“Cash rules everything around me. C.R.E.A.M. get the money, dollar dollar bill, yo.”
— Wu-Tang Clan
Cash Flowing Protocols
A lot of attention is being paid to cash flowing protocols at the moment.
On the one hand, I get it. Crypto has been notoriously difficult to value, so putting P/E-type metrics around protocols feels very appealing.
On the other hand, I think these discussions might be missing a bit of nuance. Like, for instance, does it make sense for a two-year-old startup protocol to be thinking about returning cash to investors?
I’m not 100% sold that they should be, so this newsletter will be discussing these cash flowing protocols in two parts.
Today’s will focus on a framework for thinking about capital allocation in crypto land, and tomorrow’s will be focused on the regulatory pressure that is shaping current approaches.
Corporate Finance 101
One of the most important things a CEO needs to be good at is capital allocation.
They must decide where and how to allocate capital to produce the highest return for shareholders.
Capital can be allocated to three basic categories:
Organic growth — new products and services developed by the company
Inorganic growth — acquiring and integrating new companies
Share buybacks — buying back shares in the company and reducing the float
Option number 3 is first and foremost a way to return capital to shareholders in a tax-efficient way.
Shareholder buybacks (or the distribution of dividends) are typically done by mature companies who can’t produce a higher return on capital through methods 1 or 2.
For the purposes of this newsletter, the important takeaway is that returning capital to investors makes sense for mature companies.
You don’t see a lot of early stage startups paying out dividends, because those funds could be put to better use internally (R&D, hiring developers, shipping new products, etc…)
And yet, in crypto, we are starting to see a number of projects that are less than two years old experimenting with ways to return capital to their investors.
Cash Flow Producing Protocols
If you’re interested in doing a deep dive into cash flow producing protocols, I would recommend reading this article by DeFi Man.
The TL;DR is that protocols are experimenting with different methods for returning capital to tokenholders, which are summarized below.
Buy the protocol token from the market and distribute among stakers (i.e. xSUSHI)
Buy the protocol token from the market and burn it to reduce supply (i.e. BOTTO)
Buy the protocol token from the market and keep it in the treasury (i.e. YFI)
Redistribute part of the money generated by the protocol to token holders in major tokens (i.e. GMX)
The article also provides a crypto native P/E metric called “price to distributed fees” as a way of valuing whether protocol tokens are cheap or expensive.
Now, some of these strategies look familiar to their TradFi equivalent. The buy and burn vis-a-vis Botto looks a lot like share buybacks, whereas the GMX distribution strategy looks a lot more like a dividend.
But in general, most of these are some form of returning capital to shareholders. I think that’s a little funny, especially given the fact that even the most mature DeFi protocols look like pre-revenue startups.
By definition, pre-revenue start ups are losing money, and therefore should not be returning any capital.
The most obvious reason for this is because…they don’t have a whole lot!
But the second reason is the ability to generate a return on capital should be extremely high for early stage companies, so any and all resources should be allocated toward growth and winning market share.
For instance, at least until the fee switch is turned on, Uniswap doesn’t generate any revenue that accrues to the protocol. All swap fees are paid out to liquidity providers.
Imagine what the response would have been if two years into Uber, Travis Kalanick proposed returning money to early investors.
IMO it is important for investors to see the path to profitability, but today, any and all capital should be reinvested into shipping product and winning market share.
In time, tokens will eventually need to determine a strategy for accruing value. I also believe in the concept of company lifecycles, and returning capital to investors.
In the stock market, there is fairly strong evidence over time that dividend stocks and companies with strong share buyback programs outperform those who don’t.
The reason I currently disagree with the idea is because of how early stage all of these DeFi protocols are.
As a general rule of thumb, I think the vast majority of energy and capital at startups should be focused on building great products.
It seems a bit obvious to say, but protocols should basically be exclusively focused on organic growth. Or, in the case of some larger and more mature protocols, acquisitions.
Finally, if you are looking at the list of methods protocols are proposing for returning capital and thinking “why are they making this so complicated?” you are not alone.
To understand that, however, you have to look at the regulatory pressure being exerted on these protocols.
That will be the idea that we unpack in tomorrow’s note.