Utility Tokens vs. Security Tokens – Why it Matters
It’s amazing how popular public opinion can drive herds of investors in directions that are sometimes fatal. Take for example Initial Coin Offerings (ICOs), most of which offer up something called “utility tokens”. These are largely worthless tokens that live on the blockchain and have no equity behind them, yet media pundits still offer up speculations as to “whether or not the ICO will replace the IPO.” When tokens represent actual equity in a company, then maybe we can start to have this conversation. Until then, this sort of disinformation is what has fueled millions of retail investors to throw away their hard-earned money at ICOs, sometimes giving it to outright criminals, who will then use it to commit more crimes with.
Just today, there was a hilarious article by The Onion which talks about how we should be paying employees in tokens because it motivates them better than equity:
Just kidding, it wasn’t The Onion. The above article actually appeared on TechCrunch yesterday, and we were immediately compelled to ask some questions like:
- Is there anyone out there dumb enough to work for utility tokens?
- Is there any startup out there dumb enough to think that this creates the same sort of long-term incentives that equity does?
- Are we just not seeing the value on offer here because we smoke too much weed?
In order to set about answering these questions, we first wanted to clarify which type of token the article is talking about.
Utility Tokens vs. Security Tokens
Firstly, is the author referring to “utility tokens” (little coupons you can use to buy a service later that will likely never exist) or security tokens (tokens that represent equity in a company)? It’s tough to conclude that the article refers to security tokens when it makes statements like this:
There are many ways tokens and equity are similar.
Actually, no. If a token represents equity in the company, then they have exactly the same value except for the platform on which they are exchanged and tracked (let’s leave aside the notion of a “liquidity premium” for reasons we’ll discuss later.) If a utility token contains no equity stake in the company, then it is pretty much worth eff all. It seems that based on the above statement – as ludicrous as this sounds – the article is actually referring to utility tokens. (Here’s a decent primer on the different terminologies being used here.)
If, in fact, you are willing to work for worthless utility tokens, please contact us immediately. Actually, don’t contact us, because we don’t want people that detached from reality anywhere near our team of MBAs. Let’s assume instead that these tokens represent an underlying equity stake in the company you are working for.
The Employee’s Perspective
When you’re an employee of a startup, it’s exciting when you first hear about how much equity you might be getting in the company you’re about to begin working for. It truly is motivating to know that you are now an “owner” in the company you work for, even if it’s just a small fraction of total ownership. Usually, this equity is given in the form of stock options, best described by Tech Republic as:
- A stock option is the guarantee of an employee to be able to purchase a set amount of stock at a set price regardless of future increases in value
Note that this is a double-edged sword. If the company fails to grow and gets bought out at a lower valuation than the strike price of your options, you get absolutely nothing. You also get nothing unless there is a liquidity event (usually a sign that you succeeded if the event occurs at a higher valuation than what your options were granted at). This motivates you to stick around and bust your butt until there is a liquidity event – or at least until all your options are vested.
In the case of tokens that represent equity or equity options, the intrinsic value of these options should reflect the actual price the tokens are trading at. Essentially, tokens offer a secondary market with loads of liquidity. That means that you can sell your equity options as soon as they are granted. For the employee, this prospect sounds great (apart from the tax implications). For the founder, not so much.
The Founder’s Perspective
If you’re a founder, then compensating your employees with utility tokens sounds like the best thing since sliced bread. Instead of giving your employees shares in your company, just give them little coupons that they can then later use to buy your products with. It’s as if Amazon suddenly decided to start paying their employees in gift certificates, except much worse. (That’s because at least Amazon has products that you can spend your money on today – instead of waiting and waiting in hopes that someday there will be a product to buy regardless of what the final quality looks like.) For a founder, paying employees in utility tokens instead of equity sounds perfect. Of course, no competent human being would ever work for utility tokens. So does this mean that founders should compensate their employees using security tokens?
From a founder’s perspective, there are a few major problems with issuing equity in the form of tokens, one being that they are so liquid. A good point the author makes is around liquidity. Pre-IPO shares have been historically illiquid, that is until the emergence of secondary markets like EquityZen and others. On the other hand, utility tokens are traded on various exchanges – volatile as they may be – and employees can cash out anytime. Therein lies the problem. If an employee can cash out anytime, what’s keeping them from leaving your company? Sure, you could have a vesting schedule. But what sense does it make to have everyone liquidate their holdings every time they vest at values that are assigned by external stakeholders who are largely driven by hype and mania?
The External Stakeholders’ Perspective
When the article mentions “external stakeholders”, it might refer to all the tools out there who were dumb enough to buy useless utility tokens and then ascribe sky-high valuations to them. These are not people who are capable of valuing a token, regardless if said token contains equity or not. So, when the employee goes to cash out after their tokens have vested, they may either be faced with a price on offer that is much higher than the actual value of the token (not good to reward people who haven’t earned it) or much less than the actual value of the token (good luck having your HR lead field questions around this). It seems extremely unlikely that “the market” (largely consisting of people who are driven by hype and mania at the moment) will ascribe the proper value to the tokens, something that largely offsets the whole “liquidity advantage” the article talks about. So far, we can conclude that even if the tokens used for compensation were actually tied to equity, it doesn’t benefit anyone to use them as opposed to traditional equity options – at least until some of these problems get sorted.
Leaving aside the fact that there are people out there who would equate a utility token to a security token, there are still problems with moving towards a world where ICOs replace IPOs. Firstly, experienced venture capitalists (VCs) provide a few useful services, regardless of how “broken” you think the VC community is. One service they provide is mentoring for company founders who may not have the experience or personal network to grow their business at scale. Secondly, VCs use methods to value startups based on financial concepts that have been in place for decades and which actually seem to work quite well (with perhaps social media being the exception here.) To think that we can just start issuing tokens to employees as a way to “win the war on talent” is ill-informed and it says something about the type of founders that are presently doing this and the people that are willing to work for them.
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