A utility token is a digital representation of a unit of actual service or a physical good from a company. These tokens are sold or issued by startups to fund their business ventures and convert fiat currencies into cryptocurrencies.
Generally speaking, a utility token is not considered a security, since its functionality in a given blockchain project does not resemble an investment. Instead, investors receive future access to services, products, or privileges. These tokens can be used to purchase products and services from a blockchain company. An example could be when an analytical company issues tokens that users can exchange for its data analytics services.
Tokenomics is the art and science of structuring tokens and the token sale process. Tokenomic models vary from token to token, depending on what kind of business is issuing the tokens and what kind of expectations the tokens’ buyers have.
How tokens are used in startups
There are different models a blockchain project could use tokens to connect three areas of its business:
- services it is offering,
- customers' demand and engagement,
- financing of the project
Fee-based model
Some startups charge a fee in tokens to use their services. This ensures that the tokens are constantly in demand, enabling the company to be financially viable. Filecoin, which is built on top of Ethereum, is one example of a fee-based business model.
Revenue-sharing model
Some startups allow their token holders to receive a share of the company’s revenue. This incentive structure encourages these token holders to promote the tokens to others. Blockchain startup CoreLedger is a good example of a company utilizing a revenue-sharing model.
Proof-of-stake model
Instead of paying money to buy tokens, some companies ask potential investors to stake their existing tokens. If the company decides to recruit the investor, they put their some common cryptocurrency tokens into the company smart contract and are awarded a proportional number of company tokens in return. Once the investor holds these tokens, they periodically receive some of the revenue generated by the company. or Cosmos use a proof-of-stake model.
Issuing tokens to investors
One common use for tokens is when a company raises capital by selling its tokens to investors. When a token is sold to the public for the first time, it’s known as an ICO (initial coin offering).
Some companies decide to use their tokens to solve a problem they’re already addressing. For example, a company that’s building a network for file-sharing might create a new token to use on the network. In other cases, a startup will use an ICO to raise money to build their project. In total, over $13.3 billion has been raised via ICOs. The biggest ICO in history was that of Telegram, which raised $2.7 billion.
ICOs have some big advantages. There’s a global pool of investors looking to invest in blockchain startups, which means the odds of raising money are high. Additionally, tokens released to the public can be traded on various cryptocurrency exchanges after an ICO, thus giving the tokens a level of liquidity that they might not have had if the company was merely trading on a crypto exchange. Early-stage tokens very often use crypto liquidity providers to lower the costs of trading for investors and make the token more attractive to them. There’s also a level of legitimacy that comes with conducting an ICO that doesn’t exist with other fundraising methods. However, there are also significant disadvantages to ICOs; most notably the demanding legal and regulatory requirements.
Raise traditional equity or debt
As the blockchain industry continues to mature, more traditional forms of funding are coming to the sector. Traditional fundraising methods allow companies to raise larger sums of money at a faster pace. There are many potential investors when it comes to traditional equity and debt financings. These range from private wealth managers to pension funds. Companies often begin these processes by speaking with venture capitalists, family and friends, and angel investors. Later stages of the process might involve larger institutions such as insurance companies, hedge funds, mutual funds, and sovereign wealth
Inflation of the token supply
To protect maintaining the value of the token for investors, projects build anti-inflationary mechanisms in smart contracts. For example, a portion of the tokens is destroyed every time a person uses a particular service. This serves as a deflationary mechanism and makes the remaining tokens more valuable. Take Filecoin, for example, which raised $250 million in its initial coin offering (ICO). Every time a user rents out storage space using Filecoin, an equal number of Filecoins are destroyed. This mechanism helps keep the price of the token stable by balancing supply and demand.
There are many ways for blockchain startups to raise money and support its flow through the ecosystem. Each method has its advantages and disadvantages. Eventually, we might see a combination of these methods that best suits a given company.
