Daniel Malinovski
August 10, 2023
Tokenomics Tuesday

Intro


Token economies and tokenomics are used interchangeably but, at Simplicity, we separate them into two different categories - the token economy is the ecosystem within which the token operates, whereas the tokenomics is the tables and charts that explain the supply, distribution, valuations, and vesting of the token.

In essence, we see "tokenomics" as the rules that govern the supply side of the token, whereas the "token economy" is how the demand and supply interact.

Tokenomics is one of the most important aspects of any project because it is here that the equilibrium price is assumed and the money supply and its laws are determined, which is one half of the formula that governs a token's price (supply and demand, ceteris paribus); it is a big chunk of the project's monetary policy.

The figures within the tokenomics table are interconnected, making it complicated to craft, however, segregating the numbers into sectors makes it simpler. We have separated tokenomics into 3 key sections:

  • Distribution (tranches and allocations)
  • Valuations
  • Vesting

How to distribute your tokens (tranches and allocations)?


A tranche is a part of the ecosystem where a particular allocation of the total token supply is designated to go. These tranches include most commonly the team, investors, community, liquidity, and treasury, as well as project- specific tranches.

The tranches and their allocations depend on the token utility and the economy.

If the token is used primarily for governance, then the team and investors having majority ownership means that there is not going to be any legitimate governance by the community.

If the token is used for rewards within a blockchain-proofing mechanism, then the majority of tokens need to be allocated to a tranche that will give out said rewards; and so on.

It is a logical exercise.

Industry standards

There are industry standards for how much percent of the total supply should be granted to the different tranches. The standards are predicated on maximising logic, where, for instance, the team and/or investors shouldn't ever have a massive percentage of the tokens seeing as the entire notion of Web3 is to grant ownership to users.

However, these industry standards don't take into account the intricate differences between individual ecosystems.


Problem with using only industry standards

The aforementioned intricate details include differences in:

  • token utilities,
  • team size,
  • burn rates,
  • expected revenues,
  • profit margins,
  • assets within the company,
  • roadmaps,
  • community size,
  • confirmed exchanges and launchpads,
  • marketing strategies,
  • and a plethora of other factors that need to be considered prior to deciding what tranches should exist, and how much allocation goes to each of them.

The weight of each of these factors on the token is of course dependent on the role of the token within an ecosystem, but nonetheless, the overarching reason for their influence is that they all affect the company and therefore by extension, directly or indirectly, the token itself.

For example, if a company is generating a lot of revenue with big profit margins, then it wouldn't need to sell tokens to spend on "ecosystem growth", meaning that the part of the treasury that is designated for development funding doesn't need to be as big as the industry “standard”.

Looking at the industry norm puts tokens into a box that's built on a lack of understanding. For instance, Ethereum's tokenomics are vastly different to any Layer 1s today, yet they still work because they're built on an understanding of what tokens truly are.

The inevitability of industry standards

All that logical thought being said, the sad reality is that a lot of the fundamental entities in the industry still look at industry standards as the holy grail of tokenomics.

Investors, launchpads, market makers, and exchanges all want to see particular ratios, valuations, vestings, and so on. This is due to a false notion of predictability, whereby seeing innovative tokenomics runs additional assumed risk.

To some extent they have a point, given the industry hasn’t been around for long. But realistically, if you want to truly innovate your tokenomics, you either need to not go to these entities and simply list your token on a DEX, or you go to tier 1 investors like A16z Crypto or Animoca which have enough weight behind them to overrule any speculation about potential risks.

What are token valuations?


Valuation is calculated as follows: 100 / allocation percent * (price * no. of tokens in tranche).

Example: if you give the private round 5% allocation at $1.50 per token with a 1,000,000 total token supply, the valuation of the round will be (100/5)* (1.50*50,000)= $1,500,000.

