From the rapid growth of crypto to the dramatic volatility of the asset class, governments around the world are responding through regulatory and legislative actions. Some jurisdictions have announced clear and accommodating frameworks in the hope to create the crypto hubs […]
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“This would be a much better world if married couples were as deeply in love as they are in debt”
— Earl Wilson
Happy Independence Day Y’all
Seeing as it’s the 4th of July and all, for today’s newsletter I considered writing something simple and easy to digest.
It’s America’s birthday, after all. For most people today is reserved for barbecues and drinking to dull the pain of your relatives’ political opinions.
So I started to whip together something simple, but then I thought…not this crowd. You are made of stronger stuff than that.
Even through the haze of coors light and conspiracy theories, you demand challenging, and intellectual content. No days off, dammit. I take my hat off to all of you.
So in that vein, I’m going to try to raise the bar as well.
Today’s newsletter is about token distribution mechanisms, equity vs debt financing in crypto, and the catalyst that may eventually kick off the next bull market.
The Magic of Distribution
Last week, Multicoin’s Tushar Jain made an observation on Erik Torenberg’s Venture Stories that I found very interesting.
You should listen to his full developing thesis here, but the TL;DR is that every bull market in crypto is preceded by the advent of a new token distribution mechanism.
In 2013, that was the proliferation of PoW coins after the market observed Bitcoin’s success.
In 2017, networks figured that they could bootstrap growth by selling pre-mined coins (ICOs).
In 2020, DeFi summer was kicked off by yield farming, which was protocols giving users tokens (equity?) in return for an action (providing liquidity).
In 2021, NFTs wrote the first iteration of the playbook for crowdsourcing funds to develop IP.
One way of describing all of these activities is the rapid iteration in a frontier form of equity financing.
The success of each subsequent iteration on this type of financing typically leads to a flood of copycats, which brings an enormous amount of new token supply online.
That oversupply, in my opinion, is part of what pricks that mania induced bubble at the top of crypto bull markets.
Demand eventually becomes insufficient to meet the incredible amount of supply, token prices begin to fall and eventually most projects fail.
And That Brings Us To Today
It’s now become broad consensus that liquidity mining, while innovative for its time, was at best a blunt and expensive customer acquisition tool, and at worst downright value destructive.
(Note: today’s note is going to focus on liquidity mining, but a lof the same arguments apply to NFTs which are even more immature and less investor friendly. But that’s a topic for another day).
Equity is extremely valuable. So giving 15 - 30% of it away to customers is very expensive, especially they can turn around and sell it because there isn’t any vesting schedule.
It’s especially problematic for protocols if they start relying on that free equity distribution as their primary growth strategy. It’s kind of like being reliant on paid advertising, only much worse because of the negative feedback loop that kicks in once token prices start falling.
Lower token prices mean that protocols need to give away even more tokens to generate the same amount of growth. That leads to even more supply, which leads to intensified selling pressure, which leads to protocols having to give away even more tokens, and so on.
It’s not a loop that protocols are happy to be in, and they are looking for ways out. The problem is, most projects today are still early stage and need financing.
So now, some of them are turning to another form of financing: debt.
Debt vs Equity Financing 101
There are two ways for companies to raise money:
Equity financing - selling a portion of ownership in the company
Debt financing - borrowing money to be paid back with interest
The main advantage of equity financing is that there is no obligation to repay the money. The drawback is that you surrender ownership and it’s expensive (equity is valuable!).
The main advantage of debt financing is that you don’t have to give up any ownership, and if you put the capital to good use and create equity value, it’s relatively cheaper.
The disadvantage is that you need to pay the money back, plus interest in regular intervals.
Most mature companies use a combination of both equity and debt. The decision for whether or not to leverage debt really comes down to:
Strong and reliable cash flows
Working capital (usually assets that can be used as collateral)
The reason start ups typically rely on equity financing is that they don’t have reliable cash flows or hard assets. Most start ups are valued on cash flows that extend far into the future, which works for equity financing, but are not helpful for servicing interest payments.
The terms of the issuance are outlined in the prospectus here, it’s pretty interesting. They’re essentially zero coupon bonds secured by 50,000,000 RBN (roughly $10,500,000 at today’s prices).
Now, I’m not a bond investor or a CPA. I don’t have any particular insight into the viability of this particular offering, and it seems like Ribbon’s treasury is more than capable of absorbing this liability.
But, I do think it raises interesting questions about DAO funding. This loan is relatively small and it is highly overcollateralized, but collateralizing loans with extremely risky early stage start up equity feels… kind of risky to me?
I think the right question to be asking here is “what is the appropriate financing strategy for an early stage start up?”
If a protocol can’t point to strong revenues (preferrably in some form of stablecoin, because that’s what the debt liability is in), then does it really make sense to use debt?
Or (putting my tinfoil hat here), is there another reason that protocols might be seriously looking at debt financing? For instance, now Ribbon can extract liquidity from 50,000,000 RBN instead of having to sell them on the open market.
One man’s opinion here, but it’s possible this is more about solving the negative feedback loop we outlined above than picking the appropriate form of financing.
This is not to say that I think debt financing isn’t a good fit for crypto.
Quite the opposite. I think one of the largest opportunities in this industry is the introduction of credit products, which has been sorely lacking for some time.
You could make the argument that we actually have an excess of capital seeking returns in the form of equity financing, which exacerbates the crypto market cycle.
As I have said before, VCs chase like everyone else and VC funding (especially early stage) comes at the peak of bull markets.
But for whatever reason, there is a conspicuous lack of debt products in crypto. Maybe it’s because of how early stage the space is, but that is soon changing (credit products aimed at miners are a good example of this).
The intersection of DeFi and credit present may be the most interesting opportunity in crypto today.
The introduction of borrow-lend protocols like Aave and Compound were revolutionary, but they are just the first step. Asset backed lending, while uniquely well suited to crypto, has its drawbacks. Namely, you have to start with capital in the first place.
IMO the space to keep your eye on is in undercollateralized lending. Maybe an unpopular opinion now due to the recent blow ups, but in TradFi the vast majority of lending is unsecured.
It makes sense to me that crypto would follow suit. As start ups mature past the early growth stage and begin to produce reliable cash flows, debt products become increasingly attractive.
There are a couple of protocols today such as Maple Finance or Goldfinch that are making promising advancements in these areas.
Goldfinch is targeting SME borrowers in emerging markets, while Maple is building out an AWS type infrastructure that facilitates institutional borrowing on chain. (You can listen to a recent interview that I did with Maple co-founder Sid Powell here.)
What Kicks off the Next Bull Run?
I think there is a good chance that the next bull run will coincide with the birth of a more mature suite of on-chain, undercollateralized credit products.
As companies in the space become more mature and the macro regime shifts companies focus to producing cash flows, the demand for debt financing will grow.
So while I do think that some iteration on token distribution (equity financing) will undoubtedly happen, perhaps the introduction of widely available credit products will be even more impactful on the market.
And why do I say undercollateralized lending?
Most TradFi loan issuance is non-secured (cash-flow backed)
Asset backed leads to centralization of capital (need money to create more money)
When demand (mania) eventually returns to crypto, it will shift from a lenders to borrowers market and lenders will once again loosen their terms
To wrap things up, I’ll leave you with these statistics:
The bond market is much larger than the stock market (roughly $130 trillion vs $100 trillion)
Less than 5% of that is asset-backed lending*
Directionally, I think that’s where crypto is headed as well.