Shares vs. Tokens

My key takeaway from this great podcast with Hasu, is that DAOs should be run more like businesses.

It made me think not only about DAOs and businesses but also about shares and tokens. When evaluating a crypto project or a business, people tend to look at how shares or tokens perform to get a view of the underlying business.

Two things I’ve been hearing a lot in the last months.

“Governance tokens don’t accrue value to the token holders”

“I’m not buying this token – it’s inflationary”

Both are relevant concerns around utility and supply, but I feel that stock investors pay a lot less attention to this or at least evaluate shares and their businesses a lot differently. In this piece I want to try and compare a few different aspects of shares, tokens, crypto businesses and traditional businesses and cover the following:

  • Supply

  • Utility

  • Fundamentals of a crypto/traditional business

  • How stocks are evaluated

  • How to evaluate tokens

  • Governance

Supply

 

When crypto people evaluate tokens, they often look at the mechanism of token supply and quickly judge if it’s a good investment or not. While this might not be a bad idea, I haven’t seen investors do this with shares. Corporations like Amazon issue more shares annually and by that dilute shareholders as well.

Tokens and shares can be ways to raise capital, attracting and retaining talent, representing ownership and allowing to measure the value of the underlying project or business. Both can be managed in ways to increase or reduce supply and tokens even have capabilities to embed them into processes (like locking them up; for voting power or access to yield).

Shares are governed by a board of directors which decides on issuance of new shares or buybacks, which takes them out of supply. 

In crypto, token holders fulfil this role and may vote to issue more tokens or take them out of circulation by burning them. The main difference is that the issuance of new tokens is mostly programmed into the smart contract of the protocol (see dYdX) or encoded into its mechanisms as with Ethereum EIP-1559, which burns tokens with every transaction.

Professional investors might look at the number of shares issued by corporations like Amazon, but the fact that there are no Olympus DAO-like hyperinflationary shares, makes everyone put less emphasis on it. Outliers and experimentation like hyperinflationary tokenomics only exist in crypto.

Crypto businesses get a lot more creative and you should take a close look at supply when evaluating them. New issuance doesn’t have to be bad, but shouldn’t be neglected as it’s presumably often done with stocks.

Utility

Tokens offer a lot more flexibility in designing and programming mechanisms to incentivise certain outcomes (think of time based vesting to increase voting rights), whereas corporations have to decide and implement these kinds of things. It makes tokens more predictable as in most cases, the logic can’t be easily changed.

This obviously brings trade offs. If the crypto project has a programmed mechanism to buy back and burn tokens, it might not always buy at the best possible time. A business on the other hand, will buy shares when they think the price is low. Decentralised governance via tokens could implement a similar process though.

As a rule of thumb, if the token’s only utility is governance, then evaluate it like a business. Else, it’s very important to look at how these mechanisms impact the flow of tokens.

This can make tokens a lot more complex to evaluate than shares. In fact nobody just evaluates shares on their own, it’s the business and its price that people look at. Tokens on the other hand require us to look at both the underlying business and the mechanisms in place. 

Fundamentals of the business

In most cases, evaluating the mechanisms is done fairly well in crypto, but I feel there is not enough attention on the actual fundamentals of the underlying business of the crypto project.

This is something we’ve been talking about a lot and highlighted in our Ponzi article, in our Tokenomics Design Framework and in the Evaluation Framework: 

 If the tokenomics are great, but the project or business is not, then that’s a huge red flag. 

It is thus important to look at fundamentals. 

Does the project have any cash-flow? 

Does it have revenue?

Does it make a profit? 

Is there potential for it doing so in the future?

This is an obvious one for stocks. Most investors will have cash-flows, revenue, profits and perhaps even a solid balance sheet on their radar when evaluating. 

In a crypto bull market or an environment with high liquidity and low interest rates, it doesn’t matter that much – the rising tide lifts all boats. In a bear market, however, or if you have a longer time horizon, it is something very important to look at.

How to evaluate stocks?

 

What makes stocks valuable is ONLY the business the shares are representing and that’s the only sustainable number-go-up mechanism there is (speculation aside). 

The owner of a business’s stock owns a piece of the business and this in itself is valuable because a lot of businesses share their profits with stockholders by paying out a dividend.

Without a dividend, you can’t profit from the share unless you sell. Amazon doesn’t pay a dividend and the only way to cash in on the value created is to sell it to someone who believes the underlying business will be worth more in the future, resulting in a return on his investment via price appreciation of the underlying shares. The return on investment in this case does not come from dividends, but through growth of the underlying business as the profits are not distributed to shareholders but reinvested into the business itself.

