Tokenomics Guide #2: Real yield: How to distribute profits to token holders?
Analyzing buyback-and-burn, buyback-and-distribute and co
In the first article of our ongoing series about tokenomics, we provided a checklist to help you improve your decision-making whether to add a token to your product or not.
We have identified ways in which your token could add value and capture (some) of the value it creates. In this article, we will look at the various mechanisms that exist to distribute part of the captured value back to token holders.
Why share profits with token holders?
In traditional companies, share buybacks and dividend payouts are mostly seen as a way to make your stock more attractive for investors when your business doesn’t expect high growth in the future. The reinvestment of generated cash flows back into the operations is expected to only yield low returns (limited productivity of cash), so little that distributing it to shareholders is seen as a better use for it.
While this is important to keep in mind for crypto builders, crypto projects distinctly differ from legacy companies: They use blockchains to streamline processes and grow faster, which allows more people to participate. Projects are often reliant on a network of contributors, users, partners, etc. This changes the math of “value created by reinvesting” versus “value created by distributing profits”. First, there is no longer a clear line between the two. Distributing profits can be seen as a reinvestment into the community. The more is going to productive members of the community, the closer it is to re-investing. Second, token holders can add a lot more value to crypto projects, for example, organized in a DAO, compared to centralized companies. As a result, we expect profit-sharing to make sense for crypto companies way earlier than it does for traditional companies. Teams have to evaluate the different choices of how they can use profits to add value and select the ones with the highest expected value.
The value add of profit-sharing can include:
Generating attention to stand out amongst the thousands of projects
Creating evangelists that take on important business functions (marketing, business development, product feedback, building complementary products etc.), almost like a second core team
Active governance participation where needed
Protocols would rather loot their treasury by giving out grants to fund low-value initiatives than distribute some of their profits to token holders.
Analyzing profit-sharing mechanisms
There are three main profit-sharing models projects can utilize:
Buyback-and-Burn: Using (part of the) profits to buy the project's native token and sending it to the null address, thereby “burning” it which reduces the token supply.
Buyback-and-Distribute: Using (part of the) profits to buy the project's native token and distribute it to stakeholders, for example, stakers.
Distribute: Using (part of the) profits and directly distributing them to stakeholders, for example, stakers. Usually a non-native token, such as ETH or USDC.
While buyback-and-Burn is similar to a stock buyback, the latter two resemble dividends, but in different denominators (native token vs non-native token). Diving deeper however reveals more fundamental differences between the two.
We can evaluate the (potential) effects of the three distinct profit-sharing mechanisms on different variables, namely tax effect, impact on the token price and value accrual, and equality in the distribution of rewards.
Keep in mind that any form of profit-sharing can lead to a token being seen as an unregistered security. Therefore, make sure to consult a legal advisor.
Tax Effect
Just a quick mention because a) we are no tax experts, and b) there are different tax regimes across the world, but generally, stock buybacks provide more flexibility for shareholders, which can help minimize the tax burden. This factor speaks for a buyback-and-burn model.
For the two mechanisms involving profit distribution, the yield might be seen as a dividend or income from work depending on the tax regime. Token holders have to report these income streams correctly. If they have to realize the profits into fiat for accounting purposes or paying taxes, this would result in selling pressure for the token in the Buyback-and-Distribute regime.
Token Price and Value Accrual
It’s helpful to make a distinction between the (short-term) token price and (long-term) value accrual to separate fundamentals and noise.
Token price
Both systems which are using buybacks make the token price go up = holders are happy!
Their default mode is selling profits to buy more tokens, thereby automatically “compounding” profits for token holders. Both times, token holders increased their share in the project, either because the supply decreased (Buyback-and-Burn”) or because they received more tokens (Buyback-and-Distribute).
