This blog post explores the inherent tensions between investors, entrepreneurs and consumers. Investors are incentivized to invest in many projects, and hence entrepreneurs see this as a money-grab since they do not need an exit (acquisition/IPO) to cash out. This results in deadweight loss to society where many low-quality projects will get funded and many entrepreneurs will get rich by optimizing for the short-term.
This post does not offer any answers as to how to align these incentives, but brings to light some of these tensions. I argue that there is appeal to having long-term vision and working on things that will last.
Valuations vs. Longevity
Almost all cryptocurrency projects today are severely overvalued. EOS has a market capitalization of more than $10 billion and they have not launched their blockchain. XRP has a market capitalization of more than $25 billion and yet it is barely used by banks or payment providers. This is the glaring critique of the cryptocurrency space that many people are calling out.
Valuations are a proxy for how cheap or expensive something is. If EOS was valued at $20 million, it would be much more comfortable to stomach because it is relatively cheap for the market it is trying to dominate (smart contract platform). Hence, valuation is a useful tool to evaluate an investment opportunity.
There is another angle to this — longevity, or how likely a project is to still be here in 10 years. For most regular businesses, longevity is extremely important to valuing a company because longevity represents a stream of future cash flows. The higher the chances of a business being here in 10 years, the higher its valuation today.
This is often overlooked in when evaluating cryptocurrency projects for multiple reasons. Firstly, the liquidity of cryptocurrencies and tokens make the dynamics such that it does not really matter if a project will be here in 10 years if you can sell the tokens for a higher price next month. Secondly, it is difficult to draw a direct relationship between a project's longevity with the token's price. If a project can last for decades but the underlying token does not accrue value, its longevity does not matter from an investment perspective.
It makes sense that longevity is not particularly important for an investor, but it creates very perverse dynamics for entrepreneurs.
Longevity and Entrepreneur Incentives
For regular businesses, an entrepreneur's sole purpose is to increase shareholder value. He does so by building products that people want to buy, increasing the cash flow to the business. Equity in the company represents a claim on this cash flow, hence the more equity an entrepreneur has, the more incentivized he is to increase the cash flows.
Cryptocurrency projects on the other hand have no concept of cash flows. The teams behind these crypto projects are incentivized to increase token value, by making a useful application, service, or ecosystem. However, it is not entirely clear that the more useful and the more used a project is, the higher the token value. This may hold true for the early stages of a project when there is low adoption, but as a project goes from 100m users to 200m users, it may not result in any increase in token value.
This creates strange incentives for entrepreneurs in the crypto space. It only makes sense for an entrepreneur to keep working on the project as long as the marginal increase in token value continues to go up. Hence, other than altruistic reasons, why would an entrepreneur care to make their project last for the next 10 years?
For example, let's look at the Augur project. Augur is a decentralized prediction market was created in 2014, and they are set to launch by mid-2018. This means that the founders' of Augur would likely have their tokens fully vested by the time the project launches. If the price of the Augur token REP stops increasing, the founders can cash out entirely and stop working on it. In some sense, the battle is over once the founders' equity fully vests. This will create stagnation for the Augur project and consumers lose in the long run.
Fixing the Incentive Problem
Some projects like Zcash have a Founders Reward, which states that the ZCash team will receive a percentage of all newly mined ZCash coins. Since new coins are mined over time, this means that the ZCash team is incentivized to optimize for longevity, because the longer the project is around, the more coins the team will receive. Of course, the team will want to increase the coin value as well, but they will stick with the project over time because of this incentive structure. In some sense, the Founders Reward is like a stream of revenue to the ZCash company.
This encourages the team to stick with the project over long periods of time, but creates new problems. The Founders Reward is a tax on the network, and because the ZCash source code is open-source, other people can fork the project and reduce the Founders Reward. In theory, users will instantly flock to this new ZCash fork which has no Founders Reward since its cheaper and has the same technology. So, although the Founders Reward aligns incentives for the entrepreneur and the project, it is misaligned with the consumer. The common argument here is that consumers believe that the Founders Reward will go to advancing the project, and hence increase the value of each coin. However, it is difficult to put a price on the contribution of the ZCash team and creates conflict between the different parties involved.
There are multiple variants of this Founders Reward, but they are all a tax on the network which can be forked away. In summary, incentives for working on crypto projects have a fundamental tradeoff:
- Optimize for token value, misaligning entrepreneur and project longevity
- Optimize for longevity with network tax, misaligning project and consumer
Given a choice between these two outcomes, most entrepreneurs will pick #1. It is much more lucrative to work on a project for a few years and exit at the peak versus sticking with a project that will last a decade.
The implication of this is a bunch of "blockchain entrepreneurs" optimizing for the short-term, building half-assed products that will not stand the test of time.
This is not the future which I want to be a part of.
Venture Capital is a business where the outcomes follow a power-law dynamic, and it makes economic sense to make many smaller bets. In the cryptocurrency space, there are many market segments which will probably be winner-take-all. For example, stablecoins (USD-pegged/backed cryptocurrencies) will be almost homogenous to consumers, and hence is likely to be a winner-take-all market. Hence, to get exposure to the advent of stablecoins, a sound strategy is to invest in many different stablecoin projects. Even if some of these projects fail, they will make room for the investors' other stablecoin investments to win the stablecoin market.
Since this space is so young, this same principle applies to many different market segments — smart contract platforms, privacy coins, etc. This means that many many projects will get funded, which in my opinion, messes up incentives for entrepreneurs to start crypto projects once again.
Because of the availability of capital, entrepreneurs are extremely incentivized to work on crypto projects, use the raised capital to pay themselves for a few years, and sell their tokens as they vest. From inception till exit, entrepreneurs will try to create as much sustained hype as possible to pump the price of their tokens. Even if their project turns out to be completely undesirable to the market after a few years, the entrepreneur walks away with a good amount of cash in hand.
Clearly, the availability of capital from investors is fueling this type of short-term thinking. This scenario is seemingly inevitable because investors want to invest in many projects to "spray and pray", and this incentivizes entrepreneurs to build bullshit companies that will last 2-3 years at best. This type of behavior may accelerate the advent of the adoption of cryptocurrencies to the mainstream but creates a lot of deadweight loss to society.
As an Entrepreneur....
We should be exploring new types of business models or new types of vesting structures to ensure that we remain engaged to build long-term projects. Long-term vision is what spawns decade-defining companies like Google and Amazon.
Although we can probably create crappy crypto-projects that will get funded and possibly pose good financial upside, there is magic in building something that will stand the test of time and that creates value for yourself, your investors and your consumers.
This is the type of thinking that builds the one in a billion entrepreneur like Jeff Bezos or Bill Gates.
* I am exploring a new blog format, inspired by this amazing blog.