Share holder vs Token holder: Who wins?

Photo by K. Mitch Hodge on Unsplash

A couple of years ago, we wrote a comprehensive paper outlining our views on what token economics could do in terms of creating alignment across different stakeholder groups in a business. Implicit to that view was the assumption that being able to involve larger numbers of participants beyond the traditional categories of “equity holders/owners” and “debt holders/creditors” would lead to a fundamental change in how businesses could be funded and conducted.

The natural fit for such a model was the idea of tokens, which thanks to the programmability of the blockchain VMs they were built on, could be customised to become a representation of whatever line item in a company’s financial statements the issuer desired. A share of revenues? That’s doable. A share of fixed assets on the balance sheet? That’s possible too. The permutations were endless, certainly diverse enough to make a derivatives structurer rather envious.

Two years on, the tokenomics experiment has spread far and wide. It’s now more than just about fungible tokens that represent governance claims (including, or not, claims on the treasury of some projects) – there are now projects with native stablecoins representing pegs to fiat currencies, some more successful and sustainable than others; there are NFTs with attempts to attach utility to them, including copyrights on art, commercial cashflows and licensing rights. At its base level, the idea of customising interests in a manner that addresses specific groups of stakeholders – community members, contributors, passive owners etc. – seems to be well and alive.

That said, equity remains a critical part of the capital structure even for crypto/web3 startups. Perhaps it is a function of the “real-world” legal protections accorded to equity holders, or perhaps it is a consequence of equity fulfilling its purpose of being the “catch-all” of all remaining profit at the bottom of the capital structure – either way, equity has by no means been supplanted by tokens when it comes to representations of ownership.

Programmable capital

Classical finance textbooks tell the story of how a company’s returns after its costs of operation go first to paying the debtholders of the company, and the surplus – whatever that may be, if any at all – goes to the equity holders. The tradeoff here is clear: in exchange for seniority in claims on capital, debtholders sacrifice the optionality of upside. Whether the business performs poorly or well, they get their same fixed income return. Sure, there are ways to customise these returns – floating rate debt, mezzanine debt, convertibles etc – but the tradeoff is always the same: security vs optionality.

In the early days of crypto, there wasn’t much to be “fixed income” about: cashflows were non-existent, so most tokens were essentially structured as pseudo-equity (regardless of what their issuers may say). The initial ideology of eschewing any interaction with the world of regulated capital also drove many of the structuring decisions: the appeal of the narrative at the time was one akin to “now everyone can own this wonderful new project that could change the world.”

Over time, the token economic structures of projects became ever more complex: equity-like instruments continued to exist, somewhat disguised as “governance” tokens with a claim on treasuries; but alongside these came options to stake tokens to serve as capital buffers on lending platforms, earning outsized returns on more “fixed income” basis, albeit denominated in the token itself, much like preferred equity with dividends paid in stock. Other mechanisms like internal stablecoins also rose and fell, with a corresponding token serving as the balancing term for the issuance of a fixed-value token, at least when denominated in fiat currencies.

The discussion here is not about whether these systems of token economics work – it is rather about the fact that they exist. Bundle in the world of NFTs and the utility which new projects are seeking to tie to these tokens, especially in terms of enriching the metadata carried by these tokens over their lifetimes and translating it into rights, licenses and royalty claims, and it’s clear that the experiment has only just begun.

The flexibility of programmable capital – and the accompanying decision to program away certain lines of a business’ operations – are developments that open the door to ever more strategic allocations of risk and return in business.

This is your land, this is my land

The realisation we came to here is that not all forms of stakeholdership (for the lack of a better word) are equal. We know that already with traditional debt and equity: debtholders don’t complain that equity holders get to see their stock prices rocket when a company reports good earnings; likewise equity holders don’t complain when they get diluted in order to raise capital to pay down debt. Sure, everyone complains when they lose money, but there’s no question about whether the rights and risks attached to each instrument are fair.

Each instrument type serves a specific purpose and functions in a specific way, and the management of the business picks the right instrument depending on their tolerance for risk against the prospective rewards. But with traditional instruments like equity and debt, the incentive for the investor is almost purely commercial. There are cases where strategic stakes are taken, perhaps to cement a commercial relationship or to garner strategic control of key assets, but for the large majority of buyers of stocks and bonds, it’s all about the money.

