Building a Web3 portfolio: hold tokens or hold equity?
When building portfolio exposure to Web3/crypto/blockchain, a basic question for capital allocators is whether to hold tokens (or 'coins'), or to take a more 'professional' approach and participate in funding rounds of the underlying Web3 company.
The thinking is usually that tokens are like casino chips: there's no apparent intrinsic value, they are highly volatile, and they can be stolen. Startup equity, on the other hand, has none of these downsides.
Here's the problem – none of this is accurate for blockchain-native projects.
Web3 projects are not just a different technology, but different organisations altogether. And why the native token, not a company's equity, is at the centre of truly blockchain-native projects.
To capture the true value of this disruptive technology, allocators need to evaluate and hold native tokens. This is what FNDX does, and this document describes why:
The token as the means of value capture
The best way to think about Web3 projects, is as collaborative development by participants with an economic incentive layer provided by the native token.
For well-designed blockchain-native projects, the value created accrues to this token, not to the cap table of some underlying company. Here's how:
In a web3 project, participants play different kinds of roles, not just as passive consumers or investors.
Some participants actually provide the hardware and the project software in order to provide the core service. These participants are usually required to put up a certain number of need of tokens to show their commitment to providing quality service. As the resources are used, they are rewarded with the native token. If they fail to provide the service, their staked tokens are slashed, or forfeited.
Participants who use the service typically pay for it, using the native token as well.
Other participants who hold the token may choose to back some service providers by delegating their tokens to them. In return, they get a share of the service provider's earnings.
As the service is provided and paid for, the protocol itself earns a transaction fee. This is typically used to pay for further development.
Lastly, all of these participants can potentially vote in the governance of the project in order to shape its direction.
All of these operations are laid out transparently in the project's smart contracts. The usage of each of the smart contracts whether is taking all delegating or usage or governance is open and can be seen on the Blockchain in real time.
So as you can see all aspects of the project are mediated by the native token. The token is what aligns the incentives of these various parties.
Let's see this at work in an actual Web3 project:
Chainlink and its token mechanics
Chainlink is a decentralized oracle network that aims to connect smart contracts on various blockchain platforms with real-world data sources. It is the poster child of successful, useful Web3 projects.
Smart contracts, being executed on blockchains, cannot directly access external data sources on their own. Chainlink's decentralized oracles bridge this gap.
Chainlink is a good example of how the participants play different roles in the service and how good token mechanics align their incentives.
Participants are: node operators, ordinary token holders and end users, in addition to the Chainlink protocol itself.
Now the native cryptocurrency of the Chainlink platform, LINK, serves multiple purposes within the network:
1. Node Staking
To become an oracle node in the Chainlink network, operators need to stake a certain amount of LINK tokens as collateral. This staking mechanism incentivizes honest and reliable data delivery since node operators risk losing their staked LINK tokens, a form of security deposit, in case of malicious behavior or providing inaccurate data. This also increases the overall decentralization and security of the network by preventing a single entity from gaining control.
2. Users and Network Fees
When smart contracts request data through Chainlink, they pay fees in LINK tokens to the oracle nodes that fulfill their requests. These fees create an economic incentive for node operators to continue providing data services to the network.
3. Governance
LINK token holders can participate in the governance of the Chainlink ecosystem by proposing and voting on protocol upgrades and changes. This democratic approach empowers the community to have a say in the network's future, promoting a decentralized and inclusive decision-making process.
4. Protocol Revenue
Finally, the protocol can also potentially keep a portion of the network fees before distribution to node operators to fund its own development.
Here’s how Chainlink visualises it:
This is how LINK tokens, not equity in a Chainlink company, are the backbone of the Chainlink ecosystem. They
- facilitate secure and decentralized data delivery for smart contracts
- encourage active participation from node operators, and
- enable the community to govern the network's evolution.
Web3 vs 'Web2'
Such alignment of participants is radically different from how traditional organisations operate. In such organisations, there is a clear distinction between the company, investors, and consumers. Contracts are opaque. Usage and sales are disclosed only once every quarter or less frequently. Legal recourse is only available post facto.
Token incentivised products on the blockchain enable efficiency and transparency and innovation that is often simply not possible in traditional organisations.
This is what makes the token more valuable than the equity of some underlying entity.
At scale, such an underlying entity is not even essential to the functioning of the project. For those familiar, the closest analogy is open source development. Except that instead of the motivations being altruism and status, there is a strong monetary incentive layer driven by the native, token, smart contracts, and the blockchain itself.
With token mechanics, traditional valuation and investment methodologies break down
If one were to apply the discounted cash flow model to calculate the 'intrinsic value' of a token, there are basic issues:
For instance, what is the project's operating margin in order to calculate free cash flow?
What is free cash flow itself: the entirety of user fees? Is it the share earned by by the service providers who stake their tokens? The share earned by the organisation, which may be zero?
What is the 'value' at which the business will be sold after a certain number of years? Is it the equity value of the underlying entity? The entity itself, even if it exists, only develops the product -- the service itself is provided by stakers, which participate in the governance of the product's roadmap.
VCs and other firms attempt to fit valuation models to the project.
But how reliable are any of its projections, say LINK token pay-outs to oracles over five or ten years, given that most projects like Chainlink are early-stage companies, and it may be premature to evaluate them as listed entities/going concerns?
This does not even include other dissimilarities such as, notably, multiple 24x7 markets for a token with multiple prices and multiple counterparty tokens, in some cases across multiple blockchains.
It's clear that this new economic system needs a totally new model for objectively estimating which Web3 projects, and therefore which tokens, are likely to gain adoption and succeed – which is why FNDX created the pioneering Fundamentals actively-managed strategy.
In conclusion
FNDX focuses on holding tokens of successful Web3 projects rather than equity.
In Web3 projects, value is captured by the native token, which aligns incentives among participants
In contrast to traditional organizations, such token-mediated alignment is reflected transparently on the blockchain. This encourages unprecedented transparency and efficiency, driven by token mechanics and the blockchain, making tokens more valuable than underlying equity.
Applying traditional valuation methodologies to tokens can be challenging due to the unique mechanics and uncertainties associated with early-stage projects, which is why FNDX designed and built a new, ground-up token evaluation model.
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Photo credits: Mitchell Luo, Benjamin Child, Martin Sanchez, Robert Anasch on Unsplash.