We looked at the various factors that influence token systems for a project in Part 1 of the Tokenomics Guide. In this piece let us look at how we can introduce mechanisms to control supply factors and finally how to raise money with tokens with a strong focus on public sales.

Circulating Supply

Let’s start with a short definition of what Circulating Supply is: “Circulating Supply is the total number of coins or tokens that are actively available for trade and are being used in the market and in the general public”

This is a composition of all the unlocked tokens that are free to move from wallet to wallet in the market.

Circulating Supply is a critical factor for any investor, retail or otherwise, to make a decision on whether it is worth investing in the token. Suppose the circulating supply is 1 million today, and the investor sees that there are another 500,000 tokens getting unlocked in the next 3 months. In that case, there is a high chance that the investor will not buy, because a significant spike in supply will cause an inflationary effect on the token and their tokens might be worth much less.

This is why it is essential to engineer the emissions so that there are no significant spikes in supply at any given time.

Controlling the Circulating Supply can be done in a few ways. 

Slowing Emissions

One is to slow down the emissions for each bucket of the token allocation. This method has its own disadvantages. If you slow down the token emissions for your investors, they might not invest in the first place because they are answerable to LPs (if you raise from VCs), and angels generally do not wait for extremely long periods of time to make their money back.

If you slow down the emissions of your community rewards bucket, your community might not grow at a high pace because the rewards per community member will reduce and it’s not in the community members’ best interests to contribute.

Burn Mechanisms

The other method is to “burn” the tokens. What does token “token burning” mean? Token burning is essentially sending tokens to a wallet without a private key called the “burn address”. Since the burn address doesn’t have a private key, the funds are inaccessible to everyone. 

Ethereum has an uncapped token supply (which means the maximum supply is infinity). This essentially meant that every ETH token released would move into circulation at some point in time and finally, the circulating supply would also tend to infinity. To control the Circulating Supply of ETH, they introduced a burn mechanism in EIP-1559 which would burn the base fee of the total network fees. They introduced this mechanism so that it causes a deflationary effect on the total ETH supply after “The Merge” happens. You can track ETH burn with this amazing tracker.

Binance burns its tokens through two different mechanisms. One is a time-based burn where Binance burns a certain number of tokens (which is determined by trading volume on the exchange) every quarter, and the second method is similar to the Ethereum model where a certain portion of the gas fee is burned which is a function of the number of blocks generated on BSC, the price, and a price anchor. You can track BNB’s burn with this tracker.

Burn mechanisms are also used by stablecoin-based protocols to control the price of the token to whatever currency/coin they have been pegged to. This is again to create a supply crunch.

Token burn mechanisms can be created in many different ways. There are no set rules other than the ones the protocol sets internally. 

We have seen:

1. Activity-based burn mechanisms (ETH burning on every transaction)
2. Time-based burn mechanisms (BNBs quarterly burn)

Lock-ups

Another method of reducing the circulating supply is by allowing the market to lock-up tokens for a certain period of time in order to gain a larger incentive. They play with the time preference of investors while controlling the circulating supply in the market. 

The incentives can be designed in many ways. One of the most popular methods is staking, where investors lock up their tokens in exchange for a higher yield or more tokens. This incentivizes via a certain financial gain. The other method is to incentivize via a combination of special governance combined with financial gain. 

Curve DAO on the 16th of August 2020 announced that $CRV holders could now lock up $CRV in exchange for higher gains and higher voting powers in the form of vote-escrowed CRV or veCRV. This was introduced to control the market movements of the $CRV and also to buy the loyalty of holders for a longer period of time. veCRV also starts decreasing over the lock-up period which in turn incentives users to buy and lock up more $CRV tokens for the same amount of voting power. This helped avoid any extreme spikes in the circulating supply of the $CRV token and this is how the circulating supply graph of the CRV token looks from 14th August 2020 to 25th June 2022.

Raising with Tokens

Now that you have your token allocations and mechanism designed, how do you go about raising money with tokens? 

Private Rounds

Investor-Founder fit is extremely important. Angels and VCs must not only bring money to the table but also bring in strategic support to help your project grow. Crafting your cap table is an art in itself. Find marquee VCs that have a thesis on the space that you are building in and see if your project fits into the space, and when it comes to Angels, find one that has had skin in the game specifically in the space/ ecosystem that you are building in. There is no right way to do it because every project has different needs in different levels of importance.

Once you have targeted the right investors, the time has come to raise from them. The most popular mechanism at the time this article was written is raising via SAFTs.

SAFTs

SAFT (Simple Agreement for Future Tokens) is a fork of the popular SAFE (Simple Agreement for Future Equity) notes method popularized by Y-Combinator. It is essentially a promise the project makes that says “I will give you X% of the tokens upon its release”.

The regulation, the legality, and its enforceability are different in different parts of the world, but we will not go down that path in this article.

Here is a sample SAFT agreement that is considered a security according to the Securities and Exchanges Commission in the USA: https://www.sec.gov/Archives/edgar/data/1693656/000110465919039476/a18-15736_1ex1a3hldrsrtsd1.htm

This is not the only format, but this is the accepted format if the project is registered in the USA. It is important to get in touch with credible legal experts who have the process figured out in the country and region the project is registered.

