listed companies. This is truly dreadful and misleading, perhaps sometimes intentionally so. In this post I introduce two useful metrics for comparing across ICOs: the Reserve ratio, and the Commitment ratio.
For a non-hypey introduction to ICOs please see A gentle introduction to ICOs.
Market cap is a term borrowed from traditional finance, and for a company, it means the number of outstanding shares multiplied by the share price of a single share. It’s the current total value of the company. It represents the current theoretical “fair” price of the company should all the current owners sell it to buyers who want to buy it as much as the sellers want to sell it (though in reality one side always wants to do it more than the other side, so the price achieved is pretty much never the market cap).
When this term is applied to pure cryptocurrencies (Bitcoin, Ether, etc), it kind of makes sense. It’s the total value of the cryptocurrency that exists. In theory, if you wanted to buy all the BTC in the world, and the current owners equally want to sell all the BTC in the world, and they want to sell it to you as much as you want to buy it from them, the market cap is the number of dollars that would change hands for the transaction. In practice that wouldn’t happen, as the situation won’t arise and there are other complications such as lost or immoveable coins, but you get the idea. It’s far from perfect, but it kind of makes sense.
But what about market cap of utility tokens?
Remember the first rule of issuing ICO tokens: Tokens aren’t securities. Tokens aren’t securities. Tokens aren’t securities. Tokens aren’t securities. Tokens aren’t securities. Tokens aren’t securities. Tokens aren’t securities. Tokens aren’t securities. Tokens aren’t securities. Tokens aren’t securities.
And remember the first rule of buying ICO tokens: I’m not expecting profits from the efforts of others. I’m not expecting profits from the efforts of others. I’m not expecting profits from the efforts of others. I’m not expecting profits from the efforts of others. I’m not expecting profits from the efforts of others. I’m not expecting profits from the efforts of others.
Is the “total value of utility tokens issued” a useful metric? Does it tell us anything about the health of the ICO issuer? What does it tell us, really?
Tokens vs issuers
Firstly we have to differentiate between the tokens and the issuer. The (badly-named) “market cap” of the tokens is the total value of tokens created/issued. The (actual) market cap of the issuer is the issuer’s share price multiplied by the total outstanding shares it has issued – it’s got nothing to do with the tokens. Make sense? …But that’s not quite how ICOs work. Usually the issuer of the tokens is a foundation, set up in Zug in Switzerland or Singapore. A benefit of having a foundation to issue tokens is that a foundation isn’t a company and doesn’t have a shareholder structure, so it’s harder to say that the tokens are shares (remember the first rule of ICOs): “It’s a foundation, how could the tokens possibly represent shares?”.
So, there’s another entity – the operating company. This is the for-profit company that has shareholders (founders, VCs, etc) and receives grants (payments) from the foundation in return for meeting certain goals, usually milestones in the development of the product or service, which is usually software based.
So to summarise, the foundation (with no shareholders) issues tokens (not shares) in return for cryptocurrency (usually BTC or ETH), then sometimes sells that cryptocurrency for fiat to get some financial stability, and pays (grants) the cryptocurrency or fiat to the operating company who pays staff to develop software that is later used by token holders. Token holders (not investors or shareholders) redeem their tokens for access to unspecified amounts of product or service, if they haven’t already sold their tokens first to other people who presumably want the unspecified amounts of product or service more than the original holder.
The meaningless market cap
So, token market cap… what does it mean?
Firstly, anyone can generate however many tokens they want (say, 1 trillion tokens) and then sell 1 token to a complicit friend for some nominal amount (say, $1) and create $1 trillion of market cap. You can own zillions of market cap in this way, if you want. Journalists and news reporters love this because they get to say big numbers and compare them to actual market caps of real legitimate companies, like Uber and Tesla(!).
So already we can see that market cap is an easily manipulated figure. So some of the more ethical (?) cryptocurrency lists will only include ICOs whose tokens are trading on legitimate (?) exchanges, and with a minimum threshold of daily average volume (say $10m of trading per day). So at worst it’ll cost you a few thousand dollars a day in exchange fees to maintain the illusion of a high market cap.