The key point about valuations is that they're determined by the tranche allocation and the price of the token. Projects need to keep in mind four things when deciding these two numbers:

  1. FDMC/FDV - the Fully Diluted Market Cap (FDMC) / Fully Diluted Valuation (FDV) is the valuation of the public round; to reach this FDMC, you need to keep the token price at or above the launch price throughout the entirety of the vesting unlocks - you need to ensure that your launch price isn't overvalued and is close to intrinsic value to keep the price at equilibrium.
  2. Delta - the delta between Seed, Private, and Public rounds is the difference in token price that investors invest in. You need to balance this delta with the vesting schedules: seed investors with longer vesting schedules should have a proportionately cheaper token price.
  3. Raise - this delta needs to also factor in the money you need to raise. If you need $150K in your Seed round and $1M in Private round, you can either increase the price of the Private round tokens or the allocation available. Increasing the price means that the price in the Public round will also need to increase to keep a reasonable delta, but you need to keep in mind point 1.
  4. Total VC allocations - if you were to increase the allocation however, you need to ensure you're not giving away a big chunk of tokens to investors (generally no more than 15-20%).

What is the difference between tokens and equity?


The difference between token and equity valuations is something a lot of projects and investors neglect to consider deeply enough. A token's inherent value stems from the value of whatever it is exchanged or used for (we have a one-pager on token value), whereas the company's value stems from its financials - earnings, sales, cash flow, assets, etc.

To learn more about token value, click here.

To learn more about the relationship between token and equity valuations, click here.

What is a good token vesting schedule?


The vesting schedules determine how the tokens are unlocked within each tranche - the programmable inflation of the token. They are made up of the amount unlocked at launch (1), the cliff period (when no tokens are unlocked) (2), and how many tokens are unlocked per unit of time (3) for how many months (4). Projects need to keep in mind three things when deciding these four numbers:

1. Growth - to keep the token at launch price, the supply needs to match demand. This means that projects need to keep token supply and inflation in line with expected demand growth, from the moment the token launches.

2. Liquidity - to keep price stable, there needs to be sufficient liquidity on exchanges so that buy and sell orders don't impact price greatly. This is a tranche in and of itself, and its vesting schedule needs to work in tandem with the tokens being unlocked into the market from other tranches.

3. Investor delta - for the fundraising tranches, as mentioned above, the cheaper the token price, the longer the vesting schedule needs to be in order to minimise the sell pressure from early investors that get instant returns upon unlocks.

NEAR Vesting Emissions. Source: CoinGecko

Big Picture

It is important to factor in the internal economics of the token, but it's equally as crucial to think about what picture the tokenomics paint to the outside world. For instance:

  • 50% going to the "ecosystem growth" tranche comes across as the project not being able to generate revenue.

  • A 10x delta between seed and launch price is suspiciously huge, and if seed investors have 10% unlock at TGE then they will be able to cash out their entire investment instantly, which isn’t the risk-free reality of how venture capital is meant to operate.

  • A team with a shorter vesting schedule than other key tranches implies they're not here for the long term.

What are some common misconceptions and red flags with tokenomics?


Statement: "You can copy tokenomics from other projects."

Verdict: No. Each project is different and therefore has different economics behind it, and your tokenomics need to reflect these differences. Also, if you were genuinely the same as another project, then you wouldn't have any USPs to be able to capture market share, meaning your financials will still be different.

Statement: "Tokenomics are the same as an equity cap table."
Verdict: Wrong. The token has far more utility than shares in a company and therefore the tokenomics need to be crafted with token utilities, and their impact on supply and demand, in mind. Read more here.

Statement: "Total supply is important."
Verdict: It’s not, and literally means nothing. Tokens can be divided into much smaller denominations: BTC is divisible into 8 decimal places, ETH into 18, and so on. The total token supply merely has an inverse relationship with the token price (the greater the supply, the lower the individual token price). That being said, having a random number as your token supply makes it harder to do maths on valuations etc.

Conclusion

Tokenomics is a critical aspect of any crypto project, and it's important to carefully consider each of these three key sections holistically when designing them. By doing so, you can build the foundations for the long- term success of your project, and create a sustainable ecosystem for your users and stakeholders.

Fundamentally, tokenomics need to be grounded in economics and finance, so as long as your project can explain the why, the what doesn't matter.


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