Recently we have been working for a company with a promising Digital Token application. The underlying problem they are trying to solve fits really well with a distributed, blockchain-based technology stack. However, as we worked through their long-term financial model we kept coming back to a problem that we realized is going to affect a lot of cryptocurrency projects – how do you build company financials on a digital currency. This problem touches on topics that have a deep in legacy in the history of finance.
The problem is pretty simple to understand. The company wants to avoid raising money through traditional VC channels, largely because at this point that would take a long time (a topic for an upcoming post). Under the current plan they expect to raise a little bit of cash through an Initial Coin Offering (ICO), and this should be enough to get the company started. However, over the long-term they anticipate generating revenue in the form of this digital token they are creating. This then raised the question of how do they pay employees. Employees have real world needs like mortgages, mouths and shoe habits to feed, which require payment in traditional currencies like US dollars.
This problem has two parts. First, the obvious one is how much is their token going to be worth, and secondly, how do they actually go about converting from their token to USD.
The second piece is probably a solvable problem. There are already a number of major, stable cryptocurrency exchanges. The trick is then convincing those exchanges to create a market for this particular token. It turns out that a lot of the planning in ICO world centers around creating a token that is acceptable to these exchanges. We found these discussions particularly interesting, as it implies that the Cryptocurrency ecosystem is maturing rapidly with power already accumulating in a small circle.
This leaves the problem of how to run a company which is generating tokens. Assume that the company can find a reliable way to exchange their tokens for physical or fiat currencies, the recent history of cryptocurrencies show that exchange rates are incredibly volatile. For the major coins like Bitcoin and Ethereum, the levels of volatility appear to be decreasing each year, but it is safe to say that the exchange rate will always be dynamic. Any start-up needs to be able to forecast out its Income Statement for five years, not to predict the future but to understand where the constraints are obligations rest. And this exchange rate problem is a major constraint.
Fortunately, capitalism has had a few millennia to work out solutions to this problem. For all the new shiny-ness of cryptocurrencies, the ecosystem is going to have to turn to ancient financial solutions to solve certain problems. Some of the oldest written documents are essentially ledgers keeping track of this sort of problem – Farmer Enkidu agrees to pay King Gilgamesh six cows in exchange for ten shekels. Typically, these records had a time element to them – payment today for something delivered at some point in the future. Over time these developed into the foreign exchange and options markets that are today the heart of modern finance.
So a likely solution for companies operating in cryptocurrency systems is to enter into some form of Futures contracts. For the company we are working with, there is a natural pool of stakeholders who will be interested in this. In fact, we think this could serve as an important litmus test companies holding ICOs. Can you name ten companies who would be willing to server as a counterparties to multi-year token/cash exchange contracts? If your company cannot think of an obvious, easily accessible list of answers then maybe rethink the need for having a token.
The key trick to these kinds of futures contracts is to think of the proverbial balloon getting squeezed. There is always go to be an element of ‘exchange risk’. In our experience, executive teams really like deterministic solutions – problems that have a clear answer. When dealing with risk equations, these are not available, all problems are probabilistic, with a range of potential outcomes. Often, we have seen companies come up with all sorts of frameworks and and patchwork quilts of solutions to pricing these problems. These are just squeezing the balloon, with the risk moving to the place where your hands aren’t. Instead, identify the risk. Model how it flows through financials. Then pay someone to take the risk. With volatility levels where they are, the amount they will want to hold your token risk will seem high, but at least you will be able to make payroll.
Companies can take some assurance that they are not alone with this problem. Every company that operates in multiple currencies face these problems every day. Our sense is that Tech companies are not particularly adept at dealing with these. For hardware companies, they typically enjoy supply and sales contracts priced in dollars. For Internet and software companies, hedging currency fluctuations is mostly a problem for the revenue projection team. By contrast, airlines, mining companies and many others have to deal with revenues and costs all denominated in multiple, moving currencies. This can create all kinds of unforeseen problems (that balloon shifting around). Successful companies isolate the risk and are savvy at understanding how it flows through their model. Typically, they acknowledge that some part of their financial statements (revenue, profits, hedges, liabilities…) are just going to be volatile, and over time that gets factored into their valuations.
To close, we caution that the worst thing to do is ignore the problem or rely too heavily on Excel models. Much of the financial forecasting we see in tech land is very linear and basic. That approach is almost guaranteed to lead to pain somewhere down the road. Money changers have been active in economies since economies existed, they have been portrayed poorly through history, but they play an important role. And in cryptocurrencies they are going to become very important.
Finally, for those who think they are going to encounter this problem soon it pays to have a CFO or outside consultant who can help with this. Drop us a line if you would like to discuss your specific situation.