Frightened by the high FDV of the project before investing? No need, first consider token dilution effect

Written by: SAM ANDREW

Compilation: Deep Tide TechFlow

Fully diluted market cap, often referred to in the cryptocurrency world as FDMC or fully diluted value (FDV), is a concept that twists the concept of the stock market into cryptocurrencies. The concept aims to capture the dilutive nature of the protocol. However, the way it is currently used is flawed and needs to be updated.

This article explores the fallacy of the "fully diluted market capitalization" concept of cryptocurrencies and proposes an alternative.

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Market capitalization represents the value of a company's equity in the open market. It is equal to the company's share price multiplied by the number of outstanding shares. The rise of technology companies in the 1990s gave rise to stock-based compensation. Companies began paying employees with stock options. Stock compensation has several benefits. It enables the alignment of company and employee incentives. It is a non-cash expense. It enjoys favorable tax treatment.

Until recently, stock-based compensation was not reflected in the company's income statement, nor was it a cash item on the company's cash flow statement. It's an expense that doesn't show up anywhere. But it will eventually be reflected in the number of outstanding shares. As the number of shares increases, EPS decreases, other things being equal.

Investment analysts adjust the phantom stock compensation expense by adjusting the number of outstanding shares. Analysts will add future stock issues to employees to the existing outstanding share count. The sum of the two is called a fully diluted share. Fully diluted shares multiplied by the share price gives the fully diluted market capitalization. Fully diluted shares and market caps are very common in equity investing.

Applied to cryptocurrency

A similar concept of market capitalization applies to cryptocurrencies. The market cap of a protocol is the token price multiplied by the number of tokens in circulation. The number of circulating tokens is basically the same as the number of outstanding shares. However, unlike the number of outstanding shares of a company, the number of outstanding tokens of a protocol often increases significantly.

Companies prefer not to issue stock. Issuing shares is equivalent to selling the company's equity at the current share price. If a company is optimistic about the future, why sell an equity stake at today's price? Doing so would dilute value for existing shareholders.

Protocols often issue additional tokens. Token issuance is part of their "business plan". It all started with Bitcoin. Bitcoin miners ensure that transactions are correctly entered into the Bitcoin blockchain. They are paid in Bitcoin. Therefore, the Bitcoin network needs to continuously issue new Bitcoins to reward the network's miners. Subsequent blockchains followed the same model: native blockchain tokens were issued to reward those who entered transactions accurately.

The token issuance model related to the nature of the blockchain means that there are constantly more tokens in circulation. Cryptocurrency market capitalization does not capture the future number of coins in circulation. Therefore, the concept of fully diluted market capitalization was developed. Fully diluted market cap is the current token price multiplied by the total number of tokens to be issued. For protocols with ever-increasing token counts, it is common to use token supply data ten years out.

Fully diluted market capitalization makes sense to some extent

People are rightly aware that cryptocurrency market capitalization does not fully reflect reality. Different metrics need to be employed to capture the impact of all future tokens that will be issued.

Meanwhile, the protocol's "business plan" is evolving. New token issuances are no longer just about rewarding miners, as was originally the case with Bitcoin. Tokens are also used to grow the network. Token issuance can help guide the network towards its functionality. A network, whether it's Facebook, Uber, Twitter, or a blockchain, doesn't have much utility if it isn't used by a lot of people. But few are interested in becoming early adopters. Issuing tokens to early adopters gives them a financial incentive to use and promote the network until others join and make the network itself useful.

Token issuance also became a form of compensation for the enterprising developers building the protocol and the venture capital funds that backed them. There is nothing wrong with rewarding entrepreneurs, the VC funds that back them, and early adopters. The point is, token offerings get more complicated.

But fully diluting market capitalization also has flaws

The logic of fully diluting market capitalization has many flaws.

1. Mathematical errors

Somehow, the cryptocurrency market believes that if a protocol issues more tokens, then it should be worth more. This is completely wrong. There is no example in business, economics, or cryptocurrency that issuing more of something makes an individual more valuable. It's simple supply and demand. If the supply increases and the demand is not met, the value of the item decreases.