Public Sale

Once your private rounds are closed and you are ready for the public sale of the token. There are many different ways to release your token to the public.

You have the open-ended ICO, a centralized but a high-trust method of an IEO (Initial Exchange Offering), and the decentralized and faster method of an IDO (Initial DEX Offering).

How does one go about choosing the right method of launching a token? Let us now look at the different methods of raising with tokens.

ICOs

ICOs are generally frowned upon since the 2017 ICO boom that led to many projects raising a load of capital and not delivering on the projects. Over 90% of these projects were a scam. Having said this, there have been projects that are doing extremely well that raised money via an ICO (Ex. Filecoin, Polkadot, Tezos, Bancor ). Their success has little to do with the method of raising.

ICOs have the following problems:

1. Price Discovery
   
   Price discovery becomes a problem when the project decides the price of the token, and the market doesn’t agree with the price. Let’s say a project wants to raise $1 Million by selling 1 million tokens at $1 each. At the public sale, the market then decides that the price is too high and settles at $0.70 and the project ends up raising only $700k. This is an oversimplified example because it is definitely not how markets work, but the point that gets highlighted here is that the project deciding the price of the token vs. the market can result in unpredictable fundraising.
   
2. Front running
   
   If your team has managed to garner enough eyeballs on the project and has managed to get the public excited, be wary of an ICO method because you might have interested the people building bots even more. These bots would have bought up a massive allocation and pumped up the price even before the early public can click on the buy button. These bots will later start dumping the tokens in the market thus making a high arbitrage profit within minutes of the public sale going live.
   
3. Low Public Trust
   
   Due to its dark history, ICOs have left a bad taste in the public’s mouth. With many a person investing money into the project and getting nothing out of it at the end of the day, this may not seem the best way to run a public sale in today’s day and age

IEOs

To mitigate the problems of ICOs, IEOs (Initial Exchange Offerings) came into existence. This is where the project submits a whole bunch of details to an exchange, and the project goes through a strong vetting process by the exchange. If passed, the exchange lists it. 

The vetting process is a very strong one because the exchange is solving for two things simultaneously, public trust and potential trading volumes (since they keep an order book system). 

IEOs mitigate the risks generally brought on by the ICO process, but at the end of the day, the project’s public sale is at the helm of the exchange. They are the single point of success or failure for the public sale. Exchanges also charge very high fees for an IEO and many early-stage startups cannot afford this method while raising with tokens

IDOs

Although the IEO method does solve many problems brought on by ICOs, they are centralized and expensive. This is where IDOs became popular methods for early projects raising money through tokens. IDOs also have gone through their own evolution cycle starting with 50:50 liquidity pools, to LBPs, to different auction-based formats.

Method 1: 50:50 Liquidity Pools

In this method of the token launch, one will have to provide a 50:50 ratio of a token:stablecoin/blue-chip token. The 50:50 ratio here is that of the dollar value you want to release your token at. This brings us to the first problem of releasing the token on a 50:50 pool which is, setting the price of the token. In this method, the project must set the token price, which may not match the market sentiment. Setting the price too high will not create any buying pressure, which is the single largest demand movement a project requires in an IDO. Setting a low initial price and allowing market movement may or not reach the target raise amount.

The second problem with 50:50 pools is that the project will be required to seed the pool with the stablecoin or another token on its own. Bootstrapped projects might find it very hard to raise large amounts of money when there is not much initial liquidity available.

The third problem with these pools is excessive frontrunning by whales and arbitrage bots. There have been situations where trading bots have attacked the first block on which the tokens are released and pumped up the price enough and finally dump it on a demanding market. The other problem large frontrunning can cause a huge spike in gas fees in DEXs on POW chains.

Nord Finance launched its IDO on Uniswap with a 50:50 ratio of NORD:ETH on the 21st of January 2021. Nord had allocated 100,000 tokens for the public sale to raise about $90,000 worth of ETH. The IDO went live at 15:04:14 UST, and at that very instant 12 bots purchased about 75,385 tokens and by 15:06:29 UST 52,371 of these tokens were swapped back for ETH on the very same pool by the bots. Although it isn’t possible to see how much each bot made on arbitrage, the earliest transaction bought about 91.2 NORD for 1ETH, and in the latest transaction at 15:06:29 UST a buyer would get about 171.2 NORD for 1 ETH. This essentially meant that there was an arbitrage opportunity of 87% profit all in a matter of 2 minutes and 15 seconds. There was a clear pump and dump from the bots over at the NORD IDO.

Popular locations for launching on 50:50 Pools include Uniswap, Sushi on Ethereum

Method 2: Balancer Liquidity Bootstrapping Pool

To mitigate the price discovery, front-running, and seeding issues brought on by the 50:50 Liquidity Pool method, Balancer launched Liquidity Bootstrapping Pools (LBPs). 

