Utility Tokens

These are also called user tokens or app coins. They represent access to a business’s future product or service. ICO startups can raise capital to fund the development of their blockchain projects in exchange for their users’ future access to the service. They are not designed to be a standard investment for a share of the company, and if properly structured are exempt from federal laws governing securities.

Utility tokens can be thought of as digital coupons for services that are in development. An example is Filecoin which raised $257 million by selling tokens that provide users with access to its decentralized cloud storage program. Businesses that offer these utility tokens avoid using the terms “ICO” and use phrases such as “token distribution events” or “token generation events” to ensure that they are not appearing to engage in a securities offering.

Tokens are transferred across the network as payment for service consumption. These tokens appreciate as the network becomes increasingly popular among users, though this is not the primary use case. However if the utility token appreciates a lot, it can result in the product or service becoming too expensive and a resultant fall in demand. This reduces the price, helping demand to pick up again. This endless cycle causes constant variation in the price of tokens.

Expectation of Profit

When investing in a utility token a purchaser does not invest in an instrument that is supposed to yield a return on investment to be provided by the issuer but in a “voucher” of sorts which can be redeemed for goods and services. Any of the purchaser’s expectations concerning returns will relate to the value of the utility token in the context of the secondary market rather than the features of the utility token itself. A utility token may come under regulation targeted at securities if the white paper and advertising material contain statements of substantial profit expectations, since the expected profit does not come from the issuer but from third parties outside the issuer’s area of accountability.

Key drivers of Value

Genuine utility tokens have much larger return multipliers in comparison to security tokens—security tokens have a potential of 5-10 times return, and utility tokens have a potential of 50 -100 times worth of returns over the same period of time. This is because the value of a true utility token is directly tied to the success of the product and its use by customers. Rapid and expansive customer adoption will directly drive an increase in token price. The more customers use the tokenized product, the more real demand there is for the token, as a result, utility token prices can often grow exponentially with customer adoption. Key drivers include:

• If the product or service offering has a real use case with enormous market potential, which addresses critical issues and hinges on a disruptive technology solving implementation and cost issues created by existing products/ solutions plaguing existing alternatives, allowing for market penetration.

• Enormous experience and high expertise of team members, strategic partners, other stakeholders.

• Strategic timing of the public sale can optimize return for investors.

Use Case 1: Cryptyk Inc.

The Cryptyk platform provides data storage, file sharing, document editing, cloud-based solutions for enterprises, governments, organizations, and individual customers. They employ a hybrid decentralized data processing architecture that utilizes Cryptyk utility tokens (CTKs) to power their open-source platform.

Token Management

Efficient management of the supply, demand, and flow of CTKs is critical for scalable profitable growth. Apart from a multi-stakeholder model, involving fiat currency banks, digital currency wallets, private exchanges, cloud storage providers, miners, and developers, an optimal structure of the token sale offering is key to achieving this.

A fixed number of CTKs are created and then released appropriately over time according to the smart contract framework for the sale. The total number of tokens is capped at 750 million on the initial token issue. Investors can purchase up to 33% of this total, another 33.33% are reserved for shareholders who can exchange their equity for tokens over a 2 - 4 year vesting period, remaining 250 are reserved in a pool to be managed by Cryptyk Foundation, a non-profit entity. The Foundation can use these remaining tokens to reward API developers, strategic partners, fund future development or research projects, or pay for operational costs associated with the token sale. This three-pronged framework is to facilitate rapid adoption of Cryptyk products, with the assumption that a simple process of customer adoption will increase CTK demand. The involvement of the Foundation in CTK management is to provide a publicly transparent method of reward regulation, facilitate token scarcity, and financial liquidity, which can be facilitated by ongoing platform development and rapid customer adoption. This will reduce volatility in the short term, and lay the foundation for long-term growth in CTK value.

Economics of Token Valuation

Prices for services are fixed in local fiat. When using the CTK platform, users have the option to either pay in fiat or CTK, if the customer pays in fiat the token management platform automatically converts it into CTK. Having this choice increases demand for tokens, driving their value upward.

Example: Customer purchases $1200 worth of CTK tokens for 12 months services $100 per month. Assuming the customer is pre-purchasing the tokens to avail services from the platform, for the payment to be made on a monthly basis, the CTK token value may have increased during the interim 12 month period. As prices are fixed in USD/Euros this means the monthly price in CTK has decreased in value. Consequently, pre-purchasing tokens reduce costs for customers, and very early stage customers will find themselves paying for services in cents. Thus the more utility a token has, the higher the value that accrues to investors and customers in terms of product and CTK pricing. The Cryptyk Foundation can increase or decrease the rate of release of tokens to customers, developers, and miners while considering factors such as market fluctuations, large price spikes in CTK value as a result of speculative investors, or bad actors. Long-term growth in CTK value will be ultimately driven by the usage of the Cryptyk platform by the CTK community, which includes customers, developers, and investors.

Investor Protection in the context of ICOs

It is rare for ICO investors to gain any residual cash flow rights, as this is only available in 22% of the ICOs which issue security tokens. For the vast majority of ICO, investors will only gain from their token holding if the product developed by the issuer gains momentum in terms of customer adoption. The degree by which the price of a utility token increases with the popularity of the product depends on the issuer not accepting alternative means of payments in the future. Accepting other means of payments decreases the demand for the tokens sold in the ICO and results in a decrease in the value of the token.

Liquidation

Token sale agreements typically state that firms will make a “best-effort” attempt to deliver the promised product, but investors have no additional rights in case of failure or liquidation.

A majority of ICOs hold a presale round for larger investors and insiders, during which participating investors receive substantial discounts. Presale investors can potentially lock in their own profits by selling their allocation in the secondary market immediately after the ICO. This will have a downward pressure on prices and create risk for other investors. To counter this some ICO’s (14%) impose a lockup period on presale investors.

Practical Implications for Issuer

With a capped ICO, the issuer should set a strategic sales cap, which determines the fraction of all tokens sold during the ICO. The cap should be high enough that investors are optimistic about the token’s future, and low enough so that the issuer can save a significant proportion of tokens for the secondary market trading to retain its revenue and profit-sharing rights.

Startups that issue equity tokens as opposed to utility tokens come closer to achieving their funding targets. The increase in value of utility tokens is directly tied to the issuer’s future products, and thus selling more products increases the value of the tokens, independent of their cost. Equity tokens on the other hand allow profit sharing as well as better aligning the incentives between firms and investors leading to better outcomes for both.