ICO tokens are similar to dividends and should be valued as such. However, valuing these tokens using something like discounted cash flow is a horrifying exercise.
When China banned ICOs last September, Asian trading activity shifted to Japanese exchanges. So far, Japanese regulators have been taking a hands-off approach to both cryptocurrency trading and ICOs -- and while these two things are frequently grouped together, they are very different.
Cryptocurrencies are already becoming an important part of the economic landscape, but ICOs will prove to be a short-lived fad with most ICO tokens worthless.
This is not a radical prediction. Blockchain technology does not change fundamental economics, and all tokens are not created equal. Tokens with intrinsic utility will increase in value, while those whose purpose is to extract value from a business will lose their value.Almost all ICOs are of the later type.
The two best known, and most valuable, tokens are Bitcoin and Ethereum. Both of these have novel, intrinsic utility.Bitcoin enabled rapid, pseudo-anonymous transfer of value without a controlling middleman and Ethereum’s smart contracts enable simple payment agreements to be documented in and enforced by software not under the control of either party.
Both of these tokens represented significant advances to the state of the art and introduced utility that was not practical without them. Furthermore, this utility was enabled solely by the tokens themselves and not tied to the fortunes of any particular company or group of companies.
Bitcoin’s ecosystem expanded as both illicit and legitimate transactions were attracted to the system. And while Ethereum’s smart contracts show a lot potential, demand and ecosystem growth have been primarily fueled by the fact that Ethereum enables ICOs.
In both cases, since few practical alternatives exist, the price and demand for the tokens grew as their ecosystems grew.
Most ICO startups, however, are not creating new utility, but grafting cryptocurrency onto an existing business model, and the value of these tokens are tied directly to the success of these firms.
Business ranging from electricity retailing, to crowd-funding, to credit cards, to venture capital funds are using ICOs to raise funds. The CEOs I’ve spoken to seem to sincerely believe in their vision, and that their token holders will see substantial returns.
But they are wrong.
The future value of these tokens comes not from enabling a new utility with few practical alternatives, but by siphoning cash from operations.
ICO startups usually structure their business so that tokens must be purchased in order to do business with the startup. The theory being that the demand for tokens will expand as their business grows, and 1% to 5% of corporate cashflow will be diverted to token holders. With the founders usually holding between 20% and 30% of those tokens.
Unlike Bitcoin and Etherium however, ICO startups are not creating new utility,but entering existing markets with established competition, and they will be at a significant competitive disadvantage to firms that do not have to pay out 5% of their total sales.
Although ICO startups often tout blockchain as a competitive advantage, these tokens will be a millstone around their necks once they begin operations. The more generous the token payments, the larger the operational handicap. Since the tokens themselves do not offer intrinsic utility, their value comes directly from operating margins.
Even in those cases where the blockchain improves operational efficiency, ICO companies will be at a disadvantage to startups paying out less or nothing at all and will be driven out of business. Once that happens, the tokens will be worthless.
In reality, ICO tokens are similar to dividends and should be valued as such. However, valuing these tokens using something like discounted cash flow is a horrifying exercise. Valuations often imply billions of dollars in annual sales. That’s pretty ambitious for companies that, for the most part, do not have functional products or significant industry experience.
Perhaps the most egregious use of ICOs are the firms using them to raise funds for venture investment. As is typical with most ICOs, the founders retain up to 30% of the tokens and tend to have little domain experience. While blockchain has the potential to both streamline dividend payments and helps shareholders assert their rights, that’s not what’s happening here. ICO investors are simply blinded by blockchain and paying a 30% load for a fund run by an unproven team.
Technical handwaving does not change economics, and most ICOs are simply terrible investments.
But it’s even worse than that.
Corporate equity and debt come with specific and enforceable legal rights. Tokens do not. While most whitepapers explain what the startup “plans” to do, the firm is under no legal obligation to follow those plans, and the pseudo-anonymous nature of cryptocurrencies will probably make legal claims difficult to enforce in practice.
The ultimate investor outrage, however, will occur when everything goes right. If against all odds, an ICO startup succeeds and begins generating the billions in sales required to make their tokens worth millions, nothing will prevent the firm from keeping those millions for itself.
Unlike Bitcoin or Etherium, which have intrinsic utility, most ICO tokens are simply a mechanism the startup uses to transact business, and they are free to change that mechanism. There are few legal or technical hurdles that would prevent a startup, or more likely an acquiring company, from creating a new wholly-owned token, seamlessly migrating their customers to it, and leaving existing token-holders holding worthless tokens.
In the long term, I think we will see thousands of successful, domain-specific cryptocurrencies, but the ones that win out will be those that provide the lowest-cost infrastructure, not those that promise the highest returns.
There are clearly speculative profits to be made in buying tokens at or before ICO and selling them before the company begins operations and real-world economics take effect, but in the long run, the value of almost all of these tokens will be driven to zero.
I'm a Tokyo-based founder, consultant, author, and teacher and host the Disrupting Japan podcast. I also teach corporate innovation at NYU's Shinagawa campus.
A version of this article first appeared on Forbes.
Tim Romero is the Head of Google for Startups Japan. He is a Tokyo-based entrepreneur, podcaster, author and teacher who has started four companies and led Japan market entry for others since coming to Japan more than 25 years ago. Tim hosts the Disrupting Japan podcast, teaches corporate innovation and entrepreneurship at the NYU Shinagawa campus and is CTO of TEPCO's Business Innovation Task Force. Tim is deeply involved in Japan's startup community as an investor, founder and mentor.