Blockchain & Web 3.0: The Conundrum of Tokens vs. Equity

In the world of technology, the discussions around Web 3.0 & Metaverse have clearly taken a centre stage, and the promise of Web 3.0 largely hinges upon the capabilities that the blockchain technology & infrastructure provides. But before we discuss the implications of all this, let’s take a moment to define Web 3.0.

Internet was invented on 1st Jan 1983 (around 18 days before I was born!). For the first 15-20 years, the applications built on top of internet, widely known as Web 1.0, allowed users “Read” capability, meaning that internet provided information & you could read/consume it. At the beginning of 2000s, the internet evolved & Web 2.0 was born, which allowed users “Read + Write” capability, meaning you could not only consume internet but also contribute to it. Social Media was the harbinger of Web 2.0. And now after another 15-20 years, internet is evolving again into Web 3.0, which promises to allow users to “Read + Write + Earn”, meaning that you can not only contribute & consume internet, but you can also earn in doing so.

At a more philosophical level, what this means is that the value of our interaction with the internet will now not accrue only to the application or the platform, but will also be distributed equitably to its participants, who, one can argue, created that value in the first place. In that context, Web 3.0 is the internet of the people, by the people, for the people. To understand this better, let’s look at aspects of value accrual across different versions of Web.

Value creation in Web 1.0 & Web 2.0

Like I mentioned earlier, Web 1.0 was largely a “Read Only” internet. It was largely a record of information which captured users’ time share and sold it in various ways. The simplest was to sell this time share to advertisers or directly sell products & services to the users. Hence, in a demand supply equation, on one side you had businesses & on the other side you had users/consumers. The value of these interactions on the internet accrued fully to the platform facilitating it. In 2004 (after the recovery from dotcom bust), Yahoo was valued at close to $40B with more than 350M monthly active users (MAUs) across its different applications, implying per user value of c$115.

Web 2.0 brought the “Write” capability to the internet which blitzscaled supply and in turn allowed internet platforms to capture even higher share of users’ time & wallet. In Web 2.0, the supply side was not restricted to just businesses but expanded to include individuals who were now contributing content, products & services to the internet. As a result, the time share of internet just exploded, which led to higher monetization of users via advertising & commerce. Interestingly enough, the value of these elevated time & wallet shares still accrued to the platforms facilitating it. This resulted in the creation of multiple $T platforms in last 10 years. Facebook today is valued at around $950B with more than 2.9B MAUs globally, implying per user value of c$330 (or 3x of Web 1.0 leader Yahoo!).

Web 3.0 promises to democratize the Internet using Blockchain

Web 3.0 promises to now bring the “Earn/Execute” aspect to the internet users. If an internet user’s time share is the key driver of value creation on internet, then one could argue that the user should also “earn” a significant part of that value rather than the platform which is facilitating that interaction. But how do you do that in a manner that is scalable, ubiquitous, error free & fair? Essentially how do you move value/control from the platform to the community in a manner that the platform continues to thrive? The answer lies in the advent of Blockchain.

Amongst other things, two key aspects of blockchain are core & critical to Web 3.0: a) the decentralized nature of blockchain tech allows trust-less collaboration between various stakeholders in a platform (founders, developers, team, advisors, community, users, investors, vendors, etc) which can facilitate creation of a decentralized autonomous organization (DAO), and b) the tokenization of blockchain (crypto currencies) allows an equitable & scientific way to incentivize different stakeholders for both governance and usage of the platform.

The role of Tokens in Web 3.0

Several years ago, I had explained in an article (Two Things You MUST understand about Blockchain & Crypto ) that crypto currencies are native utility tokens that reside on blockchain and act like a fuel that powers its native blockchain ecosystem. They are an innovative way of monetizing protocols & incentivizing community. At one end of the blockchain stack, you have protocols like Ethereum where a token incentivizes its community (developers, validators, etc) to maintain consensus on blockchain & drive governance for the project. At the other end of the blockchain stack, you have consumer facing blockchain based applications where a token (or a combination of tokens) not only acts as a medium of exchange but also incentivizes/rewards users to engage (consume/create) with the products/services that the application offers.

The most beautiful aspect of Tokens is that they are an all-in-one instrument on a blockchain which act as:

a)??????Medium of Exchange: You can buy/sell products/services associated with that blockchain project using tokens, effectively making them the currency of that blockchain network

b)?????Medium of Ownership: Tokens are designed to store the value of network (to be) created by that blockchain project. Hence, owning tokens allows you to own a part of network

c)??????Medium of Governance: Tokens are also used to maintain blockchain (i.e. own validator nodes) and provide governance on project related decision making through votes

Tokens essentially enable the “Earn/Execute” element of Web 3.0. The all-inclusive nature of Tokens allows blockchain companies to move value from a single entity that owns the platform to all the stakeholders that are a part of that blockchain ecosystem.