The value most associated with shares of a business comes from the fact that ownership means owning assets, intellectual property and earning power. All of this is perceived value as you can’t turn in your shares for a piece of Amazon-Warehouse.

For shares, one of the strongest demand drivers is simply the performance and potential of the underlying business. This simple breakdown argues that the value of shares is derived from the potential to pay out dividends (if the business doesn’t) and the ability to redeem some asset value in case of liquidation. The liquidation case is quite uncertain, as shareholders are served last and in most cases won’t receive anything (exits/buyouts are a different story).

Investors will obviously look at more than that, but past earnings are a pretty good start to assess earnings power. Various metrics exist:

Earnings per share = Income  / outstanding shares (distributes the income among the shares in existence - the higher the earnings the better)
Price to earning = share price / earnings per share (brings the share price in relation to the earnings per share - the lower the ratio the better)
Price to sales ratio = market cap / revenue (more applicable to businesses that are not profitable yet - lower ratio indicates it being undervalued)

As we are talking about crypto, not many will have profits or the information will be hard to find. Smaller tech businesses might thus be a good comparison using P/S:

Source: https://microcap.co/valuation-multiples-for-tech-software-companies/ 

How to evaluate tokens?

 

Token terminal gives us a price-to-sales, defined as follows:

Price-to-sales ratio is equal to the fully diluted market cap divided by annualized total revenue. Annualized total revenue is calculated as the total revenue over the previous 30 days multiplied by 365/30.

If we agree that it’s the business that makes shares valuable, then tokens won’t be that different. Let’s leave mechanisms aside for now and look at the p/s ratio for tokens.

LooksRare, the NFT marketplace, has a ratio of 3.2, which doesn’t seem too bad when compared to a business.

We might be oversimplifying. I know we are not looking at this long term and there might be more suitable indicators, but from a pure business perspective, this is an interesting way to look at crypto projects.

The biggest problem with this evaluation is the token. Crypto projects use tokens as incentives and can mint as many tokens as they want. Incentives help to grow revenue, bootstrap an ecosystem and solve the cold-start problem. This can lead to the crypto project running purely on these incentives.

Just look at the correlation between token incentives and revenue, brought up by Kerman Kohli. Here is LooksRare:

The big question is, could LooksRare continue to produce this revenue if it stopped incentivising with tokens?

In a recent piece, Bankless has evaluated several DeFi protocols for their profitability. The summary is that most protocols still run like LooksRare. The P/S ratio might look good, but if we deduct token emissions as cost, it does not anymore.

Key takeaway: we should evaluate crypto projects more like business, but should not forget to factor in the token – here it often plays a different role than shares.

Governance

 

If we look at crypto businesses more like real businesses, then governance becomes interesting. Instead of just searching for a number-go-up mechanism, we might try to find those that have sustainable revenue and a path towards profit.

Comparing governance between crypto and traditional businesses, does bring up the regulatory side. Shareholders do have certain rights, which include a claim to a corporation’s assets in case of liquidation – although ordinary shares are served last –  and a right to maximise shareholder value seems to be a myth.

For token holders such regulations do not exist, although it probably could be implemented in smart contracts. However, governance tokens offer a lot more flexibility in terms of what can be voted on.

Having decision power over a treasury that receives revenue from a profitable crypto business shouldn’t be that different from being a shareholder of a corporation that generates revenue. It seems similar to Amazon, where the return on investment of shareholders comes from selling shares as the business grows.

Closing thoughts

 

Aside from what can be voted on, crypto businesses with pure governance tokens seem to be pretty similar to traditional businesses. It’s the part where the token kind of becomes a proxy of the business, just like shares.

But once tokens are involved in more – and that’s what makes them exciting – a lot more nuance is required.

I think it is important that investors and builders look at both the business and the mechanism. Don’t disregard either. From a business perspective crypto projects can be similar and the tools we have to evaluate them should be used. The token and its mechanisms make things a little more complex though, and require us to evaluate both.

If we do, there might be fewer ponzis, crypto projects might be run more like businesses and we could see more sustainable tokenomics emerge.

In summary:

  • Supply: Pay extra attention in crypto. Inflationary supply does not need to be bad, if the business grows with it.

  • Utility: Mechanisms is where the main difference is, but I feel the crypto world knows this.

  • Fundamentals of a crypto/traditional business: Should deserve more attention!

  • How stocks are evaluated: Various metrics exist and we can adopt them to crypto.

  • How to evaluate tokens?: Evaluating crypto businesses like stocks is not enough. The token, in most cases, plays a significant role.

  • Governance: If the business is good, governance tokens can be a proxy.