The Value Trap Dilemma
Over the years, economists and philosophers have defined a range of choices that humans may experience in their day to day existence, including Morton’s Fork, Burdian’s Ass and Hobson’s Choice. My partner at Multicoin Capital, Kyle Samani recently wrote about the Scalability Trilemma that exists in the blockchain world too.
In this post, I’d like to propose the Value Trap Dilemma (VTD). The VTD is the conflict of interests that occurs when a project is funded by both traditional shareholders in a company and token holders in a network. The network is produced by a company funded by shareholders, so what is the nature of the responsibility the company has to token holders?
The classic theory of the firm is that it exists to maximize shareholder value — so what happens when you have to make decisions that will maximize shareholder profits but at the same time reduce value for token holders? This was a problem that we considered before conducting our token sale for Civic, back in June 2017 when the environment had comprised core blockchain and protocol proponents and supporters of pure innovation. Unfortunately, in the time since that sale during which public interest in token sales has become prevalent, I believe that we are in the minority in terms of progressive thinking around corporate governance and ethics in this space.
Civic’s concept is building a utility token (CVC) that enables companies to verify identities, in a decentralized manner. For example, this allows companies who are selling security or utility tokens to conduct KYC (Know Your Customer) verifications on individuals who are purchasing their tokens. As an example, we recently announced our partnership with Votem. Votem will use CVC utility tokens to provide ID verification for their ICO and their platform. A CVC is intended as a utility token that, as an overly brief summary, provides access, a reward or payment mechanism, prompt transferability of select data, stacked with the identity verification technologies or other technologies created by those who partner to use CVC. The mission of CVC is, for those reasons, different from a traditional security because it is intended to be useful and incentivize adoption of the technology rather than offer the goal of profitability.
For a quick primer on Security vs Utility tokens, I highly recommend reading Darren Pollock’s post at CoinDesk. That contrary goal is where the VTD arises.
Aligning interests at Civic
I co-founded Civic with my CTO, Jonathan Smith, who has spent many years in the banking world. We have a deep appreciation for compliance, regulations and governance and when we embarked on this journey together, we wanted to do things the right way and ensure that we would build a company that we could be proud of and imbue our values into the DNA of the company.
Through our years of experience operating venture backed companies, along with consultation with our board and shareholders, we determined that the best way to align interests between shareholders and token holders was to ensure that the primary goal of our company was not direct profit maximization, but instead the creation of and utility maximization for the public utility that we are building — an identity verification platform that consumes and uses CVC tokens to create a decentralized identity infrastructure for the world to use, as an alternative to the centralized identity products available today. This goal is intended to put neither shareholders nor token holders first — but rather the entire ecosystem.
For Civic, this was an obvious step forward in evolving governance in the token economy — by having a stated purpose intended to be at the intersection of interests between token holders and shareholders, you can avoid being conflicted in making decisions between maximizing profit for shareholders or utility for token holders — instead the idea is to provide for the best available utility.
In order to do this, it is important that the shareholders of the company understand the new operating paradigm is one where the focus is exploring what it means to be a crypto company, and that means experimentation to some degree. Civic, Technologies Inc., as a significant token holder, seeks to mitigate the potential conflict of interest by focusing on its product — the platform and infrastructure around its part of the larger token economy and development of new technological protocols.
We are breaking new ground in the world of corporate governance — how will shareholders make a profit or return on investment if profit maximization is not the goal. Shareholders in a company that is a token creator can be asked to accept that the company’s focus is the quality of the technological product and its widespread adoption, not the financial results. Delaying or avoiding profits in the early years when dabbling in the technology world is not a new concept. We can take a lesson out of Jeff Bezos’ book — his long term vision for Amazon which eschewed short term profits enabled all the possibilities which are foundational to Amazon today. If he had followed the route of profits first, Amazon would not be the behemoth it is today.
Ultimately, for our industry, the answer is unclear but the vision and mission of the company is more important than any short-term profits that would put us at conflict with token holders, who all want to help support and build the network effect that we need for CVC to be an in-demand product for those in need for a new identity verification process, those who wish to participate in technological development, those other token creators or technology developers who wish to partner with this verification service or its component parts. Building a utility token for identity is something no-one has ever done before — there are still many lessons to learn, so we need to be resourceful and thoughtful about our approach but in the end, we know we are doing something important for the world.
Our shareholders are very much aligned with us on this, but I fear that this is not always the case for the thousands of other companies out there operating with a token economy. The alignment of interests goes beyond short-term economics and into the longer-term promise of decentralization that blockchain and distributed ledgers offer.
