Token value accrual mechanics and the trouble with governance tokens
Are governance tokens suitable for investment?
Paul Joe (@0xPeejay, Investment Analyst at Lyrik Ventures) and I co-wrote this article based on our observations from investing in web3 projects. You can read more of his writing at
.Many web3 protocols and projects offer tokens as the main vehicle for investment in them, and many investors buy and hold tokens for this reason. Protocol tokens (e.g. ETH) typically combine both utility and governance, meaning the same token is used as payment for use of the network, while also granting holders the right to vote on changes to the rules and operations of the network. In contrast, some web3 apps (e.g. games like Axie Infinity) today separate their utility token from their governance token. The former is the main token used (i.e. earned or spent) within the app, while the latter separately confers voting rights. In these situations, the governance token is often issued to investors as a means to represent their ownership in the project.
However, tokens that grant voting rights (whether protocol tokens or governance tokens) don’t automatically grant shareholder ownership rights as equity-based securities (which are secured by law) do. While token investors seem to put quite a lot of value on governance/voting rights, in contrast, equity investors typically place low financial value on governance/voting rights granted to equity shareholders.
The assumption held by token investors is that voting rights grant control and control is equivalent to ownership, so governance/voting rights makes owning a token similar to owning a stock. In many cases, due to the absence of regulatory clarity, this is a regulatory workaround to grant ownership in a potentially valuable project while avoiding registration or classification as a security. But in reality, voting rights give the appearance of ownership without granting any real ownership in the project and the real (financial) value generated by it. An investor might own the token, but not the project.
Governance tokens that only grant voting rights with no link to or influence over the distribution of real value don’t translate into financial value for the token, since any future financial value that might arise from a vote on how the protocol works (e.g. voting to distribute revenue from the treasury to token holders) would need to be heavily discounted based on the likelihood of that happening. In most cases, potential voting outcomes can’t be hardcoded into and automated by smart contracts because they weren’t conceived at the time of writing of the smart contract. This means project owners/developers (specifically the signers of the multisig wallet that controls the assets and parameters of a protocol/app) have the final say over compliance with and execution of a voting outcome, and when holders vote, they’re only signalling to the multisig signers what they would like to see happen. The importance of reputation might motivate multisig signers to comply with the vote, but it’s not guaranteed, since the mutisign signers have no legal responsibility to comply. An example of this problem is how Uniswap hasn’t enabled the “fee switch”1, despite their token holders asking for it, because the developers are concerned about how regulators will view it. In the worst case scenario, multisig signers could decide to drain the token treasury for their own benefit, and where tokens are not regulated, legal redress might not be an option.
Does this mean that pure governance tokens that grant only voting rights are useless for investors who are looking for financial return? Ultimately, what matters to investors are the rights to financial returns if the project is successful and grows in value, i.e. a share of that value. This value can come in the form of price appreciation in the asset (token or equity) that the investor holds, or a revenue stream generated by the asset, derived from the revenues of the underlying business (similar to a dividend in equity). Do voting rights granted by a governance token give investors sufficient assurance of future value accrual via revenue share (or other mechanic) to justify investment today? Or do we need to define other yardsticks for value accrual to assess token investments? Should we require commitments from developers regarding future implementation of value accrual mechanics? And what would be reasonable commitments to ask for given regulatory uncertainty? What governance token design patterns are potential red flags?
We suggest that investors look out for credible value accrual mechanics built into the design of the governance token (or any token being considered for investment), such as:
Demand
Value accrual driven by pure demand for the token rather than anything else is possibly the broadest and most reliable driver of token value, provided that demand is based on real token utility instead of speculative demand (expectation that the price will go up). This typically applies to utility or protocol tokens (e.g. ETH), while governance tokens may not have the same kind of demand dynamics, and for apps (like games), governance token demand may be questionable. Some games build utility into the governance token as an asset required for the most valuable in-game upgrades which drives demand, so this makes the governance token function more like an additional utility token in addition to granting voting rights.
Encoding rights to financial value directly into the smart contract
This grants rights to financial value or the ability to influence distribution of financial value through the automatic execution of a smart contract. Legal rights typically require enforcement, but this replaces the need for legal rights to be enforced, because smart contract execution automates enforcement. Examples are CRV, where holders have the right to direct token issuance (right to treasury control), and GMX, where holders can stake the token to get a share of the cash flow/revenue that GMX generates (right to revenue share). In the latter case, a further advantage is that no new GMX tokens are minted to pay out earnings as the revenue generated is distributed in ETH. Note that this may be subject to its own regulatory risk.
Revenue sharing
Rights to treasury control or revenue share makes sense if that treasury control or revenue share is real and hardcoded in a smart contract. But many governance tokens only suggest that there may be treasury control or revenue share opportunity granted in future, without guarantee. If a project is saying that there may be revenue sharing in future, how sceptical should an investor be that this will happen, and how much should an investor discount this as a potential driver of token value (since it might not happen in future) and therefore as a rationale to invest? Here, the GMX approach of encoding this commitment in the smart contract is ideally what we should be looking for. If it isn’t done at the outset, investors may need to assess the project’s intention/commitment to do this later, bearing in mind that as the regulatory landscape changes, this may become easier or harder to do. Either way, it’s worth getting clarity on this when looking at token investments. In reality, very few web3 projects actually share revenue today, and if a protocol is actually useful, it could have meaningful demand drivers, which means it doesn’t need to share revenue to drive value accrual. But some DeFi protocols (like GMX and Curve) and apps (a hugely successful game can hit $1B ARR) can generate large amounts of revenue, and in these cases, revenue sharing is a meaningful driver of value accrual and essential to the success of the token, if credibly executed. In this case, token holders would probably demand revenue sharing and put it to a vote by the community, or else seek some kind of (legal or smart contract-based) commitment to revenue sharing in future, e.g. when revenue reaches a certain threshold. Remember, though, that this may not give investors any assurance if the voting right isn't actually real, i.e. voting doesn’t automatically trigger a revenue sharing process built into the smart contract. But can investors realistically press for or expect commitments given the regulatory uncertainty? If not, then sometimes making an equity (instead of token, or with token warrants) investment in the project may be a sensible option to consider, especially for projects where revenue generation is a key value driver.
Deflationary mechanics
What about buy and burn deflationary mechanics, which some projects use? Is it a reliable driver of token value, if projects periodically buy and burn some amount of the token to ensure deflation, reduce supply and increase price? If revenue generated by the project is being deployed in this way, it provides a link between revenue and token price. But depending on the percentage of revenue used for this, it may function more as a monetary policy and inflation management tool than a mechanic to drive value accrual. In general, we think the jury is still out on how effective this is, as one could argue that a project’s treasury could be put to better (value-creating) use than buying tokens from secondary markets to burn. More often, burning tokens through user activities might make more sense as a deflationary tool.
Token design and engineering is still a relatively new field, and as more token design experiments are done, we’ll learn more about which value accrual mechanics make sense and are sustainable across market cycles, and how effective they are. Right now, revenue sharing protocols like GMX that encode financial rights directly into smart contracts and incentivise holding by sharing protocol fees without minting new tokens are bringing new ideas into the token design space, and it’ll be interesting to see if/how these ideas get adopted beyond DeFi to the app layer in web3 games, social and other non-DeFi spaces.
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Right now, all the fees generated by Uniswap go to the LP providers in pools and none to token holders. Turning on the fee switch will transfer a portion of that fee to the treasury, either to redistribute to holders as revenue share or for other purposes that benefit the community.