FTT token is a typical example. Its token structure and mechanics are similar to other tokens. Before the FTX crash, the price of FTT was $25. The market cap is $3.5 billion, and the number of tokens in circulation is 140 million. The fully diluted market cap is $8.5 billion and the total circulating supply is 340 million.

So by issuing an additional 200 million tokens, a 2.4x increase, and a 2.4x increase in FTT's market cap... how could this make sense?

For FTT to truly have a fully diluted market cap of $8.5 billion, the additional 200 million tokens issued would have to sell to buyers at the current price of $25. but it is not the truth. The additional 200 million tokens issued were simply given away without any issuance revenue.

The table below illustrates the difference in FTT market cap and token price if 200 million FTT tokens were issued vs. sold. The token offering simply adds 200 million tokens to the existing token supply, resulting in a fully diluted total token volume of 340 million. Token issuance has no effect on the market capitalization of FTT. The projected impact is a 143% increase in the total token supply and a 59% decrease in the price per token. It's simple math. The numerator is constant while the denominator increases. The result is a smaller number.

Alternatively, if the 200 million FTT tokens were sold at the then-current token price of $25, FTT would have earned $5 billion, increasing the market cap to a fully diluted market cap of $8.5 billion. The number of tokens in circulation will increase to 340 million. Both the market capitalization and the number of tokens in circulation have increased by 143%. The end result is no change in price per token.

Stocks work in a similar way. If Apple issues more shares in the form of stock to employees as equity compensation, it doesn't get money. The result is an increase in fully diluted shares outstanding and a lower price per share. If Apple sells shares to the market at current prices, it will receive cash receipts. Its market value will increase by the corresponding amount. The outstanding shares will also increase accordingly. The end result is that the stock price remains unchanged.

Applying the fully diluted market capitalization logic of cryptocurrencies to stocks highlights just how wrong it is. If this logic holds, each company should issue more shares to increase its fully diluted market capitalization. Obviously, that's not going to happen. As a logical corollary of this logic, the fully diluted market capitalization of each company is infinite. There is no cap on the number of shares a company can issue. Therefore, regardless of a company's size, growth potential, profitability, and return on capital, their fully diluted market capitalization should be the same, i.e. infinite. However, this is clearly not the case.

So, what about deflationary agreements?

Most protocols are inflationary, meaning more tokens are issued over time. Some protocols are or will become deflationary, meaning that the number of tokens in circulation will decrease in the future. According to the fully diluted market cap logic of cryptocurrencies, a deflationary protocol will be worth less in the future than it is today.

Something in the future will decrease, yet because of its decrease, its value will decrease. It doesn't make sense. This goes against the basic economic principles of supply and demand.

2. This means the impossible case

The fully diluted market capitalization logic of cryptocurrencies suggests an impossible scenario. If FTT has a fully diluted market cap of $8.5 billion and a market cap of $3.5 billion, the market means that each person who gets an additional 200 million FTT tokens will create $5 per token after receiving the additional tokens value. As explained, there are no proceeds from this 200 million token sale. So the only way to achieve a fully diluted market cap of $8.5 billion is for those who get those 200 million tokens to create $5 billion in value overnight.

But how do they do it?

How does putting more tokens in people's hands increase their market cap? it's out of the question. Most likely, these tokens are simply held in wallets as part of a portfolio. The receiver will do nothing but trade these extra tokens.

3. Unintended Consequences

An unintended consequence of the fully diluted market cap logic of cryptocurrencies is to inflate the value of the protocol. Investors, rightly or wrongly, tend to think that the larger the market value of an asset, the higher its value and the greater its stability. Investors are comfortable with the huge fully diluted market cap valuations of these protocols, but are often unaware of the logical flaws in the fully diluted market cap calculations. In this regard, FTT is the culprit.

When FTT is priced at $50, it has a market cap of $7 billion, or a fully diluted market cap of $17 billion. During that time, however, FTT's average daily transaction volume rarely exceeded a few hundred million dollars.

