Tokenomics for Investors

Why a Tokenomics Analysis Is the Edge

Value Capture for the Investor

Value is created when a problem gets solved for a user. It is then up to the company that is providing this solution to capture said value. Value capture refers to the process of capturing or realising a portion of the value that is created by a particular activity or asset. Value can be captured by the company itself in the form of IP, infrastructure, assets, etc or it can be translated to the share price. Since we’re interested in investing here we will only be concerned with the latter, the investment vehicle. 

There are two main forms of value capture that investors are interested in:

1. Capital gains (asset appreciation): This is the most common way to make money from stocks. It occurs when you buy a stock for a lower price and then sell it for a higher price. You are essentially capturing a portion of the value that the company has created. This is because the stock price reflects the company's expected future earnings, and as the company grows and becomes more profitable, its stock price is likely to increase.
   For example, if you buy a stock for $10 and then sell it for $20, you have made a capital gain of $10 per share.
   

2. Dividends: Some companies distribute a portion of their profits to their shareholders in the form of dividends. This can be seen as a form of value capture for shareholders, as they are receiving a direct payment from the company's profits.
   For example, if a stock has a dividend yield of 2% and a current price of $100, then the annual dividend is $2.

In both cases, investors are capturing value that is being created by the company. This value is not created by the investors themselves; it is created by the company through its operations and its ability to generate profits. However, investors can capture a portion of this value by buying and holding shares of the company's stock.

When it comes to the crypto space, there exist two types of value capture:

1. Value accrual to the project
   Value that is being directed back to the project itself. This normally takes the form of a percentage of revenue/assets being directed to back the treasury, i.e owned by the protocol (which in turn can be owned by the community)
   

2. Value accrual to the token
   Value that is being directed back to the token. This is also known as token mapping since value created is being mapped onto the token. There is yet another distinction that we can make here:

   1. Direct token value accrual: revenue created by the project is used to manipulate the supply/demand dynamic of the token. Manipulating the supply/demand dynamic essentially implies the balancing of the two, since price (also known as equilibrium) is the intersection of supply and demand, thus by constraining supply via locks, burns, buybacks, and more –essentilly mechanisms, we can affect the price of a token.

   2. Indirect token value accrual: revenue gets distributed to token holders. The reason that this accrues value to the token is because the token acts as a requirement to receive revenue share –and thus is a type of demand driver whose premise is to incentivise users to constrain supply so as to manipulate the supply/demand dynamic. Simply put, users want to earn yield and thus will buy the token to do so. Indirect value accrual does not have the same effect as direct value accrual since it does not affect the supply/demand dynamic directly.

Tokens Are Not Shares

There is one main difference that has to be pointed out when it comes to thinking about Shares vs Tokens. Namely, the fact that tokens have what is called Utility.

Unlike shares, tokens have a use-case or Utility. This refers to how the token is being used within the project and by whom. The reason for holding shares is to be exposed to some form of income (i.e an investment vehicle whereby one can be exposed to capital gains and/or dividends) or to own a part of the company (i.e when you own a share you own part of the underlying company’s assets). The reason for holding a token can be both of these things, but it can also be due to the added feature of utility. 

Aside from being an investment vehicle and granting ownership, tokens can be so much more due to the fact that they can have an actual use case within the system that they are designed for. Here are some well-known use-cases:

• Cryptoeconomic security
  Tokens play a crucial role in (1) preventing Sybil attacks by making it costly for attackers to create and maintain multiple identities, (2) aligning incentives between validators and the network, etc

• Gas token
  Users require tokens to access blockspace

• Membership token
  Users require tokens to access a gated community

• Bootstrap network effects/userbase
  Users are encouraged to use the product which can help solve the cold start problem

This is where the major difference stems from. Tokens can be integrated, via their Uility, into the system in different ways. This means that there is an extra factor to take into consideration due to the fact that Utility can have a varying degree on the token demand and thus price. Similarly, the Business Model that a protocol employs can affect token demand since this is akin to a stock dividend and can make the asset a more attractive investment, thus increasing the holder base. 

Tokens Don’t Behave Like Shares

Tokens are subject to a vastly different market dynamic vs their TradFi counterparts. Have you ever wondered why a token’s price drops when more tokens hit the market but the same is not true for a stock when new shares hit the market? In fact, for stocks, new shares being issued can even be seen as bullish and increase the share price. So what’s going on?

When more tokens are issued and thus the circulating supply increases, it directly dilutes the value of existing tokens, as the same amount of value is now spread across a larger supply. This increase in supply can lead to a decrease in the token's price due to the basic principle of supply and demand.

