Will Tokens Replace Equity?

Historically, whenever someone wanted to fund an ambitious technology project, they only had one choice—venture capital. You could try to convince a bank to give you a loan, but if you are doing a “billion or bust” type of startup, a bank will likely deem your venture too risky. 

Enter 2022. A new option for fundraising is growing in popularity: crypto tokens. Some public intellectuals are proclaiming they are a 10x improvement over traditional equity. Visions of a decentralized, blockchained funding future dance like sugar plum fairies in the heads of technologists all over the globe. In this imagined utopia, greedy middlemen in Patagonia vests are entirely stripped out of the process, and community participants shower ETH into the treasuries of deserving founders. 

A claim of 10x improvement is enough to qualify for a chance at monopoly status. Zero to One, Peter Thiel’s canonical book on startups, says:

“As a good rule of thumb, proprietary technology must be at least 10 times better than its closest substitute in some important dimension to lead to a real monopolistic advantage. Anything less than an order of magnitude better will probably be perceived as a marginal improvement and will be hard to sell, especially in an already crowded market.” Emphasis Added

This essay is my best attempt to figure out the dimensions that could make crypto 10x better than equity for funding early-stage projects. It’s important because it is entirely possible that in a few years time we could be living in a world where traditional equity goes the way of the dinosaur (or, closer to home, the entrepreneurial bank loan). But it will only happen if tokens are, as some claim, a 10x improvement.

By my analysis, the differences between the two technologies come down to three important factors:

1. Narrative Network Effects
2. No Privacy, Total Anonymity
3. Public and Liquid 

Narrative Network Effects

In a 2011 study of asthma patients, subjects were split into four test groups. One cohort received nothing, the second underwent a “sham” treatment of acupuncture where the needles didn’t break skin, the third received an inhaler with nothing inside, and the fourth received an inhaler with albuterol. All 3 groups that received any sort of treatment reported “substantial” improvement to their symptoms.

Allow me to say that again in non-science speak. People who received absolutely no medical intervention reported having the same feeling of health improvement as those who had been treated with actual medication. This, however, is not a case of the placebo effect curing asthma; it is a case of the body tricking the mind. Only the patients who received albuterol had an objective, measurable improvement to their airflow.

This individual study isn’t perfect with an n of only 36 completed participants, but the placebo effect is well-established and it acts as a fun illustration of my point. 

Human beings have an incredible ability to deceive ourselves about the efficacy of interventions.

Even if the “active ingredient” in the crypto narrative is inert, it almost doesn't matter at this point. Crypto has become a religion, and Web2 companies like Facebook have become so reviled, that there is a sizable contingent that believes decentralization is the answer to everything. Many crypto diehards truly believe that a decentralized ledger of record is better in every way for every problem. Or as my granddaddy would put it, “To a hammer, everything is a nail.” By raising capital via token, entrepreneurs can tap into this narrative belief from an adoring crypto public.

This is not necessarily a bad thing! The ability to achieve instant buy-in to the story of a company utilizing crypto is a powerful distinction for tokens versus traditional equity. Think of the ICO boom of 2017. There were 800 ICOs that raised over $20B. The fascinating thing was that many of these companies were started by teams with absolutely no track record. People believed so strongly in the blockchain (or believed that their returns would be incredible whatever the underlying tech) that they ponied up vast sums of capital. Of course, most people lost everything, but hey, the founding teams did great!

This is not a crypto-unique phenomenon—the stock markets have examples of this collective belief mechanism too. ARK Capital, a notorious stock ETF, pulls on similar heartstrings. By screaming into the void words like AI, innovation, and electric vehicles, the company has somehow gotten over $12B+ AUM. This is despite losing 50% over the last year (it takes an incredible talent to lose this much money over the year tech stocks just had).