Detailed Explanation of the Composition Structure and Key Points of Token Economics

Original: Zach Zukowski

Compiled by: Paul Zhang, The Way of DeFi

In recent times, more and more projects are seeking economic models to guide their initiatives, commonly referred to as "tokenomics." We believe that tokenomics is the most critical part of project design. In this article, we will share our research with WEB3 entrepreneurs. After studying thousands of projects, we have selected several key points to share:

1. The Importance of Incentive Design

Tokenomics is an essential tool for coordinating incentives within a project. The behavior of each participant in the ecosystem is crucial for achieving a virtuous cycle. Equally important are well-designed incentives; only through them can market behavior be realigned. Many poorly designed mechanisms are abused by project participants who sacrifice long-term benefits for short-term gains. Farnam Street Media Inc. published a case study on three pre-cryptocurrency examples, where poor incentive design led to unsatisfactory outcomes.

2. Tokens Can Create Network Effects

Tokens are a powerful tool that can generate incentive effects even with a small number of participants. Before the invention of cryptocurrency, internet companies needed substantial marketing budgets to attract users and create network effects that draw in new users. Today's crypto projects can introduce token incentives to attract users and enhance network effects. A16z partner Chris Dixon has a brilliant tweet explaining this concept:

For example, Snapchat struggles to accumulate active users unless friends are viewing their posts. Similar projects to Snapchat can now use tokens to encourage users to continue creating content and expanding their social circles. Likewise, without drivers, Uber would have very few passengers, and without passengers, there would be very few drivers. Uber-like projects can also use tokens to reward passenger and driver participation or referrals to friends.

3. Ecosystem Incentives

Ecosystem incentives are one of the most creative aspects of token design. Examples of ecosystem incentives include:

• Activity rewards
• Contributor rewards
• Liquidity mining rewards
• Staking rewards
• Partnerships
• Airdrops

The mechanisms for corresponding incentive tokens managed by smart contracts prevent management from over-exploiting resources. In token distribution, this smart contract should always hold the largest share. To ensure the long-term effectiveness of incentives, we recommend that token unlock periods should be 5-10 years.

We suggest that distribution rates should be tied to the project's activity level, such as increasing distribution when trading volume rises and decreasing it when it falls. Our favorite cases are Helium (HNT) and Planetwatch Recycling Bin. Helium ensures that the protocol always has an endless supply of HNT tokens by distributing fees collected this week into linear hotspots for the next few weeks. The Planetwatch Recycling Bin project pools all unmined tokens from everyone, which will be used to increase future participation.

4. Value Distribution

Every project must define the relevant pathways for sharing value with owners. Protocol Owned Treasury (POT) is one of our preferred methods, where all revenue is shared between the project treasury and developers. Governance token holders control the assets in the POT and can unlock them as needed. Therefore, governance tokens often carry a certain trading premium.

Compared to the model of distributing the cake outside the project, we prefer POT. POT allows token holders to enjoy compounded growth benefits while holding their positions. If value distribution is necessary, then each distribution must be manually reinvested to maintain positions from being diluted. Additionally, each distribution typically requires increased accounting work.

We have devised a new value distribution method called Automatic Pre-Allocation Liquidity (APL). This value distribution method was initially brainstormed with Meld Ventures‌'s Michael Cotton‌. APL has already been deployed on Algomint. In this method, tokens are sent to the treasury, paired with another token (ALGO or a stablecoin), and sent to an AMM. This allows the POT to automatically generate returns while increasing the liquidity of the project tokens. The conversion of treasury assets into governance tokens enhances liquidity and eliminates the pressure on POT liquidity from direct redemption requests. Token holders can gain more value by selling their tokens on the AMM. Compared to Olympus DAO, APL does not require external liquidity supply; in fact, the POT has been providing its own liquidity.

Algorand's native Atomic Transfer feature allows it to inject liquidity while completing currency transactions. This eliminates the asynchrony between trading and injecting liquidity for projects.