In fact, I would argue that going forward we will not refer to call large Web 3.0 companies as Platforms but instead call them Networks. Every stakeholder in this Network will own native Tokens which would be earned by participating in the network (Creators, Consumers, Developers, Node Validators, Marketers, Vendors, Liquidity Providers, etc) and which would allow these stakeholders to a) own a certain value of the network, b) buy/sell products/services within network, c) participate in decision making regarding the future of the network, d) exchange these tokens for tokens of other blockchain networks, etc. Essentially, you would have shifted both monetary value & governance power from a single entity/platform to the entire network. Now we can own the value we create.

All companies today have shareholders who own the company. In 10 years from now, many blockchain based Web 3.0 companies will not have any such thing as equity or shareholders. These are likely to be decentralized autonomous organizations (DAOs) where tokens act as both store of value & currency (on native network). These tokens have the power of cash & equity combined in one & they are highly liquid & freely tradeable in the secondary market (crypto exchanges). Axie Infinity is a great example of a Web 3.0 gaming company which is set up as a DAO. (Axie Tokenomics & Whitepaper !)

In such companies, Tokens will replace Equity. The trillions of dollars of value that hopefully some of these companies will create will reside with its token holders which would include every participant in the network rather than just the investors, founders & the team.

In fact, the best practices for initial token allocation highlight a very distributed approach to token ownership, as we can see in the Axie Infinity Token allocation schedule below:

If you notice, there are only 21% tokens which have been allocated to Sky Mavis which is the studio building Axie Infinity, and only 4% is allocated to private sale which is equivalent of angel/VC investment. Around 50% of the tokens are allocated for users (Play to Earn) and Community (Staking rewards) to incentivize participation & governance in the network. Around 11% is offered to public which can be anyone (largely community & early evangelists).

In newer projects, the allocations towards founder, team & investors are reducing even further and proportion of allocation towards users & community is inching higher. We are clearly shifting the accrual of value from a single platform to the entire network.

Hence, if investors want to capture the value created by these Web 3.0 DAOs, they will have to start investing into Tokens. Also, since most blockchain start-ups do ICO (initial coin offering) very early on to jumpstart the network/token value, the tech investors will have to invest at a very early stage of the network to become part of the private sale. Once the ICO happens, liquidity and/or valuation can be a key challenge for investors to buy a sizeable chunk of these tokens at reasonable price in early years of the network.

How to value tokens & what do they represent?

Just like how the collective understanding of the capital markets evolved in last 50 years on how to value Equity, the same will happen for Tokens over the next 10 years.

In last 3 years, several technical models have evolved to help crypto traders value Tokens relative to each other and identify momentum/opportunities in the market. These models are widely used by sophisticated traders, and they offer technical analysis similar to that available for Equity markets to identify which assets are overbought/overpriced and/or which are oversold/underpriced (Summary of methods for Technical Analysis of Crypto ).

But for us to understand the intrinsic value of token, we need to look for fundamental ways of valuing Tokens much like how we value Equity using various valuation methodologies (DCF, DDM, EVA, etc). In that context, the valuation methodology created by Chris Burniske is particularly sophisticated & provides a lot of insights into how tokens create/store value. The Burniske Valuation Methodology (BVM) is structurally similar to a DCF model for equities but instead of focusing on forecasting Free Cash Flows (FCFs) & discounting those to present value, it focuses on forecasting the Current Utility Value (CUV) of tokens & discounts that to the present value.

To value a token using BVM model, you need to forecast the following components:

a)??????Economic output of the project (PQ): Represented as the multiple of Price (P) and Quantity (Q) of the resource/service/product being created/consumed on the blockchain, this is essentially the measure of the real-world value of the economic output serviced by that blockchain network. Taking the example that Burniske took of a VPN protocol, if the total internet consumed using that VPN any given year is Q GBs and the real-world price of internet is $P per GB, then the total economic output of VPN protocol in that year becomes $PQ

b)?????Velocity of coin (V): This is similar to the velocity of $ in M1 supply. It simply tells you how many times a Token exchanges hands in a year. Just like $1 leads to much higher economic value creation (currently $5.5) due to circulation in the market, a Token (crypto coin) of an M asset base can create much higher economic output (PQ) depending on its velocity (V)

c)??????Float (F): A large portion of Tokens in the total supply are restricted for exchange because either a) they are staked, or b) they are held by long term hodlers with restrictions on selling, or c) they have not been mined yet. Tokens which are not restricted are free to move, exchange hands & create Token velocity. These Tokens are the Float (F)

d)?????Discount rate (D): Just like DCF uses Weighted Average Cost of Capital (WACC) to discount future FCFs, BVM uses a discount rate to discount future CUV. At the core of it, it is the expected rate of return that one needs to justify an investment into a riskier asset. In more rational terms, one can construct discount rate just like we construct WACC as follows:

a.??????Risk Free Rate (RFR): We can use the annual staking yields (APYs) on BTC or ETH

