Using Tokens: Utility or Equity

Almost all projects in Ethereum today launch with some kind of token. But do all these projects really need tokens? Are there any disadvantages to using a token, or will we see the slogan “tokenize all the things” come to fruition? In principle, the use of tokens can be seen as the ultimate management or organization tool. In practice, the integration of blockchain platforms, including Ethereum, into the existing structures of society means that, so far, there are many limitations to their applicability.

Let’s start by clarifying the role of a token in a new project. The majority of projects are using tokens in one of two ways: either as “utility tokens” or as “equity tokens.” Very often, those two roles are conflated.

Utility tokens are those where the use of the token is required to gain access to a service, application, or resource. Examples of utility tokens include tokens that represent resources such as shared storage, or access to services such as social media networks.

Equity tokens are those that represent shares in the control or ownership of something, such as a startup. Equity tokens can be as limited as nonvoting shares for distribution of dividends and profits, or as expansive as voting shares in a decentralized autonomous organization, where management of the platform is through some complex governance system based on votes by the token holders.

It’s a Duck!

Many startups face a difficult problem: tokens are a great fundraising mechanism, but offering securities (equity) to the public is a regulated activity in most jurisdictions. By disguising equity tokens as utility tokens, many startups hope to get around these regulatory restrictions and raise money from a public offering while presenting it as a pre-sale of “service access vouchers” or, as we call them, utility tokens. Whether these thinly disguised equity offerings will be able to skirt the regulators remains to be seen.

As the popular saying goes: “If it walks like a duck and quacks like a duck, it’s a duck.” Regulators are not likely to be distracted by these semantic contortions; quite the opposite, they are more likely to see such legal sophistry as an attempt to deceive the public.

Utility Tokens: Who Needs Them?

The real problem is that utility tokens introduce significant risks and adoption barriers for startups. Perhaps in a distant future “tokenize all the things” will become reality, but at present the set of people who have an understanding of and desire to use a token is a subset of the already small cryptocurrency market.

For a startup, each innovation represents a risk and a market filter. Innovation is taking the road least traveled, walking away from the path of tradition. It is already a lonely walk. If a startup is trying to innovate in a new area of technology, such as storage sharing over P2P networks, that is a lonely enough path. Adding a utility token to that innovation and requiring users to adopt tokens in order to use the service compounds the risk and increases the barriers to adoption. It’s walking off the already lonely trail of P2P storage innovation and into the wilderness.

Think of each innovation as a filter. It limits adoption to the subset of the market that can become early adopters of this innovation. Adding a second filter compounds that effect, further limiting the addressable market. You are asking your early adopters to adopt not one but two completely new technologies: the novel application/platform/service you built, and the token economy.

For a startup, each innovation introduces risks that increase the chance of failure of the startup. If you take your already risky startup idea and add a utility token, you are adding all the risks of the underlying platform (Ethereum), broader economy (exchanges, liquidity), regulatory environment (equity/commodity regulators), and technology (smart contracts, token standards). That’s a lot of risk for a startup.

Advocates of “tokenize all the things” will likely counter that by adopting tokens they are also inheriting the market enthusiasm, early adopters, technology, innovation, and liquidity of the entire token economy. That is true too. The question is whether the benefits and enthusiasm outweigh the risks and uncertainties.

Nevertheless, some of the most innovative business ideas are indeed taking place in the crypto realm. If regulators are not quick enough to adopt laws and support new business models, entrepreneurs and associated talent will seek to operate in other jurisdictions that are more crypto-friendly. This is already happening.

Finally, at the beginning of this chapter, when introducing tokens, we discussed the colloquial meaning of “token” as “something of insignificant value.” The underlying reason for the insignificant value of most tokens is because they can only be used in a very narrow context: one bus company, one laundromat, one arcade, one hotel, or one company store. Limited liquidity, limited applicability, and high conversion costs reduce the value of tokens until they are only of “token” value. So when you add a utility token to your platform, but the token can only be used on your single platform with a small market, you are recreating the conditions that made physical tokens worthless. This may indeed be the correct way to incorporate tokenization into your project. However, if in order to use your platform a user has to convert something into your utility token, use it, and then convert the remainder back into something more generally useful, you’ve created a company scrip. The switching costs of a digital token are orders of magnitude lower than for a physical token without a market, but they are not zero. Utility tokens that work across an entire industry sector will be very interesting and probably quite valuable. But if you set up your startup to have to bootstrap an entire industry standard in order to succeed, you may have already failed.

Make this decision for the right reasons. Adopt a token because your application cannot work without a token. Adopt it because the token lifts a fundamental market barrier or solves an access problem. Don’t introduce a utility token because it is the only way you can raise money fast and you need to pretend it’s not a public securities offering.