Token valuation approaches
Updated: Jul 5, 2021
Token value drivers
In one of my previous articles, we talked on the topic of different token value drivers and identified the three core ones as:
Free cash flows
In this article, we will go bit deeper and discuss, how we can use each of those drivers to come up with an actual value for a token.
Before we move on how to determine the value of a token, we must first consider why are we doing it. The most common reason is from an investor's point of view, trying to determine the present value of an investment. Luckily, there is a pretty straightforward approach to determine this, by taking a series of cash flows and discounting them by a percentage. The discount rate is the tricky part here, for simplicity let's consider that it represents the expected rate of return when accounting for the riskiness of the investment. For example, the current 5-year yield on US government bonds is around 2.56%. If you consider that investment has the same risk profile as US government bonds (practicality impossible), you can use a similar discount rate, otherwise, you should use a higher one to reflect the additional risks. Discount rates of about 10% are pretty standard, going up to 15% for riskier projects. I have seen valuations in the crypto space going as high as 40% to reflect for the risk, however, I disagree with such high numbers. If your project needs a 40% discount rate - restructure your project first, in order to reduce the risk. After you have determined the discount rate and have the projected cash flows, you can use the NPV formula in Excel/Google Sheets in order to calculate the present value, or in case you are like me and prefer to break down everything to basic math, here is the formula for you (keep in mind that, same as NPV, it assumes equal length periods):
CF is the cash flow at a specific period
DR is the discount rate
n is the period
t is the total number of periods. Length of timeline expressed in n number of periods.
Same as in the token value drivers article, we will use a fictitious business in order to make the valuation - online platform for bread delivery. It would use its own native token - the BreadCoin. Recall the basic setup:
The platform connects local bakery stores with potential customers.
The platform does not sell bread on its own, but only facilitates the transactions.
In order for a bread selling company/store to be listed on the platform, it pays an annual fee of 100 USD
The platform takes a 5% fee for each transaction.
Annually 1 000 000 loaves of bread are sold on the platform, by 1 000 different bread companies, at an average price of 2 USD per loaf.
The annual expenses for running the platform are 100 000 USD.
During the ICO/STO, the company is looking for 100 000 USD investment in order to build the platform. They offer 500 000 bread coins @ 20 cents each.
In addition, we will assume that the sales grow at a rate of 20% annually and the expenses grow 10% annually. For simplicity, we will keep the listed stores at a constant 1 000 and the annual taxes at 20%. We will not consider any amortization, loans or other CAPEX. Using this, we can come up with the following proforma balance sheet (extremely simplified, you can check out how a full profit/loss model should look like):
Scenario 1: BreadCoin as currency
This is the model used by 95% of the ICOs (either knowingly or due to the complete lack of proper tokenomics setup). Don't assume the former as criticism, but rather as an observation that majority of the projects out there put very little to no thought on their token value drivers, but rather just mimic other successful projects. At the core of using a token as a currency is the quantity theory of money and the equation of exchange. The equation goes as follows:
M is the amount of money in circulation, within a specific system
V is the velocity of money or in other words: how often does money change hands within a predefined period (most commonly - annually)
P is the price at which transactions are happening within the system
T is the number of transactions for a predefined period (same period, as the velocity)
P x T in this regard is essentially the total economic output of the system for the selected period, sometimes referred to as GDP of the system. In our scenario, this is platform turnover at any given year.
This approach for token valuation was formalized by Chris Burniske and since has been widely accepted by the crypto community. It is however not without criticism, most notably by Vitalik Buterin. In a nutshell, the biggest issue with this approach is that any ICO using this model is not selling its own service, but rather is selling someone else's product. If we consider this for the BreadCoin ICO, it would translate into "Give us money to build a bread platform. In exchange, you will be able to purchase bread on the platform with our coin. This bread will, however, be provided by someone else and will not be paid for by us." While there are scenarios in which similar scenarios might work, in the majority of the cases it is not sustainable in the long run. A full breakdown of the approach will likely take an article of its own (more than one), so here we will stick to the valuation itself.
