Token economy is the most important factor to consider when investing in a blockchain startup.
It should be the structure to evaluate in any worthwhile investment. Like all economies, it is composed of two basic components: supply and demand. These will determine whether or not a startup reaches a golden intersection, the equilibrium where both meet and produce gains for investors.
This topic is very extensive. For the purposes of this column, we will start with the demand for tokens, namely where it comes from and how it works. In the future, we will discuss supply and the reduction of tokens in circulation.
Types of Demand
To begin with, there are two types of demand. There is a natural demand, which is generated by the business itself, then there is an artificial demand produced by speculation and various circumstances in the market.
Natural demand is very important when we decide whether or not to invest in a startup. Its business model should be based on it. A blockchain startup should operate in such a way that tokens are its core element so that it could transfer one hundred percent of its cash flow into the token economy. In a typical case, it would buy back tokens with the profits it yields, making tokens its centerpiece. Then, it could even decide to burn these tokens to decrease supply and increase price.
For instance, imagine a service with a simple function: it allows users to create a blockchain wallet that turns their phones into a payment device like Apple Pay or Samsung Pay. The difference is, this blockchain wallet converts currencies like bitcoin or ether for regular transactions such as paying for a coffee. It is a clear and transparent service. It has demand because there is always a need for bitcoins to be converted into some kind of payment tool and, unfortunately, it’s quite difficult to pay for any goods with bitcoin so far.
In this case, the startup solves a problem with real demand. Users who create their own wallets with the startup transfer funds into it in the form of virtual currencies. They can now use it to pay for goods at a local store. Naturally, the service charges a commission, which could be equal to three percent. This is the income the service earns and it embeds the token economy inside its structure.
The three percent commission is transferred to the exchange and converted into its equivalent value in tokens. In this way, all of the business’ cash flow — that is, all three percent of its returns — is transferred into the token economy. In fact, these returns are used to buy tokens which are put into a special wallet where they then can be used to charge the commission. This is a vivid example of how the natural demand for tokens is generated since it is entirely produced by business.
We can also speak of speculative demand adding to the natural one. Yet, we should never assume that speculators will come running. Speculators come only at the time when the token is already growing and a certain volume of natural demand already exists. Only then can the price be multiplied by speculative demand, but one should not expect that something positive will happen only due to speculation. If there is no natural demand, they will buy all the tokens and this will increase the price artificially.
A key factor in determining an investment is that the startup must rely only on its own distribution model. It’s important to evaluate what percentage of its income is used to buy tokens and burn them. This determines if the startup cares about the interests of token holders. Just as well, if the startup is conducting a token sale it should reserve some amount of tokens for the team, advisors, partners, and us as token holders. This is beneficial for both us and the startup itself. Its main objective should be to increase turnover, boost demand for its services, and increase the value of tokens as well.
Let’s say that in a distribution model only 70 percent of tokens have been distributed among investors. It is necessary to pay attention to how the management of the remaining 30 percent of tokens is conducted. We can always assume that a good scenario is when the startup says that it will not sell off some part of its tokens during some time. For example, the startup keeps all tokens for itself, its advisors, and founders during a year. Therefore, it determines your priority right to sell off tokens.
The flipside situation is when a startup takes away a bigger part of its profit and distributes it among shareholders, allocating a very small amount of money for the token economy. This is why it is important to read the distribution model described in any white paper. We should always understand who else gets tokens besides investors.
In principle, a startup should end up being on the same boat with investors. We should not hesitate to ask questions such as:
- What enables income going into the token economy and what part of it does?
- What will ensure tokens being bought up and what would the prospective rates be?
- How will tokens be emitted?
- How will tokens be preserved?
This is what we should analyze when reviewing the startup’s documents and what we should pay the most attention to.
Finally, it is just as important to conduct an analysis of the traditional business model. We must determine whether or not there is any need for this product on the market. If there is, everything is fine. If the startup addresses a significant market challenge, it is also very good for us. We must analyze market statistics and understand what demand could be and whether this demand meets the expectations of the startup.
This information is the opinion of the provider and is for informational purposes only. It is not intended as and does not constitute investment advice or legal or tax advice or an offer to sell any securities to any person or a solicitation of any person of any offer to purchase any securities. This information should not be construed as any endorsement, recommendation or sponsorship of any company or security. There are inherent risks in relying on, using or retrieving this information. Seek the advice of professionals, as appropriate, to evaluate any opinion, advice, product, service or other information provided.
Do you agree with Nick’s assessment about the importance of token economics? Let us know in the comments below.
Images courtesy of Nick Evdokimov