Huge fully diluted market caps, small market caps and tiny trading volumes are recipe for disaster. During the height of the cryptocurrency market, some coins executed this pattern. This setup makes market manipulation possible. Smaller transaction volumes allow a small number of parties to control transaction volume and thus price. The token price determines the market cap and ultimately the fully diluted market cap. This means tokens that are barely traded or laundered are backing artificially inflated token values, with inflated values being used as collateral for loans. It also masks the actual size of the investment.

Assets with high fully diluted market capitalization and low market capitalization are less common these days. But they still exist. The table below lists the number of agreements that fully dilute the multiple relationship between market capitalization and market capitalization.

4. Token offerings increasingly look like stock-based compensation

The purpose of token issuance has changed a lot since Satoshi Nakamoto wrote the Bitcoin white paper. Issues are used for various purposes other than rewarding network miners and validators.

Token offerings are more and more like equity compensation in the cryptocurrency market. The protocol rewards those involved in building the network by granting them its native tokens, just as companies grant stock options to employees, advisors, and investors for their contributions to building the company.

Token offerings should be considered similar to stock-based compensation. Issuing tokens, like issuing shares, is a cost to the protocol or company. It dilutes the number of tokens or shares in circulation. However, this cost is an investment when done correctly. It pays off. A hard-working employee being awarded stock can create value for the company that exceeds the value of the stock vested. Likewise, network participants can create value for the protocol that exceeds the value of the tokens awarded.

The returns generated from vested shares or tokens will not be known until much later. Until then, a well-thought-out stock or token grant plan is the best guide to what might happen: heavily used token allocations or severe dilution have no value whatsoever.

Not all token distributions are created equal

All future token offerings are included in the fully diluted market cap calculation. But not all token offerings are created equal. Some tokens are distributed to early adopters, some to the founding team, and some to early investors. Some tokens are issued to the protocol's foundation for future use. These include tokens issued to the protocol's reserves and ecological funds. They are tokens that will be used to grow the network. Tokens for future investment in the network should not be included in the number of tokens in circulation.

Tokens for future investment are equivalent to cash on a company's balance sheet. Cash on the balance sheet reduces the total value of the company. The total value of the company is the enterprise value. Enterprise value reflects the value of all assets of a company. Part of enterprise value is the company's equity value. For a listed company, the equity value is its market capitalization. The other part is net debt. Net debt is total debt minus cash. The concept is that a company's total assets are funded by equity and net debt. The table below illustrates how, other things being equal, increasing cash reduces a company's enterprise value.

The value of the token used for investment is equal to the token price multiplied by the number of tokens assigned. This is the money that the protocol must invest. It is equivalent to cash on the balance sheet.

The following table mechanically outlines this logic. The example in the table below outlines a protocol with 500 tokens in circulation. An additional 200 tokens are issued to the reserve. These 200 tokens are earmarked for investing in the network. At a token price of $5, the market cap and fully diluted market cap are $2,500 and $3,500, respectively. The 200 tokens earmarked for investment in the reserve have a value of $1,000. This $1,000 value should reduce the total value of the agreement, just like cash reduces the company's enterprise value.

Tokens for future investment can be considered as unissued shares of the company. As with thinking of it as "cash", the conclusion is the same. Shares that Apple may issue in the future are not included in its fully diluted market capitalization. Apple can sell shares for cash proceeds. The cash can be used to develop Apple products. The future value of these products is ultimately reflected in Apple's market cap. Similarly, a protocol can issue tokens to its treasury for "cash" income to invest in its network. The difference is that for the protocol, "cash" is its native token. It doesn't actually need to sell shares to the market to generate revenue the way Apple does. In this case, the agreement is more like the Federal Reserve, which prints more money to pay for expenses.

The difference is flexibility

The reason why the protocol has so many tokens in circulation from the beginning is because of their very rigid structure. Companies are free to issue and buy back shares, subject to board and