VCs (Still) Don’t Understand What They’re Buying

Projects that mislead about their true enterprise value are being celebrated for their smoke and mirrors, while honest projects are punished. Retail gets caught in the middle. And, as a bonus, what you can do if you’re a builder trying to structure things the right way.

Concepts from this article were discussed in a separate podcast, listen here.

Source: Pexels

Investment firms have obligations to their limited partners (LPs), but not to projects. That’s their fiduciary duty. And, in that sense, the kind of irresponsible buying we’ve seen from many VCs with little understanding of the space makes sense — their objective is for a project to get liquid asap and dump on retail. Who cares what the token or game economy looks like if Billy and Annie down the street will buy these bags at an easy 5x?

Because of this, a perverse incentive for projects to mislead about the ultimate destination of their cash flows and true enterprise value has been created. Most tokens do nothing at all. Most unlimited NFT projects (read: games) make no attempt to drive long-term value. And, though it’s a brutal dumping season on the retail side, it’s also infuriating from an investment capacity to watch projects get bid up during private rounds to insane valuations on severe misunderstandings from “industry experts.”

Projects that are transparent about their true enterprise value are punished, and projects that obfuscate their value are rewarded.

Let me explain.

Magic Tricks and Disappearing Treasuries

There are broadly three three types of “entities” in crypto, today:

• Equity
• Tokens
• NFTs

For a clear mental picture:

• When I say “equity entity” I want you to think “fiat bank account.”
• When I say “token entity” I want you to think “token chart price.”
• When I say “NFT entity” I want you to think “marketplace floor price.”

Let’s do a chalkboard example. Take a project that’s raising at a valuation of:

• $100mn on the fully diluted valuation (FDV) of the token
• $5mn in NFTs sold today, but they plan to issue more over time

This was a relatively common target at market peak. And, let’s say that during some private investor round, the project is going to sell 10% of the tokens, and all of those initial NFTs. This was also common. Let’s say we’re a big boy investor and we’re going to buy the entire private round and all the NFTs. So:

• We pay $10mn for 10% of the total token supply
• We pay $5mn for all of the NFTs outstanding today

Now, suppose that same project over the course of the next year does another $10mn in revenue. Sounds great, right? Fantastic traction for a brand new company. And, since we own 10% of it, plus some of those sick new slurp juice NFTs, we’re very excited about the prospects of the investment down the line. But let’s break down how the project generated that revenue and where it’s going:

• The projected generated revenue by selling more NFTs;
• The project charges in fiat only, which directly goes to their bank account.

So, what?

Well, that 10% of the total token supply we’re holding won’t help us claim any of the cash flows of the business out of that bank account, because tokens aren’t equity. And, since the business is selling yet more NFTs, unless the business has managed to provide additional social value to the project since we originally purchased our NFTs in the private sale, it’s likely that increasing the supply of the NFTs will drive the price down. Now we’re holding tokens with no claim to anything and rapidly depreciating NFTs. Ouch.

But, wait. Turns out there was another private round before this private round. That private private round was just for equity, on a $50mn valuation for the equity business. And, some other big-name investors bought 10% of that round for $5mn.

When in doubt, follow the cash. Remember from the initial description above that the example project charges in fiat only, which directly goes to their bank account? That’s where the value is. Since the project has generated another $10mn in NFT sales (excluding the $5mn us chumps paid for NFTs during that “exclusive whitelist”), and because the original equity business was worth $50mn, those super-secret private round equity investors snagged a 5x equity/sales banger of a position because the business managed to send all of that hard-earned cash directly to their bank account, completely circumventing any value being driven to the tokenholders or the NFT collectors.

Yikes.

This is not the way crypto is supposed to work. Crypto isn’t cool because you can wave a magic wand and create a new asset class, and then say it’s “going to govern a project” while actually moving all that value off-chain. They’re totally different entities. Equity =/= tokens. Bank account =/= wallet. Completely different universes, and, ironically, that’s actually the entire point of crypto.

Crypto was designed to enable decentralized user-owned sovereignty, and, unfortunately, in the space today, probably due to overmarketing and misinformation, we’ve completely missed the point in the past year and we’ve been set back collectively in the eyes of the public by a huge margin.

