What Is Tokenomics? How to Evaluate a Crypto Token
When most investors evaluate the potential of a startup, they go in with a general checklist of things they need to understand. Does the startup have a solid business model? Is there demand for the product it wants to sell? Is it operating in a high-risk, volatile industry? These are good questions to ask about any investment, and cryptocurrency is no different. As crypto projects have proliferated and attracted billions of dollars in investor money, a new term has arisen that seeks to describe how different crypto assets are valued: tokenomics.
Tokenomics is a portmanteau of “token” and “economics.” Just as economics studies how real-world economies of goods and services work, tokenomics explores the mechanisms behind different projects in the cryptoverse. Anyone who invests in a cryptocurrency would do well to understand how cryptocurrency works, from how it balances token supply and demand to the psychological forces that convince people it has value in the first place.
In this guide, we’ll take a wide-angle look at crypto tokenomics before discussing how Pulley can help startups integrate tokenomics into their equity picture. Some of the concepts we’ll discuss will be familiar to anyone who has passed an Economics 101 class. Others are particular to blockchain ecosystems, not all of which are well-conceived or built to last beyond the latest wave of hype.
- What is tokenomics?
- What gives a cryptocurrency its value?
- How crypto tokenomics works
- Tokenomics: What to watch out for
- Tokenomics and startup equity
What is tokenomics?
You won’t find “tokenomics” in the Oxford English Dictionary (at least not yet), but that doesn’t make it any less real or serious for investors in the crypto space.
When we talk about a crypto project’s tokenomics, we’re really talking about the underlying economics that govern that project’s native token. Though the term “token” can mean different things in cryptocurrency, we’ll use it here to generally describe any crypto asset. These crypto assets can have their own dedicated blockchains (e.g. Bitcoin and Ethereum) or they can be built on top of other cryptocurrencies’ blockchains (e.g. Tether and Chainlink).
The developers behind a crypto token are responsible for determining exactly how that token works. They must devise a delicate balance of features that ideally allows the token to maintain a relatively healthy and stable value by:
- Keeping the token’s supply and demand in check. The amount of crypto tokens in supply must be balanced against the demand for those tokens. If the total supply goes up but the demand stays constant or decreases, the token can lose value rather quickly.
- Maintaining and expanding the token’s use cases. A cryptocurrency should ideally exist for a reason. Maybe it can be used to pay for goods or services, to execute smart contracts, or to purchase digital assets such as non-fungible tokens (NFTs). If a crypto token exists only for the purpose of a good meme on social media, there’s likely something off about the project’s tokenomics.
- Providing ongoing incentives for token holders. What benefit do people get from holding (or, rather, hodling) a particular token? These incentives might include rewards for staking the token or the possibility of finding high yields on decentralized exchanges. If there’s no incentive to hold onto a token, its value may quickly plummet.
We’ll tackle some key aspects of tokenomics, such as supply and demand, shortly. But first, we should step back and ask a more fundamental question. Why do cryptocurrencies, many of which seem to pop up overnight with crazy names like Dogecoin and SafeMoon, have any value at all?
What gives a cryptocurrency its value?
The basic question of “what gives currency value” isn’t something that investors need to think about too much when dealing with fiat currencies such as the U.S. dollar and euro. The value of these currencies is determined by a number of complex factors, but it generally boils down to supply and demand. Increasing the supply depreciates the value of one unit of currency, while increasing the demand appreciates the value of one unit of currency.
These fiat currencies have value in the first place because there is a general belief that they can be used to exchange money for a wide range of goods and services. This belief is promoted and backed by governments such as the U.S. federal government, which throws its full faith and credit behind the U.S. dollar.
By design, the vast majority of cryptocurrencies are not backed by governments or third-party institutions such as banks. This is a core tenet of decentralized finance (DeFi), which seeks to provide an open, global system of financial products and services that’s owned and maintained by its users.
Crypto projects must generate belief among these users in the value of their tokens. To do so, they must devise a package of tokenomics that incentivizes buying and holding tokens while managing the overall number of tokens and ensuring a healthy circulating supply. Any slip-ups or cracks in the design can shake the users’ collective belief in the token’s value and lead to a cataclysmic failure, as users tend to quickly divest of coins that show signs of faltering.
How crypto tokenomics works
The more interesting and reputable cryptocurrencies don’t make you guess about how they work. Oftentimes, they will have whitepapers that clearly lay out how the crypto’s tokenomics work and why they were designed in such a way.
