The problem of finding an optimal structure for a token sale is quite difficult.



For starters, the objectives between teams and investors are potentially different. Furthermore, these are not homogenous groups. Teams vary widely along at least two dimensions: intent (from get rich quick to change the world) and competency. Investors differ around dimensions such as risk tolerance and intended holding period. As if that were not complicated enough, there is also a question how a sale is supposed treat incentives for the creation of a protocol relative to future participation in the protocol’s operation.

Token sales mechanisms will differ widely in how they address all these competing objectives.

So what should an optimal token sale actually be optimizing? Usually, when we say “should,” the implied normative perspective is the overall social one. That perspective includes many parties who don’t participate in the token sales at all, but rather will be using the successful tokens sometime in the future. Optimizing for this means maximizing funding for projects that are most likely to have a real impact (and do so in a way that maximizes impact), while keeping the money going to everything else as small as possible. Everything else being projects likely to fail as well as outright fraud.

This is no different from the optimum we are, at least in principle, aiming for with traditional private and public financing markets for companies, R&D projects, and so on. It explains a lot of the regulation around VC and IPOs, whether or not you believe these systems are effective (for instance, I have written about how I think the IPO market is broken). What is different is that token sales are global and do not (yet) have a regulatory framework. We are therefore in a period where teams choose independently and we are seeing a lot of different approaches. Experimentation is essential for finding out what works best. Vitalik Buterin lays out a couple of examples in his post on Analyzing Token Sales Models and it would be great to see a compendium of all of the sales to date.

The most potential for trouble are token sales which are one-time, large (possibly even uncapped) and take place when minimal specification / technical work has been done. In these the risk of outright abuse is highest (eg team starts paying themselves above market salaries, lavish perks), as well as the risk of nothing of use ever shipping is highest also. This is of course why in the traditional venture model early rounds tend to be smaller. On the plus side though the fact that a number of such sales have happened does provide a strong incentive for people to want to create new protocols. And a sale like this can finance all the work that is needed to create something quite complex.

Conversely, the least problematic and the best incentives for the operation of a protocol would come from a highly distributed “helicopter drop” of a token that can immediately be used in a fully functioning protocol. The team makes no money here so there is zero potential for abuse, there is no technical risk (by assumption) and the recipients have a windfall so they will have no issue selling or using the token. The obvious downside is that such a “sale” cannot finance the creation of a protocol since it has (a) no proceeds and (b) happens after the works is already done. It can still provide an incentive though for creation since some percentage of the currency can be retained / earned in the future by the protocol creators. ZCash is a good example of this approach.

These are obviously somewhat extreme bookends which I picked on purpose. The “optimal” approach would seem to fall somewhere in-between and have roughly the following elements

1. Keep initial sale small. This could even be a traditional investor round that helps fund early technical work. Holdings can be concentrated as more will be sold / distributed later. Little information is required and investors should meet speculation suitability requirement (meaning should be able to lose 100% without a problem).

2. Hold one or more subsequent sales of increasing size, to the extent that further funding is required for development. As the sales get larger aim for more widespread holding. Publish as much information about protocol and how it will work as is available to show reduction in risk.

3. When the protocol is ready, hold a final sale and/or distribution that gets all but a small fraction of the initially available tokens out for use. Should a large fraction of the tokens be retained, it must be released programmatically and transparently. Under no circumstance should a large fraction that’s retained be discretionary (this what Vitalik calls the “No Central Banking” rule). Also: if your token has native mining, then you can use mining instead of this step 3 to have tokens come into existence in a highly distributed manner.

What are some properties of sales that may seem important but likely are not?

A. There does not need to be a guarantee of participation (this was one of Vitalik’s proposed properties). For instance a scheme in which many orders are submitted, but only some are chosen randomly is likely economically efficient. This may violate a sense of fairness, which resides in a moral realm that I don’t want to dismiss, but does not have an incentive impact.

B. The price of a token does not necessarily have to go up in subsequent rounds. There can even be a “helicopter drop” or future mining that may turn out to be initially cheap. What is much more important for early purchasers than short term price fluctuations is understanding what percentage of the currency they have bought (note that this percentage can go down over time, see my post on monetary policy). Early buyers will generally approach a token with a view towards the possible size of the economy for that token.

There is a lot here and I will clarify in a subsequent post or posts, once I have gotten feedback. This will include a discussion of mechanisms that can be used to deal with suitability requirements and spreading sales widely.

Important disclaimer: None of this is legal advice. The entire post is written strictly from an incentive point of view.