We have spent considerable time ensuring that the token economy model is self-sufficient and can function independently of Civic as a company. I believe it is critical that token economies being built by private companies are able to stand independently of the companies that are building them today.
Rethinking Social Constructs
If we take a step back and look at the theory of the firm and start building up towards crypto assets over the centuries, it’s very clear that crypto assets represents a new type of economic social construct — in part because of the overarching non-economic elements. The nature of the firm, shareholdings, bond holdings, debentures, etc are all social constructs. They exist in structure and custom because of the evolution of laws, culture and regulations that have been created within our national and international societies over centuries. If a charter is not filed with and accepted by a government, the company might not exist at all (such as being deemed not to be validly existing). If the words used in a contract are not respected by a court (again, the government), the contract might be deemed not to exists at all (such as being deemed void or unenforceable). They are not physical things that exist outside of a legal framework, unlike, for example, gold or even Bitcoin.
Since the origins of corporations, we have built governance systems to help us ensure that shareholder and stakeholders interests were aligned and that also resulted in the creation of regulatory agencies such as the SEC and CFTC. Regulations have been built over centuries and largely to ensure that there are sufficient investor protections. History is riddled with investors losing money to Ponzi, matrix & pyramid schemes, along with the infamous pump and dumps, hence the need to provide an operating regulatory framework that punishes bad actors but still provides a fair playing field for emerging technical innovation. The problem comes into play when bad actors are purporting to be building innovative products and services, but this merely becomes a front for unsavory business practices.
In one of my prior posts, on the New Financial Revolution, I touched on the fact that capital formation is changing rapidly. The social constructs that we have today that exist within the existing legal & regulatory framework are limited, at best, as we leverage crypto to find new ways to finance projects, research and companies. Along with existing for-profit entities, we also have the notion of a foundation — the purpose of which is to deploy funds to support a cause, typically outside of the taxation frameworks that exist because the goal of the foundation is typically not to distribute profit to stakeholders, but rather to reinvest in the cause it serves. The Ethereum Foundation is a good example of how an independent organization can exist as a non-profit but fund the development of a public enterprise, without shareholders.
In the new paradigm around token economies, we are introducing a new type of stakeholder, different from any securityholder. These stakeholders must be made fully aware that they are not buying shares but rather that they are purchasing tokens that can be used in the functioning of a token economy.
There is some contention around what constitutes a security in the crypto world, but largely the Howey Test is seen as the benchmark ruling by the Supreme Court in the USA, which sets the definition of what a security is.
The SEC recently also publishes some guidelines on ICO & cryptocurrencies. These guidelines, however, are not universal — clearly not every country will accept the SEC’s guidelines and so each jurisdiction will need to create their own definition for what a token is and how their laws apply.
The nature of the firm, is that the fiduciary responsibility of the management team is ultimately to shareholders, not token holders. This applies to directors and boards worldwide, which leads us to the Value Trap Dilemma. How do you serve your fiduciary obligations to shareholders and at the same time, support a token economy for the benefit of utility token holders?
The crux of the matter is this: Where is the value that being trapped? Does it accrue to the company and their shareholders or directly to the token economy?
Navigating the Value Trap Dilemma
Let’s consider this example: Company A sells a token and receives $10m. It then uses those proceeds to continue to work on the building and enhancing of the token economy. A major partner comes in and wants to use the company’s services, but not within the framework of the token economy, but they are willing to pay $500k in fees to the company. This would require the company to slow down on building the token economy and reallocate resources to the new client in order to earn the revenue. Hypothetically, this could slow down the growth of the token economy, but the shareholders in the company benefit by having another $500k in income. That’s the Value Trap Dilemma. The company could choose to favor shareholders and profits to the detriment of the token holders.
This is one example out of many that could occur on a daily basis with token economy companies. There is probably a need for a new type of governance structure to manage this. Ultimately, it may be a poor long-term decision for the token economy but one could argue that the tokens that companies hold are akin to inventory that it will sell at a future date. So that should incentivize them to focus on contributing to the token infrastructure for the long term to ensure the value of their inventory is preserved. The reality is that as time goes on the company’s cash reserves dwindle, and they either need to sell more tokens to fund the company, or find other ways to keep going — including trading token economy resources for short term income.
The problem is exacerbated by the fact that crypto companies typically hold 80–90% of their runway in crypto. If/when there is a bear market, it becomes harder for them to pay the bills and they likely will have shorter runways to deliver value to the token economy. If a company runs out of money, and they can’t raise more, then the project fails and token holders become holders of a worthless product. It has already been reported that 46% of the ICO’s in 2017 have already failed.