Bitcoin’s famous whitepaper, written by its pseudonymous creator Satoshi Nakamoto, offers a good outline of the project’s fundamental tokenomics. It describes an inflationary model in which the supply of Bitcoin increases until it reaches a maximum supply and becomes inflation-free. This represents one of two very general types of tokenomics: inflationary and deflationary.
A crypto token can be said to be “inflationary” if its supply increases over time.
To use the above example: Bitcoin (BTC) is inflationary because it creates new coins as an incentive to validators who support the network. Bitcoin’s “proof-of-work” network requires validators to solve highly complex math problems in return for newly minted Bitcoins. The total supply of these Bitcoins is capped at 21 million, and new coins are created at a rate that halves about every four years. This mechanism is intended to keep inflation in check as more of Bitcoin’s total allocation is released.
Ethereum and its native token Ether (ETH) offer another example of inflationary tokenomics. There is no cap on the total supply of ETH and its supply has continued to grow over time. With that said, ETH’s inflation is offset by ETH being taken out of the circulating supply as it’s used for gas fees, staking rewards, open finance applications, and other use cases.
A crypto token can be said to be “deflationary” if its supply decreases over time.
A cryptocurrency can destroy tokens or remove them from circulation via a process called “burning.” Whereas inflationary cryptocurrencies tend to mint new tokens as new blocks of transactions are created on the blockchain, deflationary cryptocurrencies might burn tokens on a set schedule or at a rate that coincides with the creation of new blocks.
The purpose of burning tokens is to prevent the maximum supply of cryptocurrency from inflating to the point where an individual token loses too much value. One example of a deflationary cryptocurrency is Binance’s BNB. In a blog post explaining a quarterly auto-burn of BNB, Binance noted that it has committed to removing 100 million BNB from circulation via burning.
Tokenomics: What to watch out for
Whether you’re balancing your own cryptocurrency’s tokenomics or considering an investment in a different project, there are a few flags to consider:
- A huge or unlimited maximum supply of tokens. If there’s no cap on the total number of coins minted, there should at least be some mechanism in place to counteract the pressures of inflation. A cryptocurrency’s tokenomics can quickly go askew if the supply begins (and continues) to outweigh the demand.
- Excess token liquidity. This can be a particular problem if you’re a startup offering cryptocurrency to investors and not managing your stakeholders’ vesting schedules. If too many stakeholders vest at once and attempt to sell their tokens on a cryptocurrency exchange, you might be facing a situation of excess liquidity that can lead to issues with your tokenomics.
- A super-small or super-large market cap. Market capitalization refers to the total number of coins in circulation multiplied by the market price of a single coin. A cryptocurrency with a tiny market cap may be subject to extreme volatility and may have lower liquidity. Conversely, cryptos with the biggest market caps (think Bitcoin and Ethereum) may be more liquid and stable—but stable is a relative term in the world of cryptocurrency.
- Early token distribution to pre-launch investors. Just as an IPO works in the stock market, a cryptocurrency may have an initial coin offering (ICO) in order to raise money from early investors. It’s a sign of questionable tokenomics if these early investors are allowed to grab hold of the vast majority of tokens in supply, with few sound mechanisms for new tokens to be created.
Tokenomics and startup equity
As Web3 moves from the realm of idea to reality, the principles of tokenomics are beginning to show up across the startup equity landscape. Cryptocurrency startups with tokens of their own may be incorporating these tokens into their employee equity compensation, or offering tokens to investors in exchange for necessary funding.
Many young startups are caught in the middle, attempting to manage a complex mixture of equity and token agreements with little precedent to guide them. At Pulley, we believe that you shouldn’t have to use two separate systems to manage your equity and tokens. We’ve created a system that allows you to create new token plans for groups of stakeholders including employees, partners, and investors. We’ve also made it easy to track different stakeholders’ vesting schedules to prevent excess token liquidity and contribute to healthy overall tokenomics.
Of course, tokenomics is only one aspect of an equity future that involves cryptocurrencies beyond Bitcoin. You’ll also need to think about keeping your coins compliant as regulatory scrutiny heats up in the coming years. We’ve got you covered there, with 409a valuations that can help to determine the fair market value (FMV) of your tokens and keep you in the clear from a legal perspective.
To learn more about how Pulley can help your startup usher in its Web3 future, schedule a call with us today.