IOSG: How to Price Fair Value FDV of Projects in Irrational Markets

Author: Nelson, IOSG Ventures

Introduction

The recent popularity of "The Blossoms" has revealed the secrets of the capital market to the audience, especially in the final scene where different characters influence stock prices and their own profits and losses by buying and selling stocks, thereby changing market liquidity. These plotlines not only unveil the complexities of the stock market but also reflect the various risks faced by investors in the market.

In the traditional financial world, misestimating market capitalization is quite common, especially during the internet bubble period when liquid stocks were relatively limited, leading to many companies being overvalued without actual assets and profitability to support such valuations, resulting in market instability and eventual collapse.

Similar situations exist in the current cryptocurrency space. Due to the emerging and immature nature of the crypto market, coupled with inadequate regulation, the market is more susceptible to price manipulation and speculative behavior. In this environment, understanding the true value of assets is crucial.

Overview

For newcomers, terms like Circulating Supply, Total Supply, Maximum Supply, and Market Capitalization in the secondary market of cryptocurrencies are often their first encounter. These concepts are essential for understanding the dynamics of crypto assets. Circulating Supply refers to the amount of currency currently in the public domain and available for trading. Total Supply further develops this concept by including all minted currency, minus the currency that is no longer available. Maximum Supply represents the absolute limit of currency that will ever exist, serving as a key indicator of potential scarcity. Market Capitalization is typically calculated by multiplying the current price of a currency by its Circulating Supply, providing information about its market value.

These metrics are highly informative numbers; they are fundamental tools for assessing the health and potential of cryptocurrencies. When exploring the tokenomics of a protocol, we often encounter detailed currency allocations, but translating this information into actionable insights for different types of currencies can be challenging. Here, the concept of Fully Diluted Value becomes relevant. It estimates a project's market capitalization by assuming its token supply is fully circulating, thus providing a broader perspective on long-term market potential. However, using today's prices to calculate future Fully Diluted Value is problematic, often providing limited information as it overlooks potential changes in market dynamics over time. How do we effectively calculate different categories of currency and decide whether to include them in our calculations?

To clarify this issue, Optimism and Arbitrum may serve as a good case study. When calculating the market capitalization of Optimism, we find that its description of different token uses is quite complex. This article aims to sort through these categories and provide suggested handling methods for each. We need an objective approach to measure the current market valuation assigned to a specific project, regardless of whether the token has inflationary or deflationary dynamics in the future. We want to answer some simple questions, such as how we should determine a project's market capitalization and which project is currently more popular in the market, Arbitrum or Optimism, based on valuation methods?

The discussion will unfold as follows, first analyzing the various types of currencies that should be considered in our valuation calculations. This will include an examination of their respective functions, handling methods, and the principles behind these choices. Subsequently, we will map these currency types to the specific categories outlined in the tokenomics of Optimism and Arbitrum.

Token Types

Before clarifying how to handle each category, let’s reach a consensus on what the Circulating Supply, Total Supply, and Maximum Supply of Optimism are.

According to the definition of Optimism and the records of Optimism, the long-term Maximum Supply of OP tokens is expected to be around 4.3 billion. Optimism defines Circulating Supply as the number of OP tokens that are freely circulating without any transfer restrictions. Total Supply not only includes these circulating tokens but also tokens managed under specific allocation plans. Currently, the Circulating Supply is 911 million, while the Total Supply, including tokens under allocation control, is around 2.2 billion. This is illustrated as follows:

When calculating market capitalization, people typically only consider Circulating Supply. However, this is not a comprehensive measure. Let’s break this chart into three parts and discuss how they should be handled.

Type 1:

Currency in circulation on the blockchain

• Definition: These are currencies that are actively traded within the blockchain ecosystem.
• Included in market capitalization calculation: Yes
• Reason: These currencies have active market value and are an essential part of the blockchain economy.

