Where it makes sense to utilize a token
Parker McKee
Principal at Pillar
There is a general sentiment that blockchains are good and tokens are bad. This sentiment is too focused on the speculation and illegal scams that have existed in the market over the prior years. As a result, people get distracted from the core value proposition behind why tokens were invented: kicking off and maintaining aligned user growth in projects with network effects. In simpler words, tokens are a new tool that can help defeat the “cold start problem.” The best network businesses in Web2 from digital marketplaces (Airbnb, EBAY, Uber) to communication platforms (WhatsApp/Skype) to peer-to-peer payments (PayPal, Venmo, CashApp) to social Networks (Youtube, LinkedIn) spent billions in venture dollars to get their network effects going. Tokens issued by Web3 protocols offer a new (and much better) way to bootstrap and maintain alignment in the next generation of networks.
There are two objectives when launching a project with network effect dynamics. First, onboarding loyal users/nodes/content to the network, and second, defending the economics of the network from competitors. Many refer to the onboarding portion of this as the cold start problem. Historically, businesses have resorted to fiat-based rewards to incentivize early joiners. At Uber, for example, the company paid drivers cash bonuses and offered riders free rides. While this model can work, it is entirely reliant on venture capital dollars and doesn’t solve for long-term loyalty. Usage across Uber and Lyft has shown both riders and drivers to be unloyal and willing to move to whichever platform is offering a better short-term incentive. A logical inference to the loyalty challenge would be to offer the drivers/riders equity incentives instead of cash. Equity is free to create, would help align their actions with the long-term incentives of the platform, and has the ability to grow in value if that company succeeds. Unfortunately, securities law and organizational logistics make this challenging. Private companies are capped at 2,000 shareholders and the logistics of managing the required legal processes isn’t reasonable for a new start-up.
Tokens have several properties which make them a superior value capture tool for certain types of projects:
1.) The ability to create a new asset at zero cost
2.) Token economy designs that can result in asset appreciation as network usage grows
3.) The ability for users to easily sell/transfer that asset in a far simpler fashion than equity
4.) The ability to program the asset to guide certain user behavior
I will go into depth on each of these points below.
Creating new assets at zero cost
Unlike the traditional fiat-based model described above at Uber, with tokens, a brand new network can create assets for no cost and use them as an acquisition incentive. While not worth much to a holder in the short term, the growth of the network over time should drive the value of that asset up. The exact economic design of any given network is critical and will determine how value accretive an asset can be but the general premise of demand outstripping supply is the right place to start. Unlike a fiat-based incentive that’s value isn’t correlated to the success of a network, tokens can align all stakeholder’s incentives. The advantages of the token model shine brightest in scenarios where network user/supply acquisition is expensive. This advantage is so acute, that one could argue the more expensive the average acquisition, the more advantaged a token-driven network would be over a traditional fiat-based model. Additionally, token-based models further encourage and reward your most ardent supporters for the work they do advocating your project. As early users of the project, they themselves are rewarded for helping it grow.
Blockchain transfers
On top of this, blockchain-based transfers, enable ultra-low friction compared to equity. If a network participant decides they want to convert their tokens to fiat, in seconds they can sell their holdings on an exchange or to another user. Compare this with the process of selling private start-up stock on a secondary exchange. This process would typically entail a board approval, legal document review, ROFR period, escrow window, and finally, settlement. All told the difference in time between the two processes is measured in at best weeks if not months. This advantage is most beneficial in projects that require a significant number of individual stakeholders to reach a minimum critical mass.
Asset programmability
Less utilized today, but over time, we suspect the programmability of token assets will enable network builders to design incentives into the assets themselves as well as the structures that govern them. Examples include greater upside for longer hold durations, access to premium network services, and increased earnings power for executing certain actions. These levers will enable builders to guide users to desired behaviors through creative economically driven hooks.
When not to use a token
Not every project is a strong fit for a token. For example, projects with no network effect don’t require reaching a critical mass of users before their products are deemed useful. Hence a project doesn’t receive the same benefits from being able to create a new asset for user acquisition. We’ve also found that “single player” applications that don’t require the same user alignment are not strong candidates for a token. If a user is consuming a self-contained SaaS application like Salesforce or Canva, their day-to-day decisions and interactions with the platform don’t affect the product experience of others.
The very best use cases for tokens are models with:
1.) Network effects
2.) >2,000 users (the more the better)
3.) High user acquisition costs
4.) Benefit from easy user value transfer
Trade-offs
While launching a token has the above-mentioned benefits, it comes with significant trade-offs including public responsibility, daily volatility, and legal uncertainties. When you enable everyday consumers to purchase an asset there is a higher level of transparency required to keep holders informed. There are also challenges of keeping contributors and holders bought into the future roadmap during volatile market conditions. The biggest question right now though is found in the uncertainty that remains around how these assets will be regulated. With these tradeoffs in mind, we recommend only projects that reap significant benefits from the advantages stated above go down the token road.
We suspect a lot of the negative sentiment about tokens has been driven by the volatility from mass speculation. We don’t expect these challenges will disappear overnight but hope as the market matures and more strong projects continue to grow, a broader audience begins the recognize the extremely powerful acquisition and alignment advantages tokens bring about.