Unlike tokens, the issuance of new shares in a company doesn't directly dilute the value of existing shares. This is due to a few reasons such as: 

• Companies have assets and operations that generate revenue and earnings. Crypto protocols also have the latter, yet when it comes to tokens the market doesn’t yet seem to perceive value from these factors, unlike stocks which the market primarily derives its value from these factors.

• Companies’ share issuance is dynamic; new shares are issued as and when (not on a fixed issuance rate as with many token models) and the company has much more control over where these shares actually end up (with whom). This results in a general dampening of sell pressure on shares. However, in the case of tokens, they are normally distributed to stakeholders, AMMs or alike –i.e the market in general.

• Token issuance has been inextricably linked with an incentive-reward nature. It has become common knowledge in the crypto space that “User performs action A, protocol rewards user with token X”. This is alien in the realm of shares. 

Much of the above can be attributed to the fact that the crypto market is relatively young and speculative compared to the stock market. Tokens are often valued based on their potential utility, future adoption, and perceived scarcity. Therefore, an increase in supply can easily trigger a sell-off as investors fear dilution and a decrease in token value.

In the stock market, investors focus on a company's financial performance, growth prospects, and industry trends. The issuance of new shares is typically viewed as a sign of confidence in the company's future growth potential, and it may not have a significant impact on the stock price unless it's done in a large or unexpected manner.

Simply put, the valuation of a token differs from that of a stock due to, in the case of the former, investors focusing on factors like utility, scarcity (i.e supply and demand dynamic) and adoption. Whereas in the latter, investors focus on financial metrics such as earnings, revenue and growth prospects to evaluate a stock. The different reactions of tokens and stocks to increased supply are primarily due to the fundamental differences in their underlying mechanisms, market dynamics and investor perception.

Tokens Have a Different Demand Profile

We have covered the fact that tokens have an added feature known as Utlity and that they are affected more than stocks when it comes to their supply and demand dynamic. Therefore, it only follows that we should have a good understanding of the token’s supply dynamics and possible drivers of demand (also known as demand drivers). 

It goes as follows: 

A protocol sets a max supply (there are cases of protocols with infinite supplies, for the purpose of this explanation it is indifferent). We can understand this max supply as being theoretically divided into two main groups

• Internal supply: tokens allocated to team, investors and any possible bodies such as a treasury or foundation. 

• External supply: tokens allocated to the community. 

Note that this is a theoretical division of the max supply and is used simply to improve understanding; all tokens are fungible.

Internal supply is (should be) subject to a cliff and vest period, normally these tokens cannot be used during this period, thus we can earmark these tokens since they’re not circulating and thus do not affect price. External supply has multiple ways of being distributed such as LM programs, airdrops, community rewards, etc. The thing to understand here is that the external supply’s demand profile is closely related to three core factors:

• Utility: user is required to hold the token in order to perform their desired task.
  E.g., User has to hold ETH to transact on chain

• Demand Mechanisms: users are encouraged to acquire the token in order to perform their desired task.
  E.g., Lock CRV (thus receiving veCRV) in order to gain boost, rewards and voting rights

• Business Model: user receives revenue share by having exposure to the token.
  E.g., Users stake SUSHI (thus receiving xSUSHI) which entitles them to revenue share

These three factors are ways by which a protocol captures value. Value capture is what investors want, as stated at the beginning, this is primarily done via capital gains or a dividend. Both of these are affected by the factors stated above, namely the effect that Utility can have on token demand due to it being a requirement in order to perform their desired task. The effect that Demand Mechanisms can have on token demand is due to the aligning of incentives between users and the protocol itself. Finally, the effect that the Business Model can have on token demand is due to the dividend-like aspects of revenue being distributed back to tokenholders.

Conclusion – A Tokenomics Analysis Is the Edge

A tokenomics analysis is the only way to properly understand all of these dynamics and have an informed outlook on the prospects of the token in question. We are using frameworks (i.e those of stocks) that were not designed for crypto assets and thus only provide a partial view of the state. 

If you aren’t performing a tokenomics analysis on your medium to long-term investments then you are doing yourself a disservice akin to having a map with a missing piece of the route, you don’t have the full picture of how your trajectory may be affected. 

In order to make an educated decision as to whether you should invest in a token or not you need to understand the token utility, different demand mechanisms at play and the business model since it can have a vast impact on its price which is, after all, what you're interested in as an investor. 

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