The entire idea of expanding the scope of incentives to “stakeholders” as a broad group was to create incentives that, while commercial, are much more profound. The ease with which tokens could be programmed, created and distributed to the relevant parties not only in the first instance but also on an ongoing basis meant that specific functions and behaviours could be incentivised in exchange for carving out certain bits of a company’s cost structure.

For example, one project which we had written about before, Helium (which unfortunately is facing a rather tumultuous episode at the moment), had caught our eye because of the innovative approach they had taken to incentivising crowd behaviour to undertake something that no centralised/privately owned telecommunications company ever managed to do: install a global network of now more than 940k hotspots in high density and quantity. The secret: offering up a share of the infrastructure to the owners of each hotspot, thereby transmitting the benefits of the network to them as a result of utilisation.

To be sure, risks remain: will the network be used? Will the revenues be sufficient and meaningful? Will there be competing technologies and networks that come into play (e.g. Pollen competing in the 5G space in the US)?

Perhaps the most profound change this causes is a demarcation of interests: in the case of Helium, tokenholders are incentivised to maintain the network at its best and build the best physical network for data transmission possible. Even better, they are incentivised to encourage use of this network in their capacity as consumers, because more traffic = more data, more data = more burn, more burn = more upside.

From the perspective of the company that operates the network, this is supplier financing at its finest: suppliers pay upfront AND provide the service of installing and maintaining hotspots, in return for future payment at a more senior level than even debt. They are a cost item – in the order of claims of capital, they are a cost of operation and rank even higher than debt, on one condition: that they are a monopolistic provider of the said service.

This commercial power works both ways, however: in the case of Helium, the network is the sole provider of transmission and infrastructure services to the operating company, but the operating company is also the sole client of the network.

With a monopolist facing off against a monopsonist, “your cost is my revenue”.

While not necessarily adversarial, the demarcation of interests can be a double-edged sword. On the positive side, it focuses the interests of each group on a defined aim. On the other, interests may not always remain perfectly aligned, and even where they do, the chosen path for getting to those shared goals can diverge significantly – as we are now seeing in the case of Helium, with the proposal to move the network’s operations off its native chain to Solana causing some upheaval in the community and a potential conflict between what’s best for equity holders and what’s best for token holders.

Caveat Emptor

Whether in the case of Helium, or any other projects whose business models remain completely fluid at their early stage of development, to cast the disappointment and potential unprofitability of these ventures as an indictment of the model of tokens and equity coexisting in the capital structure is nonetheless unfair, in our opinion.

Just as the rights, risks and rewards are different between debt and equity, and upside/downside happens in very different ways, so too should we not expect all forms of “ownership” to be equal. Carving out specific parts of the means of production into a token and incentivising certain groups of providers to undertake their provision is in itself not a bad thing, and could – as Helium has proven – be a rather efficient and effective means of bootstrapping what was previously impossible.

Whether in debt, equity or tokens, investors need to make their decisions with full knowledge of what they’re buying – programmable capital offers flexibility and precision when it comes to the location on a company’s income statement to which a claim is directed. In the good times, it could be a windfall; in the bad times, it could be a zero. If it remains necessary, it is an even more senior claim to debt; otherwise, it becomes an operating consideration, perhaps a cost, perhaps something to be optimised, and not necessarily as set out in the initial plan.

Is equity always the “better” choice? Not necessarily, since the residual to equity holders could be zero, or even negative, for years, if not perpetually if a business fails. With programmable capital, this isn’t about “profit” in the traditional sense anymore – it can be much more targeted and specific.

That said, in the first instance, in return for underwriting the capital of the entire business, the choice as to “what” to program away lies with the equity holders.

The bottom line here is that with the introduction of tokens as an alternative form of stakeholdership, things get more flexible and precise. That comes with pros and cons: it makes being right much more rewarding, but also makes being wrong that much more painful.

Applied correctly though, a nimbler capital structure along with the ease of distribution of tokens to a much larger stakeholder base nonetheless allows for the birth of business models previously impossible to achieve.

And that is what we continue to look out for.