• Currency is the key to unlocking the benefits of trade. Currencies are used to buy things, which means currencies are constantly being traded

• Early stage tech companies don’t go around paying for things with their equity because their equity is a poor form of currency

• Yet, early stage web3 projects are going around paying for things with their native token thinking their native token is a good form of currency

• As a result, web3 projects are exposing their native token to tremendous amounts of sell pressure, destroying value for team members, investors, and their own treasury

• Revenue-share tokens represent a much superior form of currency that can be used to grow TVL without the adverse consequences of using the native token as a currency

A (very) brief history of trade and currency

Power of trade

Trade is the single most important social interaction in human history because of its profound economic benefits. Decreasing marginal returns dictate that people need a diversity of goods to maximize their utility. Further, comparative advantages teach us that producing everything ourselves is inefficient - it makes sense to specialize and produce only what we are optimally efficient at producing, on the condition that we can engage in trade afterwards.

These dynamics apply to people (we aren’t the ones building all our own furniture, making our own clothes, building our own houses, and farming our own food) and to countries (all countries specialize in certain types of economics activities). It is thanks to trade that human civilization has been able to develop into such a sophisticated web of globalized industries and enterprises.

Barter

Barter transactions involve trading goods for goods. They represent the original form of trade. However, barter has one key limitation: the coincidence of wants. Having a trade partner is a necessary but not sufficient condition for trade; both parties also need to also want what the other has. The solution to the coincidence of wants constraint is a central unit of exchange. Something every person will always trade for, so that everyone can always trade.

Currency

Currency solves the coincidence of wants problem.

Currency is the key that unlocks the potential of trade beyond barter. Throughout history, society has used many different kinds of currencies. Seashells, cattle, and gold were all, at one point or another, used as currency for trade among human beings (don’t worry, this post is not about Bitcoin!).

So what makes a good currency? According to the St-Louis Fed, a good form of currency needs to have 6 key characteristics:

1. Durability

2. Portability

3. Divisibility

4. Uniformity

5. Limited Supply

6. Acceptability

Early stage technology companies

When a technology company is born, it has no revenue. Despite not having revenue, the company incurs costs. In order to pay for these costs the company needs capital. But the only asset it has is equity. Can an early stage technology company pay for things with equity?

Inconvenience

The first problem is the lack of price discovery. The company would have to enter into a negotiation with the counterparty every single time it wants to pay for something (imagine having to negotiate with your landlord or AWS on a monthly basis regarding the value of your startup, explaining to them the benefits of the company, how much money it will make, what the exit multiple will be, etc.) Even if those negotiations could happen successfully, they would be followed by diligence and paperwork. Although theoretically feasible, going through diligence and legal agreements with unsophisticated counterparties is not realistic. Ultimately, the lack of price discovery and having to deal with unsophisticated counterparties makes paying for ongoing costs with company equity so excessively inconvenient that we consider it impossible.

Coincidence of wants

The second reason why paying for every cost with company equity is problematic is because of the coincidence of wants constraint. Paying for every single transaction with equity is equivalent to barter. Your landlord (probably) doesn’t want equity in your startup. The only way to convince your landlord to take the equity is to offer it at a huge discount to its intrinsic value. Your landlord will have no choice but to turn around and sell the equity to a third party for an equally discounted price. Eventually, paying for the same costs will require more equity to be sold because of how low the equity is being traded, and so on and so forth. As a result of paying for every cost in equity, you will put a tremendous amount of sell pressure on your equity.  

Is company equity a good form of currency?

Taken together, inconvenience and the coincidence of wants constraint highlight why startup equity is a poor medium of exchange. In other words, company equity is a bad currency. This becomes obvious when comparing equity to the six factors that define a good form of currency:

Early stage web3 projects

A lot of the same dynamics are currently being played out with native tokens today.

Trade via the blockchain is super convenient

The use of the blockchain, a public ledger, greatly facilitates trade for all digital assets on the blockchain. The ease with which digital goods can be traded for an agreed upon price improves all aspects of trading related to the inconvenience problem: blockchain projects can easily pay for costs incurred using their native token because the native token has a price and the transfer rails are extremely efficient (a landlord or AWS would be willing to receive native tokens as payment because they can turn around and sell the token into the market for their currency of choice).

