Reverse ICOs & The SoundCloud Exit – Part 2October 2017
Part 2: Valuation, Regulatory Hurdles & The Basic Process
Around two months ago I wrote a piece on Reverse ICOs — a mechanism that high product utility creative companies with weak revenue models like Twitter, SoundCloud, Medium, Kik, Tumblr, Snapchat, and Vine could use to become profitable. I had written a few articles before but largely for me to learn about different aspects of the blockchain space and to share my findings with a few colleagues and friends. The Reverse ICOs piece was the first one I marketed beyond Twitter but even then I didn’t expect much more attention. Surprisingly enough, feedback came in thick and fast from all over the world — the number of people interested in both SoundCloud’s survival and in blockchain technology was far larger than I could have imagined.
Towards the end of the article, I commented on some of the limitations to the model I outlined — this article reflects some thoughts I’ve had since. The theme of the piece is the little-known area of crypto economics — the application of economics to cryptography to create robust decentralised peer-to-peer networks that incentivise all stakeholders and allow communities to thrive (more here). Specifically, the focus is on valuation, regulatory hurdles, and a deeper look at the process itself.
How Should We Think About Valuations?
Current models suggest that the more a cryptoasset is exchanged, the less valuable it becomes — incentivising hoarding
Lately, there has been a lot of talk about whether or not we’re in a crypto-bubble (cue Jamie Dimon). I’d argue the former. Very few people are actively discussing valuation methodologies so most token prices are only based on hype and the occasional celebrity endorsement (Jamie Foxx, Floyd Mayweather, DJ Khaled etc)— this is not a sustainable way to go forward as the market becomes more complex and fraudulent.
One person has thought very rationally about this — cburniske at Placeholder VC. He recently outlined a method to value Filecoin (a decentralised storage platform) that uses formal economic terms like TAM and CAGR and methods including the use of S-Curves.
The (very) basic process follows four main steps:
- Calculate ‘Total Addressable Market (TAM)’ — the total market demand for the product or service
- Calculate ‘Market Value (MV = TAM x MP)’ — Market Penetration (MP): the percentage of the market that the company controls; Market Value (MV): the total market that the company can reach with their sales channels
- Calculate ‘Network Value (NV = MV / TV)’ — Token Velocity (TV): the average number of transactions a token will be used in during a given year; Network Value (NV): the total value of the network/community
- Calculate ‘Utility Value (UV = NV / TS)’ — Token Supply (TS): the number of tokens available for exchange, Utility Value (UV): the value of the use of each token
With a few assumptions not relevant for this article, we can make two substitutions to determine that:
Hence, we can claim that for a very early-stage post-ICO cryptoasset — the four price drivers are Total Addressable Market (TAM), Market Penetration (MP), Token Supply (TS) and Token Velocity (TV). From a traditional VC perspective, TAM and market penetration make sense; and we could use ‘CAGR’, ‘decline of CAGR’ and other metrics to update the basic model over time — but the market fundamentals are the same and have an expected proportionality to the token value.
From a cryptoeconomic perspective, token supply is relatively similar to the number of shares; for the same amount of investment, purchase for a smaller number of shares means that they are valued higher — much the same as making an angel investment based on capital required and relative risk.
From an economic perspective, token velocity is where things become more interesting. By this basic model, the more a cryptoasset is exchanged, the less valuable it becomes — incentivising hoarding. This is detrimental to the use of a platform like a decentralised SoundCloud because people won’t use it if the token price is not stable.
If the token velocity is low, then the token is being hoarded and acts as a cryptoasset; conversely, if the token velocity is high then it is being largely speculated on rather than being used for a specific function on the network i.e. utility function. The question is, how do we find the sweet spot? Does this change for each platform? If so, what are the key drivers behind this?
In Chris’ latest post, he explores removing ‘bonders and hodlers’ from the model i.e. speculators and holders — we could do the same. He says that ‘in reality, a small percentage of bitcoin in the float likely exchanged hands a lot more than that, while a larger percentage sat locked in hodlers’ hands’ so we may assume that the token velocity would decrease, and the token utility value would increase. This was a great update, but we need to do much more thinking about this aspect of the valuation model.
How Can We Overcome Regulatory Hurdles?