Utility token market caps are also a terrible, almost meaningless, way to compare ICOs. Can we do better?
How can we do better?
Remember, ratios are good ways to compare across companies or projects, to see if any are “good value” or “out of whack” with others. Market cap isn’t a particularly good number to compare, so what can we look at?
Financially, it’s helpful to think about who holds what immediately after the ICO / Token Generation Event / Voluntary Donation Scheme:
- The public (or self-declared accredited investors) has tokens that they have been promised will be redeemable for unquantified products or services some time in the future.
- The Foundation has money in the form of cryptocurrency – this is proceeds (donations!) from the token sale. This can be converted into fiat immediately or later.
- The Foundation usually holds back some tokens to incentivise the community or do something with later.
- The Founders usually give themselves and sometimes advisors some tokens for free (presumably the founders and advisors have a great future need for unquantified amounts of the product or service)
So the tokens in circulation are a kind of liability to the company. The company has promised to deliver to the token holders some unquantified amount of goods or services in the future. The more tokens out there, the more value the company is on the hook to deliver. Surely a high token value then is a bad thing – isn’t it a burden on the company? Isn’t a company that is on the hook to deliver $100m of value more precarious than a company on the hook to deliver $10m of value? Well, not really – just like other crowdfunding, the company hopes to make a profit by selling the product for more money than it cost to create the product. So the company pre-sells the service for $25 and the service only costs the company $10 to provide. So a bigger number here in general is better.
But some tokens are issued but not in circulation, eg those held back by the foundations. They aren’t waiting to be redeemed, they are assets to the project (the project being collectively the company and the foundation). So there are a couple of metrics it might be helpful to look at.
The Reserve ratio
The first useful metric might be the ratio of tokens reserved for product development (which are assets to the project) vs tokens that are out there in circulation (which are kind of liabilities to the project). Tokens held by founders or angels should be considered on the liability side. We can call this the reserve ratio and it provides the project some level of insulation to the fluctuating market price of their token.
The Reserve ratio
No. tokens retained by project : No. tokens in circulation
This tells us how insulated the project is with regard to price changes of their tokens. A higher number indicates that the project is more insulated against price moves. If the value of the tokens rise suddenly, a project with more tokens held back will have a larger warchest to deliver the greater value demanded by the external customers.
This metric should be known when the ICO closes and shouldn’t fluctuate with token price. It might change over time as the project releases more tokens or buys back tokens in circulation.
The Commitment ratio
A second useful metric is related to how much value the project has committed to deliver vs how much capital the project has with which to deliver it. This tells us how much value each dollar of working capital has to create to satisfy the token holders. A lower number can be regarded as safer as there is more working capital available to deliver less commitment to the token holders.
The number of tokens in circulation and amount of funds raised/donated is usually disclosed when the ICO closes and sometimes pre-determined in the whitepaper/plan, though we can never tell really who owns the tokens that were sold in the presales and public sales – potentially some of it is bought by founders or the company itself as part of the hype cycle in order to create the illusion of success.
There is an unhedged and fully hedged version of this metric.
Token redemption value : Capital raised (hedged / unhedged)
Redemption value is the current market value in USD of the tokens in circulation (that is, excluding tokens held back by the project, founders etc).
Capital raised (hedged) assumes that the cryptocurrency raised in the ICO was completely sold into fiat immediately, ie it is the USD value of the cryptocurrency raised at the time the ICO completed. (this number does not change)
Capital raised (unhedged) assumes that the cryptocurrency raised in the ICO was not hedged at all, ie it is the current market USD value of the cryptocurrency raised at the time the ICO completed. (this number changes as the price of BTC and ETH changes)
You can create a 50% hedged metric (or any other ratio) too which is probably closer to how projects manage their capital raised.
The Commitment ratio changes over time, as it is linked to the market price of the tokens. It gives us some idea of how hard the working capital has to work to keep the token holders happy. We may see commitment ratios emerge for original token holders (the original token price) and current token holders (based on current market price) – they paid different amounts for their tokens so they demand different amounts of value back when redeeming.