b.??????Beta (β): We can use the expected sensitivity of an altcoin relative to the overall market. We can derive this by looking at historical performance of alt coins in similar sector in similar valuation range relative to overall crypto market

c.??????Crypto Risk Premium (CRP): Theoretically, this should be the average economic output yield of the crypto market (including all crypto currencies) MINUS the RFR as defined above. With time, there will be ample empirical data to accurately estimate this, but today, it’s difficult to calculate it this way because of lack of data & approximations involved. Instead, we can look at this number as excess return that is large enough to attract investors from other asset classes to invest in crypto. In that context, you can take the average returns in public markets or private markets or a combination of both to use as a hurdle rate or risk premium here

e)?????Holding Period (T): This is subjective, and it is simply the period for which you want to capture the value creation by the blockchain protocol. I am assuming the definition of holding period will continue to evolve with time, much like how it did across various equity valuation methodologies

To arrive at the CUV for each year, we need to find what should be the total value of Tokens (called as Asset Base, M) that at a certain velocity of exchange can support the economic output of that protocol every year. Hence, simply put, M = PQ/V. Once you have the fair value of asset base required, you can calculate the CUV of Tokens every year by dividing the Asset base by total Tokens in Float (which are exchange hands & hence contributing to velocity & driving economic output). Hence, CUV = M/F. We can forecast yearly CUVs in this manner for the entire holding period (T), and then we can discount the CUV (T) at the end of holding period using discount rate (D) to arrive at the likely fair value of the Token today. Hence, Fair Value of Token = CUV (T) / [(1+D)^T].

Side Note: This valuation methodology values Tokens in terms of $ value. I believe that the base currency of the Web 3.0 world will evolve to be BTC or ETH (more on that some other day!). Hence, we will need to adapt this model to value Tokens relative to BTC or ETH

While valuation methodologies will most likely evolve over time, BVM shows us that the value of a Token is essentially driven by the economic output of the native Network and the velocity of Token movement within the Network, which in turn, depends upon the stage, quality, structure & maturity of the Network. Essentially, the value created by the Network resides on its native Token.

How to think of Tokens vs. Equity in the metaverse of Web 3.0 companies

This brings us to the muddy waters of blockchain companies which are currently issuing both Equity and Tokens, and which have sparked a massive debate in the industry on how should we reconcile the valuation of Tokens with that of Equity or vice-versa?

The short answer is you don’t! The value of Equity is NOT equal to the value of Tokens.

The reason I say this is because in my opinion these two instruments capture different things. As I have explained above, the value of Tokens captures the economic output of a given Network whereas the value of Equity captures free cash flows that accrue to a central organization.

To put this into context, let’s take Axie Infinity’s example & change a few assumptions. Let’s assume:

a)??????Sky Mavis takes a commission on each transaction that happens in the Axie Metaverse which generates a free cash flow (net of all $ expenses) for Sky Mavis

b)?????The Free Cash Flow to Sky Mavis doesn’t come back to the Axie Metaverse which is solely funded by burning treasury tokens that Axie has

In this scenario, if Sky Mavis plans to issue Equity, we would value its Equity by first determining its Enterprise Value (EV) using only the free cash flows that the studio generates for itself from the Axie Infinity Metaverse. Then we would calculate its Equity Value as:

Equity Valuation = Enterprise Valuation (EV) + 21% (Sky Mavis ownership) of total Axie Token (AXS) Market Cap + Net Cash

Hence, for non-DAO blockchain companies, which issue both Equity & Tokens, these instruments capture different kinds of value being accrued to different participants in the Network, and they are not the same.

This has a profound implication for Tech Investors: If we believe that blockchain is the technology of the future & is likely to power much of Web 3.0, then whether we invest in a DAO or non-DAO organization, most of the value created will reside in Tokens. As investors, we can capture a small part of the Token value through Equity investments (in non-DAO entities), but the most unadulterated way of capturing value creation in the Web 3.0 world would be to directly invest into Tokens & be part of a Network’s Tokenomics. It would not only allow investors to directly capture value creation but also allow them to generate yields on their ownership & play a significant role in Network governance & decision making (much like how board of a Web 2.0 company does!).

Side Note: There will be many blockchain companies where a token may not have utility. Current version of Central Exchanges (CEXs) & NFT Marketplaces are good examples. In these cases, in my opinion, value will continue to reside with Equity shareholders.

In conclusion, as the internet moves from Web 2.0 to Web 3.0, Platforms will give way to Networks, Boards will give way to Community, and Equity will give way to Tokens. Value and Governance will move from being central to being distributed. Your Token ownership will represent your right in both. Token is likely to become a much more powerful instrument of Web 3.0 ownership than Equity. Tech investors will have to look at Equity valuations & Token valuations separately. They are NOT the same.

The Internet is changing. It’s time we change the way we invest!?