But are native tokens a good form of currency?

Just because using the token is convenient, doesn’t make it a good currency. 

What happens when a DAO or protocol pays for things in the native token? The receiver sells the token for another currency. The constant sell pressure pushes the price of the token down. A lower native token price means the project will have to sell more tokens next time to make the same payment. More emissions lead to more selling, and so on and so forth. While all of these transactions have little friction thanks to the blockchain, the mechanics that result from using a poor form of currency are the same: downward price pressure on the native token.

This adverse consequence is compounded for DAOs whose treasuries are made up primarily of their native token: the constant sell pressure on the native token affects both the value of the protocol and the project’s runway. 

An alternative form of currency

Cinch allows web3 projects to mint ERC-20 tokens that represent specific amounts of revenue-share: revenue-share tokens. For example, a protocol can mint ERC-20 tokens that represent the right to receive [10]% of revenue until $[50]k is paid out, at which point the revenue-share expires and the tokens get burned. 

Revenue-share tokens are denominated in a widely accepted currency as chosen by the project (ETH or other). The ERC-20 format and the price discovery via Cinch’s secondary marketplace make revenue-share tokens exactly as easy to use as native tokens. Taken together, these characteristics make revenue-share tokens a better form of currency than native tokens.

Even better: revenue-share token trading does not affect the price of the native token. The wallets of core community members, investors, and the core team, as well as the project’s treasury, are spared the unnecessary sell pressure associated with issuing native tokens to short-term holders. 

Ultimately, revenue-share tokens give projects a tool with which to grow TVL without the adverse consequences of using native tokens as currency.

Conclusion

Native tokens, like equity for traditional early-stage technology companies, have all the characteristics to be a good form of currency except one: they are not widely accepted.

Many stakeholders that receive the native token want a proper currency they can use across the digital assets landscape, and as such, they sell the native token immediately upon receipt. As the token gets sold, the price required for transactions to clear is reduced, thus requiring more tokens to make payments of the same amount. Although trading native tokens is convenient, native tokens make for poor currency.

DAOs and protocols need an alternate tool with which to reward community contributors, partners, and liquidity providers, that does not harm or lead to selling of the native token. Revenue tokens are the critical tool projects need to reach their full potential.

** **

• Constant selling of native tokens destroys treasury and project value

• Revenue-sharing agreements have become popular in TradFi

• Smart contracts are the ideal way to implement revenue-sharing

• Revenue-share tokens bring uncollateralized and non-dilutive access to capital to DeFi

• Revenue-share tokens give projects a way to reward community and stakeholders without putting sell pressure on the native token

Introduction

Protocols and DAOs have two areas of focus.

Their first area of focus is to run a successful project: communicate how awesome their product or service is, grow awareness, grow the community, reward contributors, and ensure there is sufficient liquidity for their native token across DEXs.

The second is to accomplish all of this without damaging the price of the native token.

State of the market

The vast majority of DAO treasuries are made up of ~90% their own native token. That means projects live and die by the native token. The price of the native token dictates the value of the project and the amount of runway the project has.

The problem is that the native token is also the only tool DAOs have to to manage the project. Every time DAOs need capital, or need to pay for things, they need to issue their native token. This applies to salaries, contributor rewards, liquidity incentives, customer incentives, team incentives, partnerships, and potential VC investors. Unfortunately, not all stakeholders are long-term believers in the project.

Take liquidity providers. They provide a trading pair for the native token on a decentralized exchange (DEX) (often in the form of a more popular currency like ETH or USDC), and are rewarded with attractive yields in the form of native tokens (called Pool 2 emissions). In order to capitalize on the attractive yields, liquidity providers sell the native token almost immediately upon receipt into the pool into which they are providing liquidity, thus collecting fees on the trade and putting downward pressure on the native token. This transaction is repeated every time native token emissions are received.