Are these any good?
These are not perfect metrics by any means, but they are certainly better than market cap, especially for comparing across projects. Remember that value of the tokens in circulation is just the minimum amount of value the company has to deliver to keep token holders happy (and the project is not under any obligation to keep token holders happy! They are not shareholders!). And of course the company doesn’t simply shut down once all the token holders have redeemed their tokens. That would be silly. I would imagine that the project recycles the tokens and keeps delivering value. When the service is up and running, if the value of the token is $10, then a customer redeems 1 token to the company for $10 worth of service, the company can then resell that token back on an exchange (and realise the $10 and use it to pay staff), then the token is back in circulation again.
But these metrics provide something more meaningful than just token market cap, with which to compare across ICOs. A friend commented today that it would also be useful to look at the lock-up characteristics of the issued tokens. What proportion of tokens can be liquidated at short notice, and how does this change over time? Some projects stipulate that founder have a lock-up project, whereas others don’t stipulate this, making it easy for a founder to do a quick exit scam.
Who controls the price of a token?
The simple answer might seem to be “the market” or “buyers and sellers”, but this is not helpful or accurate. Sure, while initially the quantity of goods/services that the tokens can buy is unspecified (which is almost always the case in ICOs), the price of the token is subject to normal cryptocurrency market forces, and there is no way to do fundamental analysis on what a fair market price should be: you can’t price “cloud storage” without quantifying how much, for how long.
But there comes a point when the project has to make a decision: Do they set prices in USD or in tokens? Should 1 GB of cloud storage for 1 year cost $10, payable in tokens at market rate, or should 1 GB of cloud storage for 1 year cost 1 token?
Let’s explore the options:
1) Priced in USD, paid in tokens
If this is the case, then at first you’d think that the price of tokens should be irrelevant. Customers hold USD, then when they want to use the service, they buy the tokens then quickly redeem them. This is the reasoning that “bitcoin for remittance” companies use when they say that the price of bitcoin is irrelevant to their business.
If this is the case, are tokens a good investment? (Note: Tokens are not securities!) Perhaps. As tokens are redeemed, there are fewer and fewer of them in circulation so long as the project does not re-issue them to get back the USD to pay their staff. Fewer tokens may mean a higher price due to scarcity. So a project in good financial health, who isn’t reliant on reselling their tokens to pay their costs, can create scarcity in the tokens, meaning that token holders see a rising price. Perhaps. But a project in poor financial health will need to keep reselling their tokens to cover their costs. So actually, we see that the price of the tokens are related to the financial health of the company (but remember tokens are not securities!).
2) Priced in tokens, paid in tokens
This is wonderful – if the company sets the price of the goods or services in tokens, the company has pretty good control over the market price of their tokens (kind of like an airline controls the value of air miles). How? Imagine there is an equivalent service operated by a competitor, priced at $10. The project can use this to anchor the price of their tokens. They set their price to 1 token, which effectively pegs the price of a token to $10. A rational customer will pay up to $10 for a token (usually slightly less because the usefulness of a token is less than cash). If tokens are on the market for more than $10, then it makes sense to sell your token for say $11, and spend $10 with the competitor, and pocket the $1. If the project wants the value of the token to go up, it increases the amount of service you get for 1 token, then people will pay more than $10 for this token. Want to double the price? Sell twice as much service for 1 token.
If this is the case, are tokens a good investment? (Note: tokens are not securities) Probably. The founders of the project, provided they haven’t done a quick exit scam, also hold tokens and are financially incentivised to keep the price of tokens high.
So projects have more control over their token price if they price their services in tokens, so I would expect that as projects come to maturity, we will see projects price in tokens, at or above market price, providing that they haven’t all been shut down for violating securities regulations first.
As the market evolves and matures, we will need new metrics and ratios to compare across ICO projects, just as we have price/earnings, working capital, debt/equity ratios etc in the traditional equities world. In this post I have presented are just two that are applicable to ICOs and tokens, and can be used to compare across projects, and I expect many more will emerge.