The Importance Of Equity & Why Your Investing Focus Should Be On It

Today’s newsletter is written by the very talented Woken Token.

You can find more of his work by following him at: https://twitter.com/token_woken

Additionally, he likes to spend time on our Discord, so feel free to chat him up on there too! 

 

So, let’s talk about equity:

The concept of equity – the ownership of a portion of a business and anticipation of dividends/capital gains as a direct result of the performance of the business itself – is something which, seemingly, is either underappreciated or completely unknown in the burgeoning investor community encircling the blockchain sector.

 

This is, perhaps, unsurprising given that a large portion of this ever-growing community cut their teeth in cryptocurrency. Their idea of what pertains to a sensible investment has been defined by Initial Coin Offerings (ICOs); infamous unregulated offerings which allow individuals to purchase Utility Tokens in exchange for various hues of cryptocurrencies like Bitcoin, Ethereum or Stellar.

 

And it’s here that we encounter the initial fork in the road; the buzzing neon sign that’s led many to their current place of understanding: Utility Tokens. In theory, Utility Tokens can be seen as a ‘fuel’ for a blockchain-based eco-system. The narrative, sold to millions, is that as the business behind the eco-system successfully gains customers, transactions are generated within the eco-system and, in-turn, Utility Tokens are burned like diesel in some massive decentralized engine; the intrinsic value of the tokens theoretically rising due to a combination of increasing demand and scarcity. Tokenomics are discussed, approvingly, as investors send another batch of Ethereum to an ICO’s wallet address.

 

It’s a slick pitch and, on the surface at least, appears logical and progressive. However, I’m not here to discuss the merits of the Utility Token model. That topic has been covered, and will continue to be covered, by people far more qualified than I to offer their expert opinions.

 

I’m here, instead, to highlight that there’s so much more for the knowledgeable investor to consider before stuffing their hard-earned capital into the huge swathes of companies emerging from the blockchain sector.

 

The excitement surrounding blockchain is tangible and is generated for good reason. Blockchain represents a changing of the guard. A move from centralised, exploitative, old-world systems to decentralised, transparent and value-driven mechanisms of empowerment. This nascent technology will bring such significant value to the modern world that it’ll be looked back on, in the fullness of time, as a true socio-economic revolution. It’s understandable, therefore, that investors are drawn to blockchain companies like moths to a flickering bulb in the dead of the night.

 

Investors, thus far, have been happy to accept the Utility Token narrative and to plough $20b into such opportunities since 2016. However, as time passes, and recently-deflowered investors gain experience and knowledge on investment terminology, techniques and theorems; the investor-pool matures and begins to raise pertinent questions.

 

The term “equity” is now entering cryptocurrency’s lexicon thanks, in no small part, to the concept of Security Token Offerings (STOs). These offerings provide a regulated alternative to ICOs which, owing to their inherent compliance with laws imposed by the likes of the Securities & Exchange Commission (SEC), can act as an issuance mechanism for a digitized version of legal securities: traditional asset-backed investment instruments which make up a $30tr market in the United States alone.

 

As previously defined, an equity position provides investors with shares which represent a portion of the business itself. The investors become shareholders. The value of these shares are directly correlated to the success, or otherwise, of the business.

 

The above said, I’d like to take a moment to focus your attention on why this is such an important topic.

 

Investors have been drawn to blockchain-centric companies due to the disruptive and bleeding-edge nature of the sector. They see these companies as pioneers utilising a progressive technology to provide a more efficient, economic and generally improved service to industries, markets and customers. This thinking is sound and aligns with best-practice for the initial stages of any investor’s due diligence process. The investor, understandably, considers that many of the companies in the blockchain sector will emerge as multi-billion dollar unicorns.

 

This, in my opinion, is a very reasonable supposition.

 

However, here’s the kicker and the reason investors must understand the protections afforded by an equity position: the success of a company doesn’t correlate to an increase in the value of its Utility Tokens. The success of a company only correlates to an increase in the value of its shares.

 

To demonstrate this point, consider major cryptocurrencies like Bitcoin and Ethereum. Neither of these projects are structured as companies. They have no board of directors, no shareholders and no accountability. The only thing they do have is token holders. Consequently, in structuring their economic models these projects must only consider how to maximise the value of their tokens to the benefit of their token holders. An increase in the value of the token encourages the staking, mining and long-term retention of such currencies: a win/win for all parties.

