Attention, Founders: That ICO Is About To Dilute You, Too

ICOs are nothing less than a tectonic shift in the startup-funding environment. Alas, one of the most common misconceptions about ICOs is that they allow “non-dilutive financing.” You aren’t selling any shares, so there isn’t any dilution, right? Wrong.

Welcome to the Fallacy of Non-Dilutive Financing. Clearly, when selling shares or tokens to investors, the investors expect those to appreciate and increase in value. If that’s the case, they will be sharing some of the future value of your venture, so there must be some dilution hidden here.

To understand this, we first need to understand the difference between owning equity and owning tokens.

A share represents part ownership of a company.

A token has two functions: Firstly, it represents the future value of a service. Secondly, it also is a key used to access that service. The number of tokens multiplied by the value of each of them is the “network cap” value. This is very similar to owning a share of the equity of a company. The key difference is that a network token has a second function: It is a means of access to that network service.

This dual functionality of a token, encompassing both value and access can be demonstrated with Ethereum. As of January 24, 2018, the total number of ETH tokens in circulation is (roughly) 100 million. Each is valued at (about) $1,000, which is about $100 billion of “network cap.” As an investor, if you believe the network will eventually be worth more, you can buy ETH. At the same time, if you are a user that wants to execute a smart contract on the network, you need to pay for the transaction with ETH, driving demand and thus increasing the value of the ETH token.

This second function is what’s so exciting about token networks. It’s like the Berkshire Hathaway share that gets you a seat at the Warren Buffett show, but on a mass scale. This aspect of tokens creates a constant, growing demand and thus an increased intrinsic value to the token.

But the fact that tokens have two functions — they're both a "share" and a ticket to using the service — is bound to create diverging interests.

Let’s analyze this using an example. Assume you are the founder of PigeonCo, the developer of an incredible new decentralized pigeon delivery network. You took an investment, selling 50% of PigeonCo to an Angel Investor. Since ICOs have become expensive, you finance the early building of it with a SAFT, representing 25 percent of the overall tokens. You plan to sell another 25 percent in the crowd sale you’ll do once the tokens have utility. Things go well, the pigeons are airborne, the crowd sale went through. Let’s assume the total value (“network cap”) of the token base is $200 million.

Pause. What’s the value (“market cap”) of the company at this point? If you ascribe to the “company holds assets” camp, then since its holding 50 percent of the tokens, its market cap is $100 million. If an additional 25 percent of the tokens were granted under a vesting schedule to the team, then the company only holds 25 percent of the tokens, and has a market cap of $50 million.

If the company depends on value creation via the appreciation of token value and doesn’t get paid for providing a service, it won’t have revenues. If the company sells off the remaining 25 percent of tokens — and thus holds no tokens at all — the company is value-less to you, the founder and your Angel Investor. None of its shareholders own anything. As a founder of a tokenized company, selling equity is not dilutive as there is nothing to dilute. The pigeons generate value for the token holders, not the shareholders. This means that selling tokens is the dilutive event.

The shareholder vs. token-holder issue gets even more complicated if you want to IPO an ICO’ed company. How could you pitch “increasing shareholder value” to the public when the shares don’t hold the economic value of the company?

This means that once you've "tokenized" your business, an IPO or even possibly equity financing isn’t an option. If an ICO is an “initial coin offering”, shouldn’t there be follow-on coin offerings (FCOs)? As the network cap increases, it makes sense to do additional offerings. The community frowns on such a practice today, and it isn’t even possible unless you pre-plan, pre-reserve, and pre-commit a portion of tokens to all your future funding needs. This isn’t flexible and is a disadvantage compared to the traditional company equity structure, where the board of the company can decide to issue additional shares. Understanding follow-on financing is yet another one of the areas that will need to be figured out in the token economy.

If the value of a token network truly is decentralized into its token, an exit in such a company won’t look like the selling of a private company. Instead, the exit takes place via on-going secondary sales. Unless the company equity holds a value like controlling interest in the token base, there is nothing for a would-be acquirer to buy. The company is an empty shell. Amazon bought Audible to own yet another vertical in retail and media. Can you imagine Amazon buying Filecoin for its storage business? It makes no sense to own a decentralized asset because it’s not really in your hands.

Therefore, not diluting the equity cap table is actually… meaningless. Welcome, friends, to the sticky, strange, and fascinating world of token sales.