A clear ICO legal framework needs to be built in the UK if the company has any reasonable chance to sustain itself with this process
Now we understand how the token is valued, we could start to think about how to design it if this were a regular ICO. However, we still need to consider the ‘token-share swap’. As a reminder, consider this paragraph from Part 1:
Similarly, I imagine that SoundCloud could partake in a ‘token buy-out’ of some decentralised protocol, and then issue a token-share swap by creating tokens that represent SoundCloud share ownership and swapping them on a token swap platform like Swap by Consensys. This means that the company’s overall success is measured by a token price, not a share price; the fundamental price drivers behind token prices differ from share prices which is fundamental to how the organisation would make money. (Note: if they were ‘reverse ICO-ing’ with an organisation with a company and a foundation, they could acquire the private entity and proceed as above). Ideally, they’d develop their own decentralised ecosystem and undergo the switch internally.
Let’s break this down:
- Token Buy Out of a Decentralised Protocol
- Legal Dematerialisation of (SoundCloud) Shares into Tokens
- Token Swap with Swap by Consensys (or some other service)
There are two main scenarios for the token buy-out; 1) for a public blockchain with public tokens, and 2) for a private blockchain with private tokens. For the first scenario, a company would have to buy a majority of a blockchain’s tokens at a premium — feasible in principle but still very difficult (despite Apple’s cash pile, it probably couldn’t buy back all its shares). This will be made even more challenging for the increasing number of ‘platform coops’ we expect to see in the next few months (Outlier is actively working to make what we call ‘network coops’ a reality — ensuring that token ownership is spread evenly across a broad range of investors). The second scenario is far simpler — SoundCloud already owns all the tokens because no public token sale has taken place.
The next step is to convert the company’s shares into tokens; to replace a predominately paper-based document with a digital record. The current limitation here is not so much technological, but legal. As an example, if you are a charity receiving sponsorship from a corporate firm, you would likely draw up a contract, sign it and send a PDF copy to the other company for signature.The contract is legally binding because both parties have signed it, and the country (or countries) legal system(s) deem the contract to be legally binding as well.
In theory, it would be relatively straightforward for SoundCloud to claim that their digital token represents a share of their company and to proceed — but legal systems have not been built around ICOs in most jurisdictions, so there is no legal entity that can state that the token dematerialisation is valid (read more here).
Lex Sokolin, Global FinTech Strategy Research & Partner at Autonomous Research, provided a fantastic update on this at Seedcamp’s ‘Blockchains, Protocols & ICOs’ event in late September at Campus London. He broke the ‘State of ICO Regulation’ into three main categories (although not explicitly): ‘Positively Regulated’ (Switzerland & Singapore), ‘Regulation Pending’ (US [SEC] & UK [FCA]) and ‘Negatively Regulated’ (China & Russia).
Although the FCA provided an update on the legalese in September, much more is needed. Given that SoundCloud does business in the UK (including taking out loans), a clear ICO legal framework needs to be built in the UK if the company has any reasonable chance to sustain itself with this process. Outlier’s very own Greg Murphy has also been thinking deeply about this area — take a look at his latest piece titled RegTech@Wharton: Perspectives on Regulatory Approaches to Token Offerings for more information.
The token swap is then relatively straightforward in concept, a platform like Airswap would work well and we may assume that some generalised ‘ERC-20’-style token standard will be formed for all tokens and judged against as part of the process.
How Can We Ensure That The System Is Stable?
It is my hope with this process that we will move from a measure that only incentivises shareholders, to one that incentivises all stakeholders
Let’s look back at our utility value equation:
As a reminder: TAM refers to ‘Total Addressable Market’, MP refers to ‘Market Penetration’, TS refers to ‘Token Supply’, and TV refers to ‘Token Velocity’. Our aim is to make this value is stable so that people are incentivised to use utility tokens. We can consider each driver in turn and think about certain tactics to stabilise them.
Stabilising the Total Addressable Market (TAM) is a matter of market selection, not so much protocol fundamentals. However, looking at the market over time we could consider the Compound Annual Growth Rate (CAGR) and ensure that it is stable. This appears to fit our hypothesis that high product utility companies with weak revenue models are the right sort of companies that should consider this process.
Similarly for Market Penetration (MP), we would look to select competitive markets with established players where only a few stakeholders are incentivised (predominantly only shareholders) — large companies that operate in oligopolistic markets are particularly good at offering poor customer service and weak products (Examples: glasses frame manufacturer Luxottica & lens manufacturer Essilor, see below), so again this looks like the right type of process for these companies. However, the historically strong link between competition and lower prices and better service is being challenged by the digital platforms like Amazon, Facebook, and Google which take away pain-points very effectively — further analysis is definitely needed here.
