By Ken Nguyen
One of the most interesting aspects of public blockchains and decentralized apps (dapps) that build on them is how token economic (tokenomic) incentives can generate 100x outcomes. Billions of dollars of market cap have been created in relatively short periods of time, sometimes shocking even the teams that launch them. Below is a three-point mental model for how dapps and ecosystems can generate sustained network effects that would be impossible without token incentives. My hope is that this is helpful to builders, investors, and users in Web3, and prompts feedback and dialogue.
Tokenized network effects represent a significant change from traditional growth models. Traditionally, companies have been raising venture equity or debt from accredited investors – which typically don’t overlap much with users – as development and revenue milestones are achieved. Marketing spend attracts new users, and loyalty programs retain them. Successful companies can benefit from network effects (products that get more valuable as more people use them). Andrew Chen, in The Cold Start Problem, explains that these network effects often don’t occur until all the right users and content are on the network at the same time. To accomplish this difficult task, companies expend significant resources to create an atomic network (or the smallest possible network that can grow organically). Companies trigger a tipping point once multiple atomic networks are launched, after which launches become less resource intensive and adoption accelerates up the “S” curve.
In contrast, dapps and ecosystems can perform 100x by radically optimizing three tokenomic flywheel drivers:
Assembly of Resources: Aggregation of human, financial, or infrastructure inputs
Accelerated Value Growth: Conversion of inputs into value-added products / services
Aligned Value Distribution: Equitable distribution to contributing stakeholders which creates a positive feedback loop back to points 1 and 2.
Let’s refer to projects that optimize these 3 drivers well as “AAA tokenomic flywheels”. The process looks like the diagram below.
1) Assembly of Resources
This initial process involves assembling undervalued, fragmented, or delayed and uncoordinated resources. This positions projects for the highest margins, multiplier effects, and long-term compounding.
Undervalued Resources are unmonetized, undermonetized, or newly created assets that are scalable and have zero to low cost. For example, NFTs of in-game assets, art, or intangibles (brand equity, track records, other IP, culture, or community) cost little to mint onchain. But, they can accrue value quickly as NFTs (NFT market cap ~$15B) due to their scarcity, P2P engagement and programmable monetization, liquidity, divisibility, and online visibility (NFTs can satisfy the AAA framework on a unit basis: they connect creators directly with users, without acquisition cost or middlemen, and allocate value to creators and users). As a physical resource example, Helium Network, a decentralized wireless network cofounded by Amir Haleem and Sean Fanning (Napster), started with an IoT communications standard that uses free, unlicensed spectrum and cheap equipment ($400-$500); this created a low-friction means for hotspot operators (now 550k+) to earn HNT token rewards.
Fragmented Resources are hyperlocalized or hyperspecialized resources that are hard to aggregate and whose sum value is greater than their individual parts. For example, Helium’s hotspots are now in 40k+ cities and 160 countries with coverage roughly indexing to population density. This hyperlocalized coverage is incredibly useful for IoT and 5G use cases that require it. Without coordination from token incentives, many P2P wireless projects have failed to scale while traditional telcos have struggled for a host of reasons (the 5G rollout has been particularly slow in the US). In this interview from the Multicoin Summit, Amir Haleem discussed how Helium itself struggled for six years and was running low on funds before launching HNT in 2019.
Source: Helium hotspot locations per Helium Explorer
Similarly, the Render Network, a decentralized GPU rendering network launched by Otoy, has potential (RNDR tokenomics are being revamped) to replicate Helium’s success by aggregating the fragmented GPU computing power in billions of consumer devices; these devices collectively have 100x the power of cloud GPUs. Other resource and project examples include file storage (Arweave, Filecoin), video streaming (Theta Network), and mapping (Hivemapper).
As an example of hyperspecialization, Yield Guild Games has assembled tens of thousands of gamers via its YGG DAO (community formed entity with blockchain enforced rules), game and region specific sub-DAOs, and YGG token. Each sub-DAO coordinates communities expert at monetizing and investing in a certain play-to-earn blockchain game. This specialization is valuable to its 20+ game partners which can leverage YGG’s communities to bootstrap game adoption; thus YGG is the first money and sweat “in”. YGG also provides signal to VCs / other investors in YGG, who lack specialization, by serving as a value-added, fund-of-funds / index of games and game NFTs.
