A Letter from Placeholder to VCs: The Original Sin of Cryptocurrency Allocation

This article was published on Blockbeats, author: Placeholder, compiled by: 0x26.

As the total market capitalization of cryptocurrencies surpasses two trillion, it seems that the cycle of the market has returned to the "prosperity" of "emerging VCs everywhere, opening dozens of times, and making money just by getting in on the primary market." Many so-called "star" projects leave most of the allocation for teams and investors, while only distributing a few thousand or tens of thousands of dollars to the public, simultaneously employing Twitter follow, @ friends, and retweeting strategies akin to "Ponzi" marketing. The market conditions where listings immediately soar to xx times have left many secondary market participants at a loss, unsure how to support or participate in their favorite projects. Even the "fair launch" that rose alongside DeFi and was strongly advocated within the industry has faded away with the market's boom and DeFi's return to calm.

In response, Placeholder co-founder Chris Burniske published an article titled "The Original Sin," outlining the advice from Placeholder and USV to VC and founding teams in the industry, discussing with "insiders" how to help VCs who have "occupied the high ground" shed the so-called "original sin" and promote healthier development of cryptocurrencies.

Star Wars Obi-Wan: It's all over, I have the high ground

While analyzing the market, Placeholder is also reflecting on itself. Joel Monegro from USV, who wrote "The Fat Protocol," and Chris Burniske from ARK Crypto have been guiding the market's pace. This article not only provides guidance for VCs but also offers direction for founders of new projects. Throughout the analysis, there is a strong sense of industry mission akin to "the cold stars do not notice, I offer my blood to recommend Xuanyuan."

The translation and organization of the original text are as follows:

This article is concerned with only one thing: what is the initial allocation strategy of capital supporting a cryptocurrency project? In a recent conversation between the Placeholder and USV teams, Fred Wilson (co-founder of USV) commented that in the cases of projects he has experienced deteriorating over time, it often traces back to the initial "original sin" (here, original sin refers to: team, method, economic model, or key decisions). Focusing on cryptocurrency projects, one original sin we frequently observe is that in systems touted as absolutely fair, insiders hold too much.

Of course, "fair distribution" is a normative judgment that stems from a shared belief within the crypto industry: to create a fair competitive environment that allows everyone the opportunity to enjoy financial sovereignty. If a small group of insiders regularly takes half of the FDV (Fully Diluted Valuation, i.e., the total market value after all tokens are released and distributed) (which is quite common in the current situation), we severely undermine the original intent of this technology—redistribution, and the purpose becomes merely to make a few people wealthy. The fact is, even if these individuals take a little less money, they can still do very well; they simply let things go, taking as much money as possible, using the erroneous phrases "this is how things have always been done" or "fiduciary duty" to excuse themselves and others.

The industry has long been committed to establishing technology that is open and has no barriers to entry. This process is largely open, but the most closed and mysterious part is early financing. While this is driven to some extent by regulation and social norms, a more insidious factor is that insiders can disproportionately tilt the scales in their favor while keeping the details hidden from public view. The more impatient early investors become, the bolder and more powerful they become, to the extent that this power can adversely affect the health of the entire industry.

Under this veil of opacity, the norms and structures of past imbalances in wealth and power distribution also play a role in this industry. If we do not openly address the issues that arose at the inception of cryptocurrency networks, we will inevitably repeat the mistakes of past societies.

Where there is capital, there is power.

The two types of organizations most closely involved in the initial creation and distribution of capital are founding teams and early investors (including VCs, high-frequency funds, and mixed entities with diverse business interests in the industry). If founding teams want to build something, unless they have the money to support themselves and their teams independently, they will turn to early investors who provide venture capital for this journey. Although the cryptocurrency space often demonizes this process, it can be a healthy and beneficial one, allowing an entrepreneur without wealth to take risks on an idea, and if successful, of course, to reap sufficient rewards; if it fails, the founder can move on to the next journey.