The sell pressure on the native token leads to a reduction in price, as the supply and demand of the token adjust automatically within DEX smart contracts. In fact, one (very rough) proxy for expected price reduction is slippage, which is the “loss” incurred by liquidity providers as a result of the price of the assets moving relative to one another in liquidity pools. 1inch is a DEX aggregator that can be used to estimate the slippage from native token emissions [link]. We looked at two industry-leading DeFi projects and input their planned token emissions for the next 6 months as one “sell” transaction in exchange for USDC. While clearly an imperfect proxy, we can use this to contextualize the potential token price downside over the next 12-18 months as a result of expected native token emissions.

The expected slippage or “transaction cost” is extremely high at 38-96%. That is an extremely damaging loss of value for long-term holders of the token, including a project’s treasury.

Sell pressure doesn’t just come from liquidity providers: contributors may sell the token to pay their bills, investors will sell their vested tokens upon first vesting cliff to lock-in fund returns, early customers will sell their tokens to capitalize on the yield, launch partners will sell the native token because they prefer capital, etc. Each individual transaction may not seem like a lot, but taken together it becomes clear that **issuing native tokens to stakeholders that are not aligned with the long-term potential of the project leads to sell pressure. Sell pressure is extremely damaging to the token price and thus costly to the project.

**

Current attempts at solving the problem

This problem has become so acute that we’ve seen DAOs experiment with various strategies to mitigate token selling. The “ve” model popularized by Curve incentivizes native token holders to lock their token for a portion of protocol revenue (and locking means they cannot sell) [link]. “POL” or protocol owned liquidity, a model popularized by OlympusDAO, was designed in response to mercenary liquidity providers in Pool 2 liquidity pools with the goal of reducing the sell pressure on native tokens [link]. DAOs recognize they need to diversify their treasury but they cannot afford the market slippage, so they are opting for asset swaps instead [link]. Finally, DAOs are experimenting with vesting schedules for customer rewards [link].

All of these potential solutions are designed to improve the long-term outlook of the treasury by diversifying assets or by redirecting native tokens towards long-term holders. However, these solutions remain anchored in the idea that the native token is the only tool DAOs and protocols have at their disposal.

Revenue-based financing in TradFi

At this juncture, it is helpful to take a step back from web3 and think about how things work IRL (in real life).

After they incorporate, traditional companies have access to capital via two ways: equity and debt. Equity is a perpetual claim on the future net income of a company, while debt is a fixed obligation (i.e., fixed interest payments with a fixed amount to be repaid at the end).

The notable difference in blockchain is that entities are permissionless. That means even if a project generates revenue and is cash flow positive, there is no entity to which you can assign a fixed obligation in the form of a debt agreement. A project’s only option is to sell its native token. But as we’ve seen, constantly emitting the native token to stakeholders who are not going to hold for the long-term creates unsustainable sell pressure on the token. A lower token price leads to more tokens being required to make payments. Thus the selling and downward price pressure must continue.

We believe projects deserve another alternative.

One area of TradFi that has grown extensively in recent years is revenue-based financing. Think of a small business that has no collateral but needs capital. The business generates $5M a year (evenly across every month). It “borrows” $1M and has to repay $1.2M. Payments are made by diverting 15% of revenue every month.

• Amount borrowed: $1M

• Amount to be repaid: $1.2M

• Revenue paid each month: 15%

Mapping this out in excel, we see that the IRR (internal rate of return) of this investment for the capital provider is high at 30%. We can look at the cost to the small business in two ways: (i) repay $200k extra on the $1M, so 20%, or (ii) the IRR to the lender is the implied cost of capital to the SME. Either way, the cost to the business is 20-30%. This is an extremely high cost of capital.

The reason the cost of capital is so high is because of the risk profile of this uncollateralized agreement: the small business could choose, at any point, to stop making the required payments, with little immediate adverse consequence. Eventually, the capital provider would have to send payment notices and/or involve lawyers, at which point the two parties could renegotiate, or take the battle to court. Either way, it’s an extremely lengthy, drawn-out, and expensive process for the capital provider. The mere possibility that the small business can choose this path means the capital provider needs to charge a high price - making an additional $200k on $1M of capital provided - to get adequately rewarded for that level of risk.

