The Adjusted Market Cap and the Time Value of Dilution

A simple framework for reconciling FDV, circulating market cap, and the introduction of discounted dilution in tokenomics

Quick definitions:

• Circulating market cap(CMC onwards): Current circulating # of assets * price of asset
• Fully diluted market cap(FDV): Total # of issued assets * price of asset

What’s going on/intro

For anyone trying to value tokens within decentralized finance, simple valuation methods can become not so simple when trying to reconcile the market cap vs the FDV. When looking at fee/usage/earning multiples, what protocol valuation are you supposed to use? In almost all cases, neither number represents what you should be looking at, and it’s concerning to me the amount of times I’ve seen people claim one is correct, when in reality, the likely answer is somewhere in the middle of the two. The goal of this article is to provide a framework for adjusting the FDV, and introducing the concept of discounted dilution.

In traditional finance, the fully diluted shares outstanding is the consensus way of measuring the equity value of a company as all shares issued are essentially dilutive with employee vested stock being the least dilutive form of stock(although just marginally). Protocols and tokens don’t operate quite like companies and shares, they are often more nuanced requiring deeper analysis to determine what tokens are non-dilutive(somewhat productive), and which ones aren’t. In doing this investors and other stakeholders may gain a better understanding of protocol valuation currently.

Why neither CMC and FDV alone don’t tell the whole story

In short, the CMC assumes that future token unlocks are not priced into the current price of an asset. If XYZ protocol’s token is intrinsically worth $1B, has a 1B total token supply, and 50% of the supply unlocks tomorrow for VCs, the current price today shouldn’t be $1B / 500M = $2. The price should reflect the public information that all the tokens will be circulating tomorrow and be priced at $1 today.

The FDV on the other hand assumes two things, 1) all future unlocked tokens are 100% dilutive and in the hands of market participants, and 2) the unlocks are occurring at time zero(let’s say tomorrow for example). On the first point, while parts of tokens can be vested on behalf of VCs who are guaranteed to sell for example, some unlocks like treasury tokens will not necessarily ever hit the market, hence are not as dilutive. This means that for valuation sake, a token unlocking for a VC in the future isn’t the same as a token destined for the protocol treasury in the sense that known unlocks for VCs will already be priced into the current price 100%, while unlocks for a treasury may factor in a fractional amount respectively.

A Framework

Discounting Token Unlock Distributions

A list of common distribution entities in token launches are listed below along with proposed token supply discounts in order to have an “adjusted supply” with dilution in mind. A 100% discount in this context would mean the unlock would essentially be burned for example’s sake, and 0% would mean these tokens are guaranteed to be in the hands of market participants. The % ranges are up for debate and can range from protocol to protocol, but nonetheless my ballpark estimates.

· Investors/VCs — 0–5% Discount

Early investors and VCs are almost guaranteed to be in the market for cashing in positions when possible, particularly coming off a tough 2-year bearish market where they’re looking to be returning capital to LP’s. In the rare case an investor is personally drawn into the mission of a given protocol, there is a scenario where a marginal supply discount could be argued for, but this is rare and not material.

· Public funds/Grant pools/Treasury/Foundations — 30–60% Discount

These pools are set up to be furthering the mission of the protocol, meaning that these tokens start to look more like cash on a balance sheet. This makes this harder to estimate a correct supply discount as it’s debatable how effective these pools are. You would hope that a protocol would be able to allocate a grant for example, and in return generate protocol value worth more than the grant amount, but in reality I’m often skeptical of how efficient grants are. The % discount here is up for debate and depends on foundations vs treasury allocations etc — I’d love to hear reader’s input. If one figures the allocations will end up in market participants hands/not be used efficiently the number should be closer to the lower end of the range and vice vera.

· Future liquidity mining/Airdrops — 0% Discount

It should be clear that these allocated tokens are going to active market participants acting in their best interests.

· Team — 20–40% Discount

Those with active roles within the protocol are less likely to be active market participants with their tokens, but in many cases these tokens are the first paycheck the developers might be getting, especially for those not taking in significant outside investment.

· Advisors/ Contributors — 10% Discount

Same as the team except with less personal commitment and involvement with the protocol.

Below is an example with these discount rates by entity showing how one could reconcile the CMC being at $50M, and the FDV at $100M. The Adjusted FDV shows $87M as an example valuation.

The Dilution Discount

Discounting future dilution is an idea that I’ve been playing with in my mind recently and I still haven’t quite figured it out on my own yet. What I do know is that dilution tomorrow is not the same as dilution 20 years from now. As an extreme example, say 90% of your supply entirely unlocks tomorrow vs 20 years from now — instinctively the price of the asset today will not be the same.

This concept is more pronounced within DeFi as most protocols often have both significant and entirely known token issuance. Within traditional companies, locked/vested shares are usually not large portions of the total shares of publicly traded companies, and the perpetual unlock of shares is not entirely known. Within protocols, it’s not uncommon for circulating tokens to only make up 20–80% of the supply which is difficult to reconcile. Often all token issuance is also completely transparent and known indefinitely which is a unique concept to traditional finance.

I have not come up with a framework for estimating a discount rate for dilution as it’s a difficult concept to quantify. If any readers have any ideas I’d love to hear it. While this is not a fully formed method yet, this idea is not something I’ve seen talked about before and do think it is a more novel and unique idea.

Here is a continued visual example from the last table. This time the example shows a simple 5-year linear token unlock, with the same supply discounts for given distributes, and three different dilution discounts from 10–30%.

I think this methodology is extremely valuable for anyone struggling with the concept of dealing with the binary market caps, and hopefully the idea of a dilution discount gets people thinking about the topic. In this example, I showed how I came up with a $72.5M protocol valuation with the CMC at $50M, and the FDV at $100M: (1M circulating shares + 449K adj tokens with 20% dilution discount) * $50 a token.

Please reach out on twitter with any thoughts/questions @altograyson.