Total Coin Supply and Disinflation in ICOs

Startups are doing ICOs and issuing protocol tokens rather than equity fundraising. It’s a frothy scene but I’m still a big fan of this trend and cheering on the revolution. One of many differences between an equity raise and an ICO is that ICOs have a new weird disinflation dynamic where your investment will almost certainly get diluted in a systematic way. This isn’t as alarming as it sounds, but for some ICO investments it could make a huge impact on long-term returns. Could also be seen as a good argument for regulators not to classify an ICO as an equity equivalent.

In an equity sale you have a pre-money and post money valuation. Pre-money is what an investor values the business at. Post-money is the pre-money valuation plus the cash they put into the business.  Investors understand how much of a company they own at the time of the financing (their investment/post-money valuation). Seasoned investors know in the back of their mind which businesses will need money in the future, but there’s always a chance that any given company will go into hyper growth and fund future growth with generated cash flows. If your company is failing, generally, additional equity slows or stops (reducing dilution). And once a company reaches a certain scale they need a REALLY good reason/opportunity to raise more money and the market generally penalizes those who raise additional money for no reason.

Future dilution at the time of an equity investment is unknown so we can say that equity investments are not disinflationary by design.

In an ICO you buy a proportion of a new protocol token. Depending on the structure of the crowd sale it can be a bit opaque what proportional stake in the protocol you are going to get relative to your capital commitment. However, once the sale is done, you know how much your investment represents relative to the total market cap. Here’s where it gets interesting. Founders/teams make decisions and try and guess how many coins to reserve for all scenarios like potential future fundraisings, miner rewards, and generally how many tokens they will need to issue to make the protocol a success at scale in the future. Basically, they have to try and think of every possible scenario.

Founders/teams do this partially because of technical reasons and partially because crypto has a strong cultural ethos towards transparency and openness and ICO investors expect to know exactly how many coins will exist over the lifetime of the project. This total coin number is important because this is how much your investment will be diluted over time. This sounds scary, but the idea is that a successful protocol will grow faster and create much more value than its dilution factor could ever erode.

Depending on the decisions of the founder/team, increases in coin circulation can happen at pre-planned intervals (eg. foundation lockup ends) and/or by protocol design (eg. mining rewards) and is not necessarily correlated to whether a project is successful or not.

Future dilution of an ICO investment is a relative known so we can say that ICO investments are disinflationary by design.

While any single ICO can gain traction and grow significantly more than its own dilutive factor, not all can. Lots of speculative projects are being funded via ICO and power law dictates that only an extreme minority will ever reach scale. Yet, all projects are planning for a coin supply at scale and therefore, investors can assume that overall ICO investments market will be disinflationary in the long run (even though the overall market cap will expand as winners emerge).

Conclusion

A new class of fundraising enabling businesses to raise capital but has a built in deflationary feature which acts as a new headwind for investors. The headwind might be worth it based on the individual opportunity and the value that the protocol unlocks – that’s up to the investor. It’s hard to guess how much of this risk is already priced by the market but my guess is that it isn’t fully internalized by the average ICO investor. Most people are just caught up in the froth.

People seem to pay attention to a new token’s market cap as a signal of success relative to established protocols. But established protocols have most of their token supply already issued so their market cap is a more realistic representation of current value. New protocols do not. For example, Bitcoin has already issued most of all the coins, whereas Ripple still has twice the amount of coins issued still held in reserve. Market cap is calculated by using Circulating Supply * Coin Price. See here. ICO investors should think about total supply of coins just as much as they think about the circulating supply since we know that the overall market for ICO investments will be disinflationary in the long run.

Ryan Shea came up with a smart solution to this problem: PPHM (price-per-hundred-millionth) after N years. It gives a normalized price relative to 1/100M of N years supply (eg. 20 years). You can read more about that here. This strategy gives a good apples to apples comparison when comparing old and new protocols on a relative basis and allows you to make a better valuation judgement than market cap alone.

People are coming up with good ideas on how to mitigate some of these problems, such as locking up reserved tokens into smart contracts. We’ll see where the industry trend goes.

Also, I’m talking in broad strokes here and I know that mining rewards are related to network effects of a project and many of the other self regulating factors in how the coins are issued. Investment risk is still by far the biggest factor. Equity and ICOs both go to zero if the project itself fails.

Further reading and some of the inspiration for this post:

The Economics of Filecoin

Losing Alpha: Why Most New Crypto Funds Are a Sh*t Deal

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