Delayed and Uncoordinated Resources are resources that would not otherwise come together due to investment risk, lack of utility, or first-mover disadvantages. Illuvium is building what it aims to be the first blockchain game with big-budget quality. It has amassed hundreds of thousands of community members and a $400M+ market cap in a year without a playable game and only $5M in capital raised (game studios typically spend $60-80M and 2-4 years on average to develop a big-budget game before players are involved). Illuvium has gotten traction by partnering with guilds like YGG, using interactive governance for game features, NFT drops, and decentralized finance (DeFi) mechanics that incentivize the community to buy and hold ILV tokens (ILV holders are also entitled to all future game revenues). So instead of “build it and they will come”, it’s a “we’ll build it together” approach that can work so long as they deliver a great game.
In the future, token incentives can be applied to challenging use cases like pharmaceutical development which takes 10-15 years, costs $2B+ on average, and has a high failure rate; coordinating capital, patients, and scientific community members with token incentives can address all these problems. For example, rare pharma compounds could be tokenized as NFTs and transferred to a token bonding curve contract which mathematically relates supply with price (first adopters pay less for a share of NFT revenues, later adopters pay more along a preset price curve). The TBC could incent earlier funding (crowdsourced with DeFi integrations) and attract scientific community members and patients that would benefit most.
2) Accelerated Value Growth
AAA tokenomic flywheels take resource inputs and accelerate adoption by offering faster, better, cheaper or novel products / services. For example, rendering for metaverse and NFT apps on Render Network costs 70-90% less than with cloud providers (Nvidia / AMD charge cloud providers 8-10x more for GPUs vs consumers with only a marginal increase in power; these higher costs are passed onto users). Jobs on Render are also processed 8-10x faster than in the cloud by distributing computing loads across the network and using Otoy’s software. Per founder Jules Urbach, the special effects in a Marvel movie can now be rendered on a laptop. Faster speed and lower cost democratizes access for independent artists like Beeple, enabling development of new art and open metaverses that might otherwise be dominated by large companies / studios (Matthew Ball has a good piece on compute in the metaverse). As jobs are rendered, their provenance is recorded onchain back to inception, to the atom, and displayed publicly. This creates an artistic track record on which a new layer of royalties or licenses can be added; thus, a novel, high-value byproduct is created.
AAA tokenomic flywheels also build and ship faster due to the massive opex and capex efficiencies inherent from leveraging token incentives and open blockchains generally. For example, less time and money needs to be spent for personnel, marketing, office space, equipment, as well as capital to fund the aforementioned items. Helium leveraged $200M+ in capex from its 550k+ hotspot operators in 2.5 years with billions more hotspots on back order (telcos spend orders of magnitude more on both spectrum and tower infrastructure). By end of 2020, Uniswap, a decentralized exchange, achieved a third the trading volume of Coinbase in less time (2 vs. 8 years) with 1% labor cost (12 vs 1123 employees) and 2% the VC Funding ($11M vs. $547M). Efficiencies across DeFi are even more pronounced versus traditional financial service firms as seen below.
Source: ARK Investment Management LLC, 2021 based on data sourced from: YCharts; TokenTerminal; LinkedIn
3) Aligned Value Distribution
Last, AAA tokenomic flywheels equitably distribute value to key stakeholders – community (use case specific), investors, team, early contributors – in proportion to their contributions over time. This aligns all stakeholders with the long-term success of the ecosystem, and with each other. In the vast majority of traditional IPOs, investors own ~50-85% (in 60 / 71 IPOs, Founders retained 36% or less of the equity. Assuming 15% went to employees implies ~50-85% to investors) of the equity with users getting little to nothing. In contrast, 50-60% is typically allocated to user / contributors in Web3. For example, 65% of Helium’s HNT tokens will be distributed to hotspot operators or staked validators that secure the network; only 35% goes to Helium Inc., the company developing the network, and its investors. Optimal distribution provides an ROI for early adopters, substituting for app utility and other resources required to form an atomic network (Chris Dixon has a great post on this). This bootstraps the “hard” side of the network, mitigates the cold start problem, and buys time for utility to grow (Helium now has $60M+ in annual data credit usage from customers like Salesforce and Dish Networks).