LBPs are time-bound events (usually 72 hours) that use token pairs in any weights (80:20, 95:5, 98:2, etc.) and set the initial price of the token. The token value gradually decreases over time with or without any buying pressure (See Fig.1). The token value goes up only when the upward movement due to volumes swapped exceeds the downward movement of the LBP. This allows the market to decide what it thinks is a fair price for the token. The high fund seeding problem is also solved because the project only has to provide a small amount of money to the pool initially.

The front-running problem is mitigated because the falling price discourages whales from purchasing the token at the launch of the LBP. Even if the whales buy a large chunk in the middle when there is good market movement, there will still be downward price movement post the purchase (See Fig. 2) 

LBPs with consistent buying pressure (ideal scenario) will look something like Fig. 3 below.

Having seen the benefits of LBPs, it does have a disadvantage. Whales can spike up the price towards the end of an LBP and spike up the price thus putting late buyers at a disadvantage (See Fig. 4)

Let us look at an example of Maple Finance’s token (MPL) on a Balancer LBP. The price of MPL fell sharp initially and corrected itself over the course of the next 60 hours.

Let us look at another example of how the price of the token can also increase from the initial set price of the token. This happened when Perpetual Protocol released its token $PERP.

There is no way to predict how an LBP can go, but it sure seems like a much better way to release a token over a 50:50 Liquidity Pool.

Method 3: Uncapped Batch Auction

Uncapped Batch auctions are another interesting way to raise money with tokens. There is no requirement for any seed liquidity. In an Uncapped Batch Auction, a project announces that there are a certain number of tokens allocated for the public sale and open up a pool that accepts deposits. Once the deposit period is over, the tokens are distributed to the wallets in the exact proportion of their share in the deposit pool. This makes it a very capital-efficient way of raising funds.

There is absolutely no risk of being front-run by bots because the price of the token is decided only post the deposit period is complete. The risk of running uncapped batch auctions is that a project may raise too much money at a very high valuation and it may be very tough for a project to maintain or increase the token value after it enters the market.

To mitigate this problem, projects can accept all the deposits and then allow a withdrawal period after announcing the final valuation of the public sale before it goes live. 

This is how Mango Markets ran their public sale where they allocated 5% of their max supply. They divided the auction period into two phases: one where people could deposit or withdraw funds, and the next was a withdraw-only phase. This ensured transparency to the public about the valuation at which Mango Markets was raising and gave them an opportunity to back out if it felt overvalued to them.

Miso on Sushi is a popular location to run Batch Auctions

Method 4: Dutch Auction

The Dutch Auction method combines all the good bits of the methods that are mentioned above. Let’s look at how Dutch auctions work with a small example: A project has allocated 100 tokens for the public sale and has initially set the price at $1000. There may not be buyers at this time and the price slowly starts reducing. When the price hits $500, Buyer 1 puts in a bid to buy 30 tokens. The price then reduces to $400 dollars when Buyer 2 comes in and puts in a bid to buy 45 tokens. The price further reduces to $250 dollars and Buyer 3 then puts in a bid to buy the remaining 25 tokens. The auction then closes and all the buyers (1, 2 & 3) get to purchase the number of tokens they bid for, for $250 each.

With this method there can be no front running with bots, it is capital-efficient, and there is no chance of raising at a very high valuation that the project cannot live up to. The market also gets to decide the price, and it’s also great for the initial higher bidders when they get to purchase the tokens at a value lower than they intended to.

Here are two examples of Dutch Auction token launches best explained by Jason Choi and Sanat Kapur in their article:

“Algorand (ALGO) used a Dutch auction successfully to sell 25 million ALGO tokens to public investors in June 2019, alongside the launch of their mainnet. The initial price was set at $10, and the auction ran for 3 and a half hours before concluding at a clearing price of $2.40. 690 unique addresses participated in the auction, which raised $60mn for the Algorand foundation[5]. In addition, Algorand also provided a put option mechanism for buyers, whereby buyers are granted a right to sell their tokens back to the Algorand foundation at a 10% discount one year after the auction.

The Algorand Dutch auction was successful as the initial price was set high enough ($10 implied a $100bn FDV); however, should the team fail to set a sufficiently high initial price, they risk pushing price discovery to the gas market and re-creating similar first-come-first-serve dynamics previously discussed.

For a real example, we may look to Yield Guild Games (YGG)’s Dutch auction on MISO. The auction had a starting price of $0.50 and was supposed to decline to $0.20 over a 24 hours period. Unlike the Algorand sale, however, the auction was over in two blocks, and only 32 participants were able to participate at the $0.50 price. One participant who committed $258k in USDC set the gas price to 14,000 gwei, paying more than $9,000 in gas fees to have the transaction succeed, effectively front-running buyers that failed to pay higher fees”

Dutch auctions will succeed when the initial price of the token is very high and also good traction during the auction. Investors have to carefully balance between waiting for a better price and getting in before it is all sold out.
Miso on Sushi is a popular location to run Dutch Auctions.

Closing words

There is no one right way to design a token economy for a protocol. There is also no one best way to raise money with tokens. This is a space that is constantly evolving and there will be a lot more learning and execution. It is important for founders to keep in touch with the innovations, strategies, and implementations of various different launch mechanisms when they are planning to run the same for their projects.