The Distribute model’s default mode isn’t impacting the token price. Dividend receivers need to actively buy the native token with their profit shares. Therefore, it’s safe to assume that buyback models will have a bigger impact on the short-term token price than the Distribute model. At worst, even if all recipients sell the native token to lock in their rewards, the price will revert to the level prior to the buyback, the same price the Distribute model will result in (no price impact).
*Assuming no sandwich attack on the buyback or LPs pulling liquidity in the time between buyback and profit lock-in by token holders.
Note: Both buyback models only have a direct impact on token price if they are done on the open market.
Value accrual
Profit-sharing mechanisms only decide how captured value gets distributed. The profit generation takes place somewhere else. Consequently, the distribution doesn’t have a direct effect on the fundamental valuation in itself, but rather the subjective interpretation of it, which can result in deviating behaviors by token holders, and therefore, different outcomes, at least in the short-term.
The price-to-earnings ratio (P/E ratio) is commonly used as an indicator of fundamental value. In the Distribute model, the token price doesn’t change in the default situation. Therefore, all earnings help improve (lower) the P/E ratio, making the business more attractive this way. In both buyback models, earnings are used to increase the token price, making the P/E ratio worse off (higher). However, most crypto investors only look at the token price, meaning it’s often of benefit to pump the token so new buyers pump it even more. That works until it doesn’t.
The overall effect on price and P/E ratio ultimately depends on the market participants. For example, in a market full of P/E ratio enjoyoooors, the Distribute model would result in buy pressure by “value investors”, which results in a higher price, and in turn a higher P/E ratio. On a long enough timeframe, no matter the profit-sharing method, valuation will fluctuate around and then converge towards an equilibrium. What differs is the variance, influenced by the market participants’ mental models. In the crypto market where most people only look at prices, especially in a bull market, reflexivity is high, leading to more variance (stronger boom-and-bust cycles).
In the end, the profit distribution logic doesn’t affect the value captured by a business. It does however determine how stakeholders can capture that value (profit) themselves, as the next section discusses.
Equality and fairness of profit-sharing
Both buyback models have the issue that locking-in profits becomes competitive between stakeholders, resulting in inequality. The first people to sell after a buyback enjoy higher profits than the rest as they get to sell at higher prices (excluding any potential additional demand). That leads to vast discrepancies in the APRs (measured in dollar terms) that individuals earn. Value can even be extracted by non-holders if teams aren’t cautious with their buybacks. MEV bots can sandwich attack buybacks to make the team buy at a higher price and immediately sell to the liquidity pool afterwards to realize a profit, which brings the price down to its previous level. To mitigate this, buybacks can be done at random times, from different addresses, through private relayers, or via OTC deals.
Looking at it from a token distribution perspective, the Buyback-and-Burn model increases every holder’s share equally by decreasing the total supply. The “buyback-and-distribute” model is more flexible and allows for a targeted approach to profit-sharing. For example, profits could only be distributed to stakers, which is usually the case. It’s also possible to use the model to incentivize good behavior, for instance by requiring recipients to be active governance participants. By distributing profits to value-adding stakeholders, the Buyback-and-Distribute model can be seen as more fair, depending on your definition of the term.
Another problem of the Buyback-and-Burn model is that it takes tokens out of circulation, so they can no longer be used to incentivize the community, pay for services, etc.
The Distribute model appears to be the most recommendable.
All recipients receive an equal profit share (if rewards are paid in stablecoins or a highly liquid token like ETH)
Everyone keeps their existing share of the protocol measured as the percentage of the total supply
Distribution can target specific users
Conclusion
The popular Buyback-and-Burn mostly acts as a value signaling tool (some would call it price manipulation), but ultimately seems inferior to the Buyback-and-Distribute, and especially the Distribute model in most cases.
While a Buyback-and-Distribute system adds the flexibility of sharing profits to specific, valuable stakeholders, the Distribute system seems more equal and fairer by not making profit lock-in competitive between stakeholders and not sending short-term price signals to the market via buybacks.
Written by