HNT distribution is also optimized over time. Helium started with a relatively fair launch (anyone could launch a hotspot to earn HNT). HNT inflation is then halved every 2 years (supply is capped at 223M) and “burned” based on network activity (converted to data credits with a fixed USD price). These mechanics drive up the price of HNT to everyone’s benefit. HNT inflation also changes to incentivize what the network needs most. Initially, more goes to hotspots for building and securing coverage. As the network grows, hotspots earn more for transferring device data while Helium Inc. and investors earn less (no new money in). As time passes, users become owners, and financial investors are incentivized to become long-term, strategic investors. Both are healthy outcomes. HNT has grown to a $3B circulating market cap ($6.5B fully diluted) in just 2.5 years since launch, generating 100x gains for early adopters with more growth ahead.
Another element of aligned distribution is how big each stakeholder wins versus their prior economic, social, or power baseline. Axie Infinity, a Pokemon-like blockchain game that popularized the play-to-earn business model, provided token income in excess of the minimum wage for players in the emerging markets during the Covid crisis. This created huge brand loyalty as seen by its 13x growth in daily active users to 2.2M in 15 months post-token launch. At the same time, AXS (governance token) has grown to a circulating market cap of $3B ($17B fully diluted) despite Axie’s limited visual appeal, fun factor, and reliance on new users (game economy needs to be diversified).
Similarly, Packy McCormick has a great post on how Braintrust, a user-owned-talent network, aims to beat Web2 incumbents by delivering big wins to both companies that need talent and technical talent seeking work. Braintrust charges clients an industry-low 10% fee (vs. 28% for Fiverr or 70% for IT talent at Deloitte, PWC, and Accenture) while talent is actually paid to use it with BTRST token rewards. Talent also retains ownership of their track record without fear of de-platforming as a result of BTRST governance rights. The thesis for Braintrust (and other Web3 projects generally) is that “less is more”; or a larger value pie can be created by extracting less from users.
Aligned value distribution also creates powerful feedback loops back to the first two “A”s, promoting sustainability. Earlier users benefit as token value grows (AAA tokenomic flywheels have high LTV / CACs when viewing token inflation as customer acquisition cost). Early users, as owners, have an economic incentive to evangelize the product to future users and to build supportive businesses. Here’s a few examples of how Helium’s aligned distribution drives the first two “A”s:
A proof-of-coverage algorithm distributes more HNT rewards to new nodes that cluster near existing ones; this drives higher quality network coverage per unit of capex spend
Numerous podcasts, books, and social media content have been created by users, providing zero cost and effective marketing (Bitcoin and Ethereum have grown to a combined $1T+ market cap with no marketing budget. Uber has negative EBITDA and billions of SG&A expense per year 12 years post launch).
Companies like Fairspot.host provide free hotspots to users and a location based ROI assessment in exchange for a share of HNT rewards
Two dozen manufacturers now make hotspots, up from only Helium at the start, reducing cost
In total, hundreds of companies and thousands of developers are now building on Helium
Recap
“AAA tokenomic flywheels” leverage token incentives to generate 100x outcomes by radically optimizing 3 flywheel drivers: Assembly of resources, Accelerated value growth, and Aligned value distribution. With assembly of resources, they aggregate undervalued, fragmented, or delayed and uncoordinated resources to position projects for the highest margins, multiplier effects, and long-term compounding. They then accelerate value growth by creating faster, better, cheaper, or novel products / services for users, and shipping faster due to massive cost efficiencies. Aligned value distribution mitigates the cold start problem by incentivizing users and other contributors with ownership, delivering a big win for each stakeholder versus their prior baseline, and creating powerful feedback loops that promote sustainability. Distribution is such a potent contrast to Web2 business models that it’s often the key step in building a AAA tokenomic flywheel.
In goes without saying that great projects need a strong team, a large TAM, a differentiated product, and a viable business model (they also don’t always need a token). But, great tokenomics that radically optimize these three flywheel drivers will significantly increase the speed and likelihood of a 100x outcome.