Recently, companies like Pipe and others have improved on this model. They’ve found ways to draw the revenue directly from the source so as to remove the risk that the borrower stops making payments; Saas companies sell their actual customer contracts to investors for capital. By selling the actual customer contract there is no risk that the Saas company (or “seller” in this instance) chooses not to make regular payments - the capital provider has the right to receive the revenue from the end customer directly! This structure drastically reduces the risk to the capital provider (“buyer”), which leads to an attractive cost of capital for the Saas company.

Applying this model to smart contracts

Here is where it gets interesting: smart contracts do an even better job of this.

If we refer back to the small business example, imagine the revenue gets taken from the business’ bank account via smart contracts and goes directly to paying the capital provider. That removes all the risk associated with the small business not paying. By using smart contracts the risk is drastically lowered. Plus, the intermediaries involved in the legal agreements are removed.

Imagine if every DAO could trade 20% of their revenue for the next two years and receive that money upfront? Or even better, if they could receive ERC-20 tokens that represent this future revenue?

The ERC-20 revenue-share token could be minted and traded in a matter of minutes. It would represent the quickest and most efficient way of accessing capital. The price at which the tokens are sold will determine the cost of capital to the project. The more revenue the project generates, and the better track-record it has, the better the price will be. Further, the secondary trading of the revenue-share tokens will continuously inform the expected yield of the asset, similar to the pricing of a public bond.

Figure 4 below illustrates the expected price of the ERC-20 revenue-share tokens that represent 20% of revenue up to $400k.

Structuring a temporary revenue-share agreement using smart contracts allows DAOs and protocol to access 100% uncollateralized, permissionless, and non-dilutive capital for the first time in DeFi. The DAOs and protocols that are early adopters will contribute to improving capital efficiency and improving the overall potential of the DeFi ecosystem.

ERC-20 revenue-share tokens are easily understandable and can be used as a substitute to the existing ERC-20 native token across all systems and infrastructure. That means DAOs and protocols could use revenue-share tokens to pay their liquidity providers instead of continuously issuing native tokens. ERC-20 revenue-share tokens could also be used to pay contributors, early customers, investors, and partners.

By using revenue-share tokens to reward stakeholders in search of yield, projects protect their long-term community holders, investors, team members, and protect their treasury from native token sell pressure. Less selling means less slippage, and the token price can remain the same or even appreciate. Believers in the long-term potential of the project can purchase the native token knowing that it is not being issued to cover capital outflows that do nothing for growing the protocol. Instead, the native token is used to incentivize the people in charge of making decisions for the long-term benefit for the project, which is what it was designed for.

Being a forced seller of any asset in any market represents a sure way of destroying value and leaving money on the table. Using the native token to pay for things in a bear market is extremely damaging to the runway and value of the project. DAOs and protocols would benefit greatly from having another tokenized asset at their disposal - one that does not represent a perpetual claim on future net income, but represents a future claim on a specific amount of cash. Having the ability to trade future revenue to pay for ongoing expenses while the native token is at all-time lows will greatly improve the outlook of a project.

Finally, with another tool at their disposal, projects could develop more sophisticated treasury management solutions. It is easy to imagine scenarios where projects choose to purchase revenue streams for other projects with the dual purpose of (i) generating an attractive return and (ii) receiving ETH in exchange. This represents an improved version of native token for native token block trades.

Conclusion

By tokenizing future revenue, DAOs and protocols can finally access 100% uncollateralized and non-dilutive capital in a permissionless way. This innovative structure will improve the capital efficiency in DeFi and provide a much-needed alternative for projects looking to operate without continuously sacrificing their native token.

Minting ERC-20 revenue-share tokens gives projects another tool with which to manage their growth - one that can be used to incentivize stakeholders in the community in search of yield and returns while preserving the native token.

DAOs and protocols can extend their runway and make their native token a more attractive investment opportunity for the stakeholders who believe in the long-term potential of the project.

Long-term believers in the projects - team members, investors, and community members - can once again hold the native token without the risk of the native token being issued to holders with different incentives.

Our mission is to help blockchain projects reach their full potential, and we think revenue-share tokens are a critical tool for the development of the web3 ecosystem.

https://www.cinchprotocol.io/