Token Economy Design
In the first half of 2017 and before, there was no real public interest for tokens. Only technologists, innovators, developers, and sophisticated students of crypto knew how to read about, access, purchase, and hold tokens. The amazingly rapid developments in technology made tokens more understandable, accessible, tradable and holdable, eventually developing into public interest.
Since, and in particular in late 2017 when demand for tokens reached new heights, Token Economy Design has been an overlooked area of focus for crypto companies. But, it doesn’t seem like companies care because, historically, the perception has been that it’s relatively easy to raise money for a token sale. In reality, if the token economics are poor, it’s unlikely that the token economy will survive in the long term .
Token Economy Design has been an overlooked area of focus for crypto companies. But, it doesn’t seem like companies care because, historically, it’s very easy to slap together a white paper and raise money. In reality, if the token economy model cannot function as a utility token, then the token is most definitely a security and it’s unclear how buyers will recoup their investment, other than Greater Fool Theory.
In addition, if the token economics are poor, it’s unlikely that the token economy will survive in the long term — and there are many examples where I’ve asked founders about their token economy design, and the answer is literally this : “We have so much demand, we haven’t really bothered to figure this out yet, so we’ll sell the token now and do it later”. Talk about red flags — if crypto enters a prolonged bear market, most of these projects are going to fail and that will give the regulators even more ammunition to regulate this industry. If you’re building a utility token, it has to have real utility — if you’re just using it to raise money, then it’s a security.
Members of a utility token community look to join an ecosystem and seek to benefit from the technology, the incentivization of developers, rewards to bona fide contributors, and interactions between a token and the globally developing crypto economy. This is why many enthusiasts do not “bet on” a particular token, but buy a variety of different tokens, with hopes that together they will usher in a universe of utilities that, in the aggregate, might add to our lives a great deal of ease and efficiency, reliability and privacy, control over our property and assurance about what we hold dear. Just as computers were once the purview of masters of technology and now can be found in everyone’s pocket, we would like that next economy to function not just for experts but for all, and so we are not proponents of prohibiting non-experts from supporting and contributing to the system.
That is not to say that the masses don’t need some protections. Like the warnings we see the accompany any consumer product, disclosures and education about what the technology is, and what the tokens are not (a traditional investment), and the risks that a token will not have sufficient adoption to become part of the crypto landscape. Proponents of the token economy need to be responsible and think about the long-term viability of what they are adding to the overall ecosystem.
When a founder is asked what they are adding to the new technology revolution, the answer must not be: “We have so much demand, we haven’t really bothered to figure this out yet, so we’ll sell the token now and do it later”. If crypto is sold solely because of a favorable economic environment, most of these projects are going to fail, the public will have bought into a false premise and the regulators will have no choice but to further regulate the overall industry. If you’re building a utility token, it has to have real utility — if you’re just using it to raise money, then it’s a security.
Civic has been working with Llew Claasen, of Newtown Partners, a company I co-founded, that specializes in Token Economy Design, to improve the functioning of the CVC economy and we were excited to release the summary of those improvement last earlier this month, with the updated full white paper to follow shortly. This is another example of how Civic focuses on ensuring that a well-functioning and robust token economy is the primary goal of the company, and our long term holding of an inventory of tokens helps align our interests with other token holders.
The big question is, why would shareholders choose to forgo short term profits, in favor of an unknown outcome? From my background in startups and investing, I can attest to the theory that the investments with the most undefined outcomes, lead to the highest returns. This also means they have to accept a high level of risk — which in venture capital is usually par for the course. If the ecosystem is successful, they will benefit. In most cases, the background of your shareholders will determine how you are able to govern your startup in the crypto world.
Civic has the benefit of having some of the most forward thinking investors in the world, including Social Leverage, Propel Ventures, Pantera Capital, DCG, Blockchain Capital, Sound Ventures & Founder Collective. These investors are thinking long term and are more interested in ensuring that we can actually change the world, rather than focus on short term profits or cultivate behaviors that could lead to a conflicted management team. It is for that reason, that we are a very aligned and focused team and even though we have multiple stakeholders in the token economy, we have a shared focus on ensuring that the CVC token’s economy is resilient, useful and productive. If a token creator’s shareholders can buy in to the idea that this is not a mere profit-making endeavor but also a mechanism for plugging a new idea into the burgeoning global crypto ecosystem, the VTD — the value trap dilemma that stands between the interests of shareholders and other stakeholders — can fall aside.
This area of crypto governance is a fast growing area, and I’m excited to delve into the opportunities and pitfalls as I present my views on the importance of remembering the core role of token holders in a crypto ecosystem, at Token 2049 in Hong Kong tomorrow (20th March 2018).
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