Token Supply (TS) is where things become a little more interesting (and untraditional!). The easiest way to stabilise token supply is by offering a fixed number of tokens; the problem is that a fixed supply results in hoarding, which implies low token utility and a low Token Velocity (TV). Therefore some variable supply of tokens is likely the best solution — potentially using a quantitative easing and tightening process based on whether the number of users is decreasing or increasing. Traditionally this would have been managed by a central bank — this is a whole new world in monetary policy and it’s unclear of the longer-term implications of mathematically-enforced monetary policy.
As mentioned, Token Velocity (TV) is the crux of the current limitation of the valuation model and by extension, this process. Specifically, we need to incentivise against hoarding. I think we can do this in a few steps:
- Build inherent loss of value into the token similar to SteemIt to negate against hoarding and quick flips through a demurrage and despatch process based on how long or how short the amount of time that a user holds a token
- Consistently release new product features and partnerships to make sure that the company is always offering the best service possible (which will drive up token prices for a short-time, similar to an Apple share spike on the announcement of a new iPhone)
- Regularly release new tokens at a discounted price before announcements (potentially just to the most active and/or most influential users) to ensure that creators and consumers benefit (financially) from using the service
Aside from product-utility, the ‘Reverse ICO’ process has also resulted from an increasing displeasure about the validity of the share price. It is my hope with this process that we will move from a measure that only incentivises shareholders, to one that incentivises all stakeholders (including the aforementioned).
To switch from the old way to the new, existing shareholders would sell their tokens to the public — but especially to SoundCloud’s active user base. I could imagine that there would a freeze period where the tokens could not be sold to the general public during which time the Reverse ICO would ‘pop’, existing shareholders would make their money back and then we would proceed as above. As with a successful IPO, we would expect the token price to increase well above the price at launch after the pop.
What Comes Next?
The last couple of months has brought on a flurry of regulatory changes across the world (including South Korea, below!), but surprisingly enough it is taxation that affects this process more so, specifically where results of this process appear on the balance sheet — much more on this to come.
The next important ‘pure’ cryptoeconomic step of the process is token design — that’s what makes everything possible. As outlined in Outlier Ventures’ Community Token Economies paper, the SteemIt protocol demonstrates what’s possible when trying to reward creators, curators, and consumers for their contributions through a multi-token economy.
Abstracting this and applying it to SoundCloud will be an interesting exercise. I will also start thinking about how to incentivise developers to build on top of the system as we move towards an ‘investment stack’ of protocols, equity-based companies and API economies of those companies.
There are also important questions around ‘token mechanics’, specifically around improving our understanding of token velocity, understanding how we can program IP and shareholder rights into a token, as well as maintaining stability through quantitative easing and tightening.
Furthermore, the token valuation model can definitely be improved. At present, it resembles pre-seed/seed-stage funding but growth-stage funding has many more metrics. We can expect the same here, including the unit economics, P&L-driven markers like churn, gross & net burn, margin, as well as MAU, DAU, revenue-to-date, number of deals and user value. At Outlier Ventures Research we are actively exploring how to incorporate community metrics into the overall valuation model including sentiment analysis, community engagement, and other social signals. Further analysis is to be published soon.
Once this is all in place, there will be much more to do around financial analysis, executive buy-in and applications outside of social networks — teleradiology already looks like another potential use-case. Much more to keep me busy!
With thanks to Lawrence Lundy, Greg Murphy, Eden Dhaliwal and the rest of the team at OutlierVentures.io for support on RegTech and cryptoeconomics, my fellow WarwickTECH board member Artur Safaryan for valuable feedback on the state of crypto-regulation and finally Kyran Schmidt and the Seedcamp team for valuable conversations and inspiration through their fantastic event on ‘Distributed Futures’: Blockchain, Tokens & ICOs’ last month!
Harry McLaverty works on the Research team at Outlier Ventures focusing on the fund’s convergence thesis through deal flow analysis and thought leadership into the emerging ‘Reverse ICO’ space. He also delivers weekly and monthly research on convergent emerging technologies to the Outlier Ventures community at Convergence VC. He is also a co-founder and trustee of WarwickTECH and an RSA Fellow. Previously, he has worked for Doughty Hanson, Stockhorn Capital and humble ventures as well as YC SS17 rental marketplace startup Fat Lama. His background is in Discrete Mathematics including dissertations on the Riemann Zeta Function and branching blockchains for use in the exchange of fiat and cryptocurrencies.