The formula itself (2) is pretty straightforward. P x T is our platform's turnover, M is the total supply of coins which we have chosen. And this leaves V to be determined. Unfortunately, we cannot just solve for it, since the two sides of the equation are denominated in different units. The left side is denominated in BreadCoin, while the right side is denominated in USD. We can address this by expanding the formula to:
Here, E represents the exchange rate (price) of the token with regards to USD. Now we can rewrite the formula as:
Which means that in order to solve for the token value, we need to first determine the token velocity. As it turns out it is another pain point for this approach since velocity is somewhat hard to determine and can vary greatly. Furthermore, there are multiple other factors which come into when determining the velocity, such as lost tokens, speculators holding the token, staking schemes and others. For the purposes of simplicity, we will ignore all those, but if you would like to take a look how a complete model, taking all those factors into account, might look like, check out one here. The best we can usually do is to use other coins, as a benchmark, which can be a challenge of its own. For BreadCoin, let's take a look at Bitcoin's and Ethereum's hybrid velocity (velocity-based not only on circulating coins but all coins available). Also, we will consider the M1 (money supply of currency in circulation - notes and coins, traveller’s checks [non-bank issuers], demand deposits, and checkable deposits) and M2 (includes M1 in addition to saving deposits, certificates of deposit (less than $100,000), and money market deposits for individuals) USD velocity.
As you can see the figures can vary greatly not only from currency to currency but also for the currency itself. Let's be conservative and choose a higher velocity (high velocity = lower price) for BreadCoin of around 30. From here it is trivial to calculate the expected value of the coin, based on the company turnover.
At this point, it may appear that an investor would break-even on year 3 and have a 50% Return on Investment on year 5 (recall that the price during the BreadCoin ICO was 20 cents). However, we still need to consider a discount on the cash flow, as mentioned earlier. Let's take a discount rate of 15%. Using this number, a cash-out on year 5 would have a net present value of 0.148 cents or a return on the investment of negative 26%, when considering the cost of capital.
Again, I need to stress, that the model provided in this article is very simplistic and does not take into consideration many important variables. For example, if we do consider (and we do) that part of the participants in the BreadCoin ICO is investors and not platform users, this would mean that the circulating supply of coins would not be equal to the total coin supply.
Scenario 2: BreadCoin as access/coupon token
This model is rarely used, although it is considered one of the most stable ones, and was actually referred to as a viable ICO model by Vitalik Buterin (Ethereum’s chief scientist and co-founder). In this scenario, only fees on the platform are payable in BreadCoin, while all other transactions are settled in another currency.
“If it were the developers themselves that were acting as the seller, then this would be a very reasonable and normal arrangement, very similar in nature to a Kickstarter-style product sale. The token actually would, in a meaningful economic sense, be backed by the services that are provided by the developers…..
The developer builds the product and gives it to each of the buyers. At the end of the day, the buyers are happy, and the developer is happy. Nobody feels like they made an avoidable mistake in participating, and everyone’s expectations have been met. This kind of economic model is clearly stable.”
Vitalik Buterin - On Medium-of-Exchange Token Valuations
In this scenario, we have several variables to consider:
Par value - the BreadCoin token was sold at 20 cents during the ICO. In order for the token to have value, and for people to purchase it during the ICO, one token should be redeemed for more than 20 cents, once the platform goes live. Let's assume that we set this value to be 50 cents and call it par value (during year one).
We need to determine if the par value will change over time. If it is fixed at 50 cents, then it would be in everyone's interest to use up the token as soon as the platform goes live, they will have no incentive the hold the token for a longer period. There will also be no incentive for anyone to purchase the token after the ICO. We can solve this by either always selling the token at a small discount, or by gradually increasing the par value each year. For example, we have determined the par value to be 50 cents on year one, but we can set it to be 70 cents on year two, thus incentivizing ICO participants to not spend all their tokens right away and giving reason to platform users to pre-purchase tokens even after the ICO.
When we determine par value for each year, we also need to make sure that the platform can handle it. Looking at the BreadCoin example - there are 500 000 coins in circulation and we have set par value at 50 cents during year 1. This makes the total addressable value of the coin equal to 250 000 USD, while our proforma financials show that we expect to collect only 200 000 in fees during year one.
The critical takeaway for this approach is that by providing a discount during the ICO, we are effectively forfeiting part of our revenue. Some questions to consider (as illustrated by BreadCoin the example above) are:
Can we afford to have 0 actual revenue in year 1 (e.g. will the money raised during the ICO be enough for year 1 operational expenses)?
What is the maximum amount of revenue (especially at the platform start) that we can afford to forfeit, in favour or ICO discounts?
Is it OK from customer sanctification point of view, that we are likely to have sold more coins in the ICO, than what can be actually redeemed during year 1?
Do we consider/allow that all the revenue is addressable solely by the token?
How many new tokens can we release annually, after the platform is operational?