Non-circulating currency:

Distinguishing different types of non-liquid currency: Although these currencies are currently not in circulation, they are reserved for specific roles and have the potential to affect the future value of the blockchain. Therefore, when considering whether to include them in our Circulating Supply calculation, it is crucial to examine the conditions under which these currencies will be allocated and assess their potential impact on the ecosystem. More specifically, a key question to consider is whether the circulation of these currencies is used to reward community contributions that benefit the ecosystem or if they are allocated because they provide funding for the project. For instance, for locked shares of investors, this situation can be likened to the real world: when a company goes public, founders have a lock-up period, but when calculating non-circulating shares, we still consider this portion, even though it may not align with market liquidity.

Type 2:

Allocated but "locked" currency

• Definition: Typically, the portion of Total Supply not included in Circulating Supply is mainly held by core contributors and investors, referred to as "sugar xaddies" by Optimism. Tokens allocated to contributors and investors are currently locked but will be unlocked and tradable in the future according to the planned schedule.
• Included in market capitalization calculation: Yes
• Reason: These tokens have already been allocated, and regardless of whether the project improves or deteriorates in the future, they will eventually be tradable.

Type 3:

Unallocated currency

• Definition: Typically, the portion of Total Supply not included in Circulating Supply is mainly held by the Optimism Foundation. They reserve this portion of tokens for future allocation to developers, contributors, and other key stakeholders to reward their contributions to the project.
• Included in market capitalization calculation: No, until they are allocated
• Reason: These tokens are primarily held by the Optimism Foundation for future investment, and if no value is generated in the future, they will not be allocated.

More specific examples:

The previous discussion may have been somewhat obscure, so in the following sections, we want to discuss different scenarios. These cases may not occur in the case of OP.

• 1. Paying employee salaries: This type of use should be accounted for after it occurs. Compared to locked tokens for contributors, this situation is more autonomous, and we do not know what will happen in the future.
• 2. Selling tokens to the market in exchange for USDC: This type of transaction should also be recorded after it occurs. But we must remember that this will also inflate the asset side of the balance sheet (just like selling treasury stock in the stock market). This is an act of value exchange rather than value creation.
• 3. Allocating tokens to ecosystem projects: This is an investment in the future of the ecosystem, typically autonomous and well-considered. Therefore, once a certain allocation is granted, it should be included in the market capitalization calculation.
• 4. Airdropping tokens to users: This is an investment in its users, either to gain their loyalty or to market its protocol, and once it occurs, it should be included.
• 5. Burning tokens: These should be deducted from the calculation as they will not be active in the future.

Mapping to Specific Categories of Optimism

Click this webpage (https://cryptorank.io/price/optimism/vesting) to see how Optimism allocates its tokens and the methods of allocation.

Airdrop - Type 1

• Included in market capitalization calculation: Yes
• Reason: Airdrops are similar to "loyalty/marketing expenses" and can be freely traded once granted. Participants can freely trade these tokens; they should be considered Type 1, and we need to include all tokens in this category. Before allocation, these tokens are held by the Optimism Foundation (Type 3). There has been much discussion around the conditions of allocation in the forum (https://gov.optimism.io/t/treasury-appropriation-proposal-foundation-year-2-budget/5979/6). An important metric is the return on investment (ROI).

Ecosystem Fund - Type 3

• Included in market capitalization calculation: Not included, until allocation
• Reason: This category has four different subcategories: governance fund, partner fund, seed fund, and unallocated fund. Based on information provided by cryptorank, we can conclude that partner, seed, and unallocated funds are not tracked and therefore are not counted as circulating tokens. A portion of the governance fund is considered circulating tokens. This is the correct decision. These tokens are used for future investment and growth plans. They should be included after any allocation is announced.