 

In contrast, the vast majority of ICOs were operated by structured companies who welcomed investment in return for Utility Tokens. The fact that such ICOs were operated by standalone corporations with traditional boards of directors, shareholders and equity investors – and not by unaccountable entities like Bitcoin or Ethereum – presents a very clear conflict of interest.

 

The directors, owners and founders of any business are governed by laws which place upon them a fiduciary duty – legally enforceable – to act in the best interests of the company’s shareholders. In investment parlance, acting in the best interests of shareholders is doing everything reasonable to increase, wherever practical and without conflict of interest, the value of shares.

 

The same fiduciary duty does not extend to those who hold a Utility Token and, consequently, company directors are legally obliged to prioritise shareholders over token holders.

 

It’s important to take a step back and consider the ramifications of this fact, which – judging by the relative silence on the topic from otherwise-heavily-opinionated “experts” on crypto-twitter – is being wilfully, or unwittingly, ignored.

 

In essence, what the above could mean is that if projects – and therefore the overarching businesses connected to the same –  perform as well as many believe they will, then they’ll almost certainly be subject to takeover by the traditional giants in the space they’re aiming to disrupt. It’s a fair assumption that, in such a scenario, new owners wouldn’t wish to reinvent the wheel; instead taking advantage of the leg-work done by others and simply absorbing all existing technology, clients, investor databases, etc.

 

In the above example, it seems logical that any company absorbing, for instance, an STO Issuance Platform, would aim to shed any fat; to streamline and remove all instances of friction. The business owners, as we’ve already discussed, would hold zero fiduciary duty to token holders, but will retain that duty to their own shareholders.

 

In such an instance, could new owners simply dismantle the token eco-system; or remove mechanisms which had been put in place to assist in value creation for token holders? Those who hold positions in utility-based projects may argue that the eco-system is integral to the underlying business processes, and therefore intrinsically linked to how the business generates revenue. However, as a bare-minimum, if a particular eco-system is proven to be indispensable to the businesses revenue-generating power – then it’s a fair assumption that the value of Utility Tokens will be a distant afterthought; just as long as it’s propped-up to ensure a bedrock price where it’s advantageous to hold, stake or mine. This, in some instances, might even be seen as the best-case scenario for holders of Utility Tokens in projects subject to corporate takeover and the inevitable value-engineering process that would follow.

 

Everything boils down, quite simply, to this: the direct value created by a business is funnelled to shareholders and not token holders. By holding a Utility Token, you are not betting on the success of a business, but rather that the eco-system will be used, and will continue to be used, as a fundamental and indispensable part of the core business. Utility Tokens are, when compared to an equity shareholding, a wildly speculative investment, not benefiting from legal governance and which, even in the best-case scenario, may not provide returns anywhere near those enjoyed by the equity shareholders of the successful controlling-business.

 

Speculation, of course, is par for the course in cryptocurrency – but relative levels of risk must be assessed and a consideration of alternative approaches (i.e. equity shareholdings) must be considered and wholly understood before investors can claim to be capable of making fully-informed decisions.

 

I write this piece not to swing a machete in the direction of Utility Tokens and the companies who have issued them as part of their ICO funding rounds; but to illuminate an issue, the apparent absence of which from current discussions – given its obvious significance to investors – is worrying in the extreme.

 

It’s imperative that those whose initial experience in investment was centred around Bitcoin and similar cryptocurrencies, as well as those more experienced individuals currently involved in the space, begin to demand a fairer deal – the structure of which should be aligned with the benefits enjoyed by traditional investors in time-served markets.

 

If we wish for the blockchain-based investment space to continue its fantastic growth – or indeed to surpass previous cycles and break new ground – there will be a requirement to cater to the more traditional, nuanced, risk-averse investor who wishes to become involved but cannot accept deals which are, currently, so heavily-weighted in favour of Issuers who offer so little in return for so much. 

 

Until we collectively agitate for change, the standard blockchain-based investment structures (whether termed ICO or its re-labelled, nigh-identical sibling the IEO) will remain as is. I’d urge everyone to educate themselves, and one another, on the benefits of equity positions and to begin holding blockchain companies to the same degree of expectation as those in more traditional spaces.

 

The market must continue to mature.