However, there is another world where this relationship becomes unhealthy, especially in the case of opportunistic investors who realize the asymmetry of information distribution between investors and entrepreneurs, compounded by the presence of inexperienced entrepreneurs. First-time entrepreneurs must be cautious. We have frequently observed predatory behavior in early stages of deals in the crypto space, more so than in other fields.

This asymmetrical advantage gives investors a home-field advantage; as long as they can get entrepreneurs to agree to those legal agreements before other investors say those agreements are unreasonable, the entrepreneur may "foolishly" agree, and thereafter the project may be forever affected by this original sin.

For entrepreneurs, an important resource for protecting themselves is other entrepreneurs who have already gone through fundraising. Ask them about the reputations of different investors, what they regret, what they consider fair, and so on. If you are considering a major investor for a round, you should communicate with projects in that investor's portfolio to get references about that investor—references do not need to be one-sided. Additionally, if possible, try to obtain more than one term sheet. These are a few simple steps for protecting yourself as an entrepreneur.

If we want to effect structural social change, then entrepreneurs and investors need to collaboratively explore what kind of change we want. If we do not do this, we can only continue as we always have. While crypto technology is a large-scale deflationary and flattening technology for society, thus opening up channels for capital acquisition, the (re)distribution of crypto technology varies greatly depending on the social norms we tolerate and recognize.

At Placeholder, our goal is to occupy only 1-5% of the total amount of a project, with the current most concentrated share being 7%. Some may argue that this number is still too high, but it is far from the 10-20% ownership targeted by private equity investors. We believe this ratio is appropriate: cryptocurrency projects are emerging economic forms that use protocols instead of companies, provide specialized services, and have global capabilities from the start. We assume that their scale, vision, and diverse stakeholders require a more equitable distribution of token ownership than companies to maximize efficiency (companies do not use equity to increase growth for both supply and demand, but cryptocurrency projects often use their assets to do so).

Without discussing our particular case, let's look back at the entire industry. Placeholder advocates that when capital is first allocated, the ratio should be "25% internal, 75% external (with external receiving three times that of internal)." By "insiders," we refer to core teams, investors, and closely related advisors—essentially all those who risk investment potentially going to zero, along with labor and capital loss. Moreover, 25% may sound too much for some insiders—for example, Bitcoin holders have long complained that Zcash allocates 20% of its block rewards to non-mining network contributors—but 25% is quite small compared to the more common 40%-50% allocation to insiders in the industry today.

However, Placeholder is not perfect either. We cannot always achieve this goal, and when we do not (for instance, when more than 25% of funds are allocated to insiders), it is usually based on expectations of long-tail inflation, as a redistribution and growth strategy over time. Additionally, as governance rights gradually transfer to token holders, planned supply allocations can change (ironically, when external investors receive tokens, they quickly behave like internal investors).

Another way to view the relative distribution of capital is to analyze the ratio of amounts allocated to external versus internal. For Placeholder, we currently believe that a feasible situation that can help society move towards a fairer state is for external allocations to be 2-4 times that of internal. Internals represent a much smaller group, thus needing to reserve multiples of allocation possibilities for the open public.

To achieve this goal, insiders can receive 20-33% of the total allocation to facilitate their start and growth. In this configuration, our expectation is to allow founders to receive twice what investors can get: the team is more important than the investors and should be valued as such. Then, the open public ultimately receives 67-80% of the supply (at least twice that of insiders, and at most four times).

Some may argue that there should be no private financing at all, just like Bitcoin. Depending on the project's goals, this may indeed be a viable alternative for some projects and founders (for example, Decred's self-funding plan). We look forward to seeing more experiments in this area and potentially supporting them in secondary markets.

As an entrepreneur, it is important to remember that for your project, you need to decide what you believe is the fairest capital distribution for the network, and then find investors who align with those values. If you prefer a more centralized approach, seek out investors with similar preferences. If you want the world to move towards a more balanced capital distribution, do not hesitate to express this to potential investors. Once the project has passed the initial phase and initial distribution phase, your network mechanism design will feedback into the system, giving you a second chance to shape and accumulate energy and resources.

If there is one thing we can all do, it is to ask every project, "What is the initial allocation model here, and what are the reasons behind this allocation?"