TLDR. The big coming wave is Security Tokens, but the backlash against Utility Tokens is overdone. On Monday, Daily Fintech analysed the recent moves by the SEC to provide regulatory certainty to Utility Tokens. This is a big deal. Until now, entrepreneurs faced a regulatory environment where everything was a security, because in that world there was nothing else. Now entrepreneurs can use a Security Token to raise capital and a Utility Token to reduce their Customer Acquisition Cost (CAC).This is a a big deal for entrepreneurs. It is only exciting for investors who have equity in the ventures created by those entrepreneurs. That is how it should be. A Utility Token is a great business building tool; it is not primarily an asset. If you buy a Utility Token, it may appreciate in value, but you buy it in order to use it and any price appreciation is a side benefit.

This post is an update to the chapter on Investing in Utility Tokens in The Blockchain Economy digital book.

This post describes:

• The SEC rules governing Utility Tokens.

• Laws change over time and vary by jurisdiction.

• Four reasons why other jurisdictions will probably follow the SEC rules.

• Utility Tokens can be used to improve CAC/LTV, which is a critical metric driving valuation. 

• Invest in Security Tokens of ventures that offer great Utility Tokens.

• Two ways that a Utility Token is different from a traditional crowdsale.

• The future cryptocurrency landscape will have 4 different types of assets.

The SEC rules governing Utility Tokens

The SEC rules were analysed in Ilias Louis Hatzis’s Daily Fintech post on Monday.  For convenience the key rules (defined in a No Action letter for the Utility Token of a company called TJK) are copied below:

• “Token holders won’t be granted an ownership stake in the company.

• Any funds raised from the token sale will not be used develop the platform or app.

• When the tokens are sold,  they must be usable immediately for their intended functionality.

• Transfers of the TKJ tokens are restricted only to TKJ wallets. External wallets are not allowed.

• TKJ tokens will be priced at 1 USD per token. Each token will essentially function as a pre-paid coupon for TurnKey’s air charter services. If TurnKey wants to buy back the token (coupon), it must do so at a discount (less than 1 USD).

• The token must be marketed in a way that emphasizes its functionality, and not its potential to increase in value, over time.”

Laws change over time and vary by jurisdiction

The Legacy Finance world has Debt and Equity. The Blockchain Economy has Utility and Security Tokens. You can tokenise Debt (just like you can tokenise Equity or any other asset) but that does not change the fundamental characteristic of that asset.

Debt is illegal in Islamic Finance (for more please read this). There are workarounds that dress up debt to look like equity, just like there are workarounds that ICOs used to dress up a security to make it look like a utility token. This perspective is useful when you look at the legality of Security vs Utility tokens ie laws change over time and vary by jurisdiction.

Four reasons why other jurisdictions will probably follow the SEC rules

Yes, the SEC only has jurisdiction over one market – America, but here are the four reasons why other jurisdictions will probably follow the SEC rules:

1. America is still the biggest single market.
2. SEC is known as a tough regulator that is not afraid to take cross border action.
3. SEC has defined some clear rules. So entrepreneurs can plan around these rules.
4. There is no single regulatory market in Asia, which is the growth engine of the 21st century.

There will be minor markets that differentiate by being easier on Utility Tokens, but unless they also offer a large investor pool, that will be “noise on the line”. Europe’s legislation/regulation will be interesting to watch. Unless Europe takes a differentiated position soon, the market will follow the SEC rules.

Utility Tokens can be used to improve CAC/LTV, which is a critical metric driving valuation 

CAC/LTV = Customer Acquisition Cost/Life Time Value.

You can use this to evaluate the value of both Banks and Fintechs, as we described in this post from 2015. In fact just about any company can be evaluated using CAC/LTV.

Both CAC and LTV are complex in their own right, but it is the interaction between the two that is so often confusing or difficult.

Customer Acquisition Cost (CAC) is the metric to evaluate Marketing efficiency.

Churn is the kryptonite of Superman Marketing. The problem with Churn it is not directly under the control of Marketing. This is where Product is key. Another way of saying Churn is “if customers think the product sucks, all that expensive Marketing is wasted”. Churn means customers cancel the service and then Marketing have to win new customers, which is far more expensive than retaining them.

Life Time Value is not static. LTV is all about getting the balance right between cross selling, upselling and low churn – too much selling to customers may increase churn. If LTV goes down, you have to reduce CAC. Product strategy, pricing, marketing, customer service all have to be in alignment.

The story of Banking in the 20th century can be summed up as Low Churn. We are statistically more likely to get divorced than change banks. There was no point in changing Banks, because the difference between banks was marginal. The Fintech disruption changes that. Now customers have more real choice and regulation is seeking to protect consumers from lock-in strategies that make it hard for them to switch.

Crowdsales are a great way for companies to sell a service aka reduce CAC. It is Internet Marketing 101. Crowdsales have been around for a while, but Utility Tokens enable Crowdsales on steroids.

Two ways that a Utility Token is different from a traditional crowdsale.

• The buyer has the comfort that if they no longer want to use the service they can sell their Utility Tokens. If everybody wants to sell their Utility Tokens because their service is no good, token holders will lose. If the service is great but the token holder’s  life situation changes they can sell their Utility Tokens.

 

• The buyer feels more committed to the success of the venture. Some of that commitment is psychological and some of it is quite practical. A Utility Token is like a Loyalty Coin (more than it is like a Security) but it is a Loyalty Coin with some fungibility (you can sell it for cash if the venture/service is a success and demand exceeds supply).

Invest in Security Tokens of ventures that offer great Utility Tokens.

If a venture offers a Utility Token that is successful in the market, that venture is likely to have good CAC/LTV metrics which eventually translates into equity value held in Security Tokens. I say “eventually” because market mismatching can last a long time ie price does not always equal value or vice versa.

The future cryptocurrency landscape will have 4 different types of assets

An Altcoin Pump & Dump is about cornering a very small market. Cornering a big market – like say Gold or Bitcoin – requires a lot of capital. You can corner an Altcoin quite cheaply and then pump & dump your way to fortune. If you are trading Altcoins and not pumping & dumping, then you are the sucker at the table. This is Penny Stocks 2.0 – watch Wolf of Wall Street for an entertaining guide to this sort of market.

So there is good reason why the SEC clamped down hard. Most Altcoins should be regulated into the dust. 

The fact that Bitcoin & Ethereum got a get out of jail free card from the SEC, puts them in much stronger position versus their challengers. The future cryptocurrency landscape will have 4 different types of assets:

• Decentralised, permissionless cryptocurrencies with market traction and a free pass from regulators – Bitcoin & Ethereum today. 

• Challengers to above (maybe there is a pony in there).

• A large number of early stage ventures listing as Security Tokens where the standard rules of early stage ventures apply (market, product, team, funding, timing, valuation etc).

• Utility Tokens issued by those early stage ventures that have little value other than to users of that service. There are likely to a very large number of these. 

Bernard Lunn is a Fintech deal-maker, investor, entrepreneur and advisor. He is CEO of Daily Fintech and author of The Blockchain Economy.

I have no positions or commercial relationships with the companies or people mentioned. I am not receiving compensation for this post.

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