RetroPGF - Type 3

• Included in market capitalization calculation: Not included, until allocation
• Reason: RetroPGF tokens represent payments for past contributions and should be included in the valuation calculation after any allocation is announced. However, this inclusion should be limited to the amount that has already been allocated. Because allocations through this channel are subject to periodic voting based on people's contributions, similar to how a company outsources projects to other external entities. This approach ensures that contributions are properly recognized and rewarded, aligning incentives with the growth and success of the community. Moreover, this type of fund is sure to have the highest return on investment (ROI) for the ecosystem, as it is more like compensation for outstanding achievements rather than purchasing future commitments.
• Nature and allocation of RetroPGF: RetroPGF, conceived by Vitalik Buterin, operates on the principle of rewarding past contributions rather than anticipated ones. Managed by a DAO (Decentralized Autonomous Organization), it retroactively funds projects that are valuable to the community. The distribution of these funds is managed by the DAO, referred to as "result oracles," which allocate rewards based on past performance and impact.

Core Contributors - Type 2

• Included in market capitalization calculation: Yes
• Reason: These tokens represent the original issued shares of the entity and are crucial to its foundation. They belong to Type 2 and should be fully included in the valuation. Although they have a "lock-up" period, they can be viewed as an IPO lock-up period that restricts core members from selling shares for a certain period. This does not affect their holdings, regardless of what events occur in the future. These stock grants are rewards for their past actions and contributions to building the ecosystem. Even if they stop actively participating, their holdings will continue to increase as planned.

Sugar Xaddies - Type 2

• Included in market capitalization calculation: Yes
• Reason: Similar to core contributors, these tokens are crucial for the entity and should be considered Type 2, thus fully included in the valuation.

Mapping to Specific Categories of Arbitrum

Click this webpage (https://arbitrum.foundation/) to see how Arbitrum allocates its tokens and the methods of allocation.

DAO Treasury - Type 3

• Included in market capitalization calculation: Not included, until allocation
• Reason: Arbitrum describes it as "for the ongoing development and maintenance of the organization and its technology." Therefore, the allocation of these tokens should be viewed as a one-time cost or investment. These tokens are not circulating and do not generate value before any deployment.

Team and Advisors - Type 2

• Included in market capitalization calculation: Yes
• Reason: Same as Optimism

Investors - Type 2

• Included in market capitalization calculation: Yes
• Reason: Same as Optimism

Airdrop - Type 1

• Included in market capitalization calculation: Yes
• Reason: Same as Optimism

DAOs in the Arbitrum Ecosystem - Type 1

• Included in market capitalization calculation: Yes
• Reason: These tokens have already been allocated to different DAOs, which will have independent choices on how to distribute these tokens. Therefore, we can view these tokens as a two-step airdrop (from Arbitrum to DAO, then from DAO to users). Thus, Arbitrum has no control over these tokens.

Here is a summary of the above content:

Table 1: Token Types Classified by Function

Table 2: Matching Optimism Tokenomics with Different Types

Table 3: Matching Arbitrum Tokenomics with Different Types

Table 4: Basic Comparison of Optimism and Arbitrum on January 14, 2024 (Data provided by GrowThePie)

Conclusion

New cryptocurrency projects often face the challenge of low circulating supply. Market capitalization calculations primarily focus on circulating supply, often overlooking tokens designated for future use. This can lead to inaccurate market capitalization data and raise issues such as potential supply manipulation, complicating the accurate assessment of project valuations. When secondary market traders focus on circulating market capitalization, they may overlook the large allocations of tokens reserved for the future, making matters even more complex.

To address these challenges, the goal is to establish a method for assessing a project's current market valuation without considering its future dynamics. This aims to provide clear answers, such as comparing the market capitalizations of projects like Arbitrum and Optimism.

In tackling this issue, it is crucial to define the principles that guide market capitalization calculations. These principles should align with the value that each token can generate. For example, tokens allocated for employees, VCs, and airdrops should be included in the market capitalization calculation, regardless of their lock-up status, as they have specific uses. Conversely, tokens reserved for undefined future uses should not be considered future supply until their intended uses become apparent.

Applying these principles will yield general rules for token classification. Tokens with clear uses and allocations, for VCs, communities, employees, or developers, should be included in market capitalization. However, discounts may be applied to account for long-term release schedules. Conversely, tokens lacking specific allocations should not be considered until their intended uses become clear. For example, ecosystem funds and reserves are among those examples.