Another popular model is the buyback and burn model. It allocates revenue to buy back and destroy tokens, resulting in deflation and an increase in unit price. We believe APL is superior to the above model because it utilizes Web3 tools like AMM to convert revenue into a reduction of circulating tokens and an increase in liquidity.

5. Multi-Token Models

For the vast majority of projects, we recommend issuing only one token. Multiple tokens mean there is no longer a clear investment target, which can confuse the market and diminish the project's brand value. Governance tokens should typically serve as utility tokens. However, in certain cases, issuing a dedicated token for specific activities is also necessary.

Governance Token + Stablecoin is a common multi-token model, with applications seen in GARD, Algofi, and xBacked. In these models, governance tokens are used to allocate project ownership to its users, increasing the project's annual percentage yield (APY) while incentivizing governance token holders to stake tokens for additional rewards. This creates a virtuous cycle:

To achieve combinatorial applications with other DeFi projects, Governance Token + Proof of Deposit Token is used by many DeFi protocols, including Folks.Finance, Tinyman, and Humble. In this model, the project provides depositors with newly minted tokens as proof of their deposits, which can be used as collateral in other DeFi applications. Governance tokens allow participants to share in the profits of the governance treasury.

Fixed Supply Governance Token + Variable Supply Burn Token is another multi-token model frequently used in P2E games. We helped Alchemon design its model. Its governance token (AlcheCoin) must be earned by staking Alchemon aNFT, which comes with treasury management rights and a hard cap on issuance. Its other token is the burnable AlcheGold, which is minted during gameplay; AlcheGold can be burned to enhance characters or reduce wait times.

6. Circulating Supply

We have found that the market tends to give a premium to projects that clearly describe their token supply. We recommend creating a webpage that visually represents the supply. Circulating tokens are primarily influenced by two factors: the unlocking schedule for the development team and investors, and ecosystem incentives.

For the vesting schedule, we recommend that the team's cliff (the period before token unlocking) be 1.5 times the length of the investor's cliff, and the team's vesting period be twice that of the investor's vesting schedule. This indicates that the team has confidence in the project's long-term success. The founding team should view their tokens as one of the best investments and have no reason to reduce their positions before investors' unlock. Investors should receive 50% of the tokens before the team's vesting cliff begins.

Once the cliff is reached, we recommend daily vesting instead of monthly or quarterly. A large unlock after a long wait can trigger a prisoner's dilemma‌ as it incentivizes token holders to accelerate sales to secure optimal prices. Daily vesting allows parties to trade to mitigate this risk, preventing panic selling. Algorand's low transaction fees enable stakeholders to sell tokens frequently at a low cost.

7. Governance

Our recommended design system is as follows: in the first year, allow a "founder-led" approach (by issuing "team-aligned" tokens), with the founding team primarily operating in the first two years and transitioning to true community governance in the third year. Typically, the founding team and strategic investors have invested significant time and effort into the project's development and success and are capable of making decisions that maximize long-term benefits for the project.

8. Token Distribution

Most projects primarily study equity structure tables before creating tokens. In the initial stages of a project, it is often unclear what the differences are between equity and the value generated by tokens (usually, the vast majority of value is generated by tokens). When creating tokens, we recommend that stakeholders be allocated tokens rather than going through multiple rounds of fundraising. This keeps stakeholder incentives aligned and prevents potential conflicts.

Since there are no "unissued shares" for the company to freely allocate, token distribution differs from traditional equity structure tables. The amount of tokens and the distribution method are determined when the project is publicly launched. In contrast, traditional companies can continuously issue new shares, although this dilutes the ownership of existing shareholders. The crypto industry standard is to allocate at least 50% of tokens to the community, effectively diluting the ownership that the founding team and investors can retain. For example, if the team has 100% control and allocates 50% of the tokens to the community, the team will ultimately have only 50% control.

Here are our token distribution guidelines:

Tokenomics is a cutting-edge and increasingly important field in the crypto industry; after all, poor tokenomics can ruin a potentially great project. The above shares are merely preliminary suggestions in the design process. Each team must fine-tune these recommendations based on their unique characteristics.