The answers to most of those questions are dependent on the project's business strategy. For BreadCoin let's assume that we increase the par value by 20 cents per year and always sell the token at 10 cents below par value (in order to incentivize all the customers to use tokens instead of FIAT). From here we can estimate a worst-case scenario (from purely revenue point of view), where everyone tries to use the token as soon as possible and we can determine the maximum new sales of tokens and the new net revenue (after accounting for discounts) for each year:
While this approach is very stable economically, very few ICOs choose to go this way, because they only way that the coin can get 10x on its value is if the company forgoes a huge amount of revenue in order to support it. Furthermore, for such a coin, the best course of action is to not be listed on exchanges as it can create artificial scarcity and introduce volatility to the price.
All that being said, I personally, consider this iteration of BreadCoin to be the only real utility token out of all approaches. Also calculating a return on investment in this scenario is not really logical since the coin can only be used on the platform itself. Of course, secondary markets might emerge, but logically the can always only be selling below the current par value of the coin. If we do insist on calculating the value, we can simply refer to the NPV formula to do so. For example, if we take the value of 70 cents in year 2, with a discount rate of 15% this would translate into a present value of 0.53 cents or a return on investment of 265% based on the ICO price of 20 cents.
Scenario 3: BreadCoin as equity
BreadCoin as equity has way too much different variations which we can consider. It can be pure shares in the company, options, a loan, a convertible note, a non-valued investment at a discount, to name just a few. In our example, we will consider the simplest possible scenario where BreadCoin is equivalent to shares. On the other hand, whichever scenario we had chosen, we would still be able to evaluate the fair token price, using a discounted cash flow analysis (DCF). The difference would come from the complexity in calculating the cash flows themselves and their respective distribution. The DCF formula is very similar to our NPV formula above, with the only difference, that we would also calculate the Terminal Value - this is our exit from the investment, the price at which we expect to sell our shares at a later point in time. The terminal value is commonly calculated as:
CF is the free cash flow in the exit year
DR is the discount rate
GR is the expected long-term growth rate of the company
n the year we exit the investment
In essence, the formula takes our last known cash flow, discounts it by the chosen discount rate and then extrapolates the expected perpetual returns of the investment, based on the expected annual growth of the company. The last two steps in order to finalize the valuation are to add the NPV which we have calculated to the terminal value and divide it by the total number of shares (tokens in our case) outstanding. It is important to point out that here we are using the sum of the discounted cash flows, while in the previous two examples we used the discounted value of single cash flow. The reason for this is that we are assuming that in the current example, the company pays dividends annually, while in the other two examples, it was single cash out.
Before we run the final numbers, in order to calculate the terminal value, we need to decide on a long-term growth rate of the company. Recall that we estimated that the revenue will grow 20% year-on-year. However, we cannot use this number, as this is the growth rate of the company at its inception and not at maturity. Determining the long term growth rate can be a topic of its own, but for now, let's just assume it to be 8% annually.
Putting it all together we get a sum of the discounted cash flows (or NPV of the cash flows) of 328 721 USD and a terminal value of 987 683 USD. This gives us a total valuation of 1 316 404 USD, over a 5-year forecast horizon. given that we have 500 000 tokens in circulation, this gives us a fair token value of 2.63 USD per token or the ever-elusive > 10x in value for the token. We could also calculate the fair token price based on cash out for each of the 5 years. As can be seen on the chart below the value slowly grows over the five year period.
Looking at the numbers above, you might be tempted to conclude that given the numbers, an equity model is best suited for the BreadCoin token. Before you do so, please consider that in this example, we have given away 100% of the company in form of equity tokens, eventually forfeiting any profit from our company apart from salary. In a real scenario, it is likely you would we willing to give away only 10% of your company, which would also mean that the actual value of the token would be 26 cents rather than 2.6 dollars.
Determining your core business its relation of your token is probably the first and most critical step which you need to take before running any ICO or STO. While the crypto space is currently still ruled by marketing and indeed marketing will determine the success of your fundraise, it is the business model, proper financial projections and tokenomics, which will determine the success of your project 1-3-5 years down the line. If you are still unsure about the high-level setup of your tokenomics, feel free to take a look at one of my other articles covering the principle token value drivers.
All that being said, this article has barely scratched the surface of all the things you need to consider when building your financial and token setup. The days when an ICO/STO project could be properly run by a couple of crypto enthusiasts or you could get all the information you need on your own is over. Please consider proper technical, legal and financial advice for your project.