If you’re designing a project (or actively investing), and feeling quite irate and confused right now, the solution is simultaneously complex and obvious. Just pick one entity type. You’re either an equity business or a token project, and you should consider your cash flows accordingly.¹ And, if you have NFTs, you have to be very careful about the economy that you’ve created for them, and consider them as an affiliated entity that you’re also responsible for.

If you want to issue a token, you have to consider the actual purpose that token serves, and how the project’s activities will actually support the token’s valuation. The vast majority of tokens simply do nothing. Projects call them a “utility token” or a “governance token,” and then highlight that the token’s chief utility is to be staked to earn more tokens.² Or that it’s used for off-chain votes to determine if the new Discord banner should be blue or red (really sick “governance”). But there’s no actual cash flow, and no actual user-owned sovereignty. It’s an absurd joke that’s been made of arguably one of the world’s greatest inventions (which is cryptography for distributed consensus, end-user sovereignty, & autonomous execution).

But what are we supposed to do?

Builder’s Guide to the Galaxy

If your project is taking revenue only in fiat:

• You should have a bank account
• You could be an equity business
• Your equity holders could have rights to the cash generated by the business
• You should NOT be issuing a token under the guise of a “governance” token

If your project is taking revenue only in tokens:

• You could be a token project
• You could have an on-chain treasury which receives all revenue
• You could issue a governance token to participants to grant them control over the treasury, on-chain (no middle-manager off-chain crap)
• Note: If you’re immediately liquidating all token revenue into fiat (not stablecoins, I mean proper fiat), then you’re essentially taking revenue in fiat and probably fall into the first “revenue only in fiat” bucket

If your project is taking revenue in both fiat and tokens:

• A blend of the above applies, and you need to be realistic about how much cash flow is going to each separate “entity,” and be honest with users about what that split looks like
• This usually happens if an equity business issues a “utility” token which is used to conduct some amount of sales (e.g. you can buy NFTs using TOKN)
• This is dangerous and complex, and you have to be extremely careful

If your project has an unlimited number of NFTs (like a game), you have three options:

1. Treat the NFT market as a “third entity,” and use certain cash flows to underwrite prices and provide value support; or
2. Ensure the NFTs are degradable or otherwise leave circulation after some period of time; or
3. Acknowledge that the entire success of your NFT collection(s) depends on the equity/token entity creating enough supporting content that new users will infinitely join & provide price support, and hope that such equity/token entity is even incentivized to do so in the first place (hint: this probably doesn’t work)

If your project has a limited number of NFTs (like most art):

• You could drive value to the holders through whatever wild scheme you come up with; or
• You can just call it a collectible and hope its social fabric supports value.

Optimism for a Brighter Future

Because I’m a crypto nerd and actually very optimistic about this space, I advocate for on-chain governance & revenue flows that are actually owned by the users. That means that protocol treasuries, in my opinion, should actually be owned by the people participating in the protocol, and those related tokens should grant real on-chain governance rights (see Compound if you have no idea what I mean). Which, to be clear, has been the web3/crypto mantra all along, we’ve just been swarmed with hypermarketing and misinformation.

That means we have to stop:

• Driving revenue to multiple entity types, then claiming that’s actually beneficial for investors because they’re holding multiple different assets at once;
• Supporting middle-manager style “governance” tokens that severely mislead the public, and are actually just social tokens (Wonderland, anyone?);
• Infinitely issuing staking rewards or new NFTs without any regard for a closed-loop economy, or at least just the avoidance of hyperinflation.

If you’re building something that you’re proud of and you feel that you’re not getting the credit you deserve because other projects in the space have crowded you out with their smoke-and-mirrors around true cash flows & enterprise value, please DM me on Twitter. Let’s build the real future together.

¹There are legitimate scenarios where having an equity business and a token work together in synergy, but you have to be extremely careful about the way that value is being driven between the two. I’ll write another piece on that later.

²If everyone is staking, this also implies that if I do not stake, my net effective value will be diluted to zero. Locking a token for an infinite amount of time is not “utility.”

Sam is the CEO of Playground Labs, a web3 protocol dev organization, and Partner & Head of Interactive at Hivemind Capital, a crypto-focused multi-strategy fund. Follow him on Twitter.

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