Token value drivers

Can we determine the fair value of a token?

Some people would argue that the only way to do this is by listing the token on an exchange and letting market discovery take care of it. Others have come up with analytical approaches for determining the token value such as the quantity theory of money and other approaches. You can check out my article on the various ways to value a token in case you are looking for a summary on the topic. As it turns out there are several approaches to doing so, however before that we need to determine what is the major driver behind the value of the token. You can think of this as determining the real-life value and utility of the token. Almost all projects associate their token value (explicitly or implicitly) with a stream of payments – either the turnover of on a platform, the revenue of the said platform or its free cash flows. To illustrate this better, let’s consider an example.

The setup

For the purpose of comparison, we will use a fictitious business – an online platform for bread delivery. It would use its own native token – the BreadCoin. The setup of the platform is as follows:

The platform connects local bakery stores with potential customers.
The platform does not sell bread on its own, but only facilitates the transactions.
In order for a bread selling company/store to be listed on the platform, it pays an annual fee of 100 USD
The platform takes a 5% fee for each transaction.
Annually 1 000 000 loaves of bread are sold on the platform, by 1 000 different bread companies, at an average price of 2 USD per loaf.
The annual expenses for running the platform are 100 000 USD.
During the ICO/STO, the company is looking for 100 000 USD investment in order to build the platform. They offer 500 000 bread coins @ 20 cents each.

Scenario 1: BreadCoin as currency

This model is used by over 95% of ICOs, but also is the one subject to the most critique. The basic setup is that everything on the platform needs to be purchased with BreadCoin. This works out to:

Sales of bread: 1 000 000 x 2USD = 2 000 000 USD
Fees for sales: 2 000 000 x 5% = 100 000 USD
Company subscriptions: 1 000 x 100 = 100 000 USD

Or the total transacted volume, which needs to be facilitated by the Coin is 2 200 000 USD. In turn, there are 1 001 actors on the market (the bread companies and the platform) which have interest in cashing out the coin for USD. This creates a situation, where the value of the coin is governed by the total transacted volume and the velocity of exchange (see Quantity Theory of Money).

The major problem here is that during the ICO, the company is essentially raising money to build the platform, but selling you someone else’s bread production (rather than a platform native feature). What is more, this bread is not owned by the platform itself, but by 3rd party participants (the bread companies). Essentially the platform is selling someone else’s product. The reason why this model works is:

As long as the sales on the platform are growing – everyone is happy. After the 3rd party company receives the BreadCoin it can re-sell it for USD to another customer, who in turn would purchase some other company’s bread. As long as next year there are more bread sales than the current year – the value of the coin will increase and everyone will profit.
The risk is shared among all participants on the platform, pro-rata to their vested interest in the platform. In essence, the platform has 200 000 USD worth of risk and the bread companies have 2 000 000 USD worth of risk.

The obvious issue here is that, as soon as the platform has a down year, people start losing money. Depending on the severity, people might start mass selling their token, driving the price in a downward spiral, from which recovery would be very hard.

Scenario 2: BreadCoin as access/coupon token

This model is rarely used, although it is considered one of the most stable ones, and was actually referred to as a viable ICO model by Vitalik Buterin (Ethereum’s chief scientist and co-founder). In this scenario, only fees on the platform are payable in BreadCoin, while all other transactions are settled in another currency. This works out to:

Fees for sales: 2 000 000 x 5% = 100 000 USD
Company subscriptions: 1 000 x 100 = 100 000 USD

Or the total transacted volume, which needs to be facilitated by the Coin is 200 000 USD (only 9% vs Scenario 1). There is only one actor on the market (the platform) which have interest in cashing out the coin for USD. In essence, this means that:

The platform can assign any value to the coin, as it is the only party which settles transactions in the coin.
The platform is forfeiting part of its revenue to bring value to the coin.

Let’s look at some examples:

If the company sets a par value of the BreadCoin at 50 cents (value at which fees are paid), this would mean that the coin was sold at a 60% discount during the ICO. It would also mean that the total circulating worth of BreadCoins is 250 000 USD. If everyone decides to use their BreadCoins, this means that the company has to forgo all of its revenue during year 1 and 25% of its revenue during year 2, in order to “acquire” all BreadCoins back. Essentially the company raised 100 000 USD during the ICO and paid back 250 000 USD (in the form of forfeited Revenue) during years 1 and 2.
If the company sets a par value of the BreadCoin at 10 cents, this would mean that the coin was sold at a 100% premium during the ICO. This would essentially mean that half of the money raised during the ICO was raised “for free” at the expense of the investor. This would, of course, have an extremely bad reputation (and possibly legal) consequences for the platform.

This model (assuming the coin is sold at a discount during the ICO) is clearly stable and widely used by companies on platforms like Kickstarter. It is important to point out here is that the company is forfeiting Revenue and not Profit, which might cause liquidity issues for the company.

Scenario 3: BreadCoin as equity

This model has many variations (with regards to the type of security), but here we will cover the most basic one – the one which most non-blockchain companies use. All fees and sales on the platform are settled in another currency and BreadCoin is used only to define pro-rata profit sharing. Other setup scenarios can include:

Sale of Options
Sale of convertable notes (starts as debt, pays interest, convert to equity later)
Simple Agreements for Future Equity (SAFE same as notes, sans interest)
Sale of Equity (The equity can either be valued or unvalued and include provisional conditions such as discount rates and raise caps (either on pre or post-money valuation).

In our example (please consider all the follows a very, very simplified version), the platform has collected 200 000 USD worth of fees during year 1 and paid 100 000 USD in expenses. Assuming a tax rate of 20%, the platform, has paid 20 000 USD in taxes and this leaves us with 80 000 USD of net profit. This profit is then divided equally between all token holders. Given that we have 500 000 tokens, this works out to 0.16 cents payout per token. Essentially any investor in the platform would break even after 16 months. Everything after this is pure profit. Please note that the example above does not include important variables such as:

Token set aside for the founders and the team
Cost of capital (discount rate) on the investment
Other important P/L considerations

In this scenario, there is no liquidity risk per se, but shareholders could have claims to the company’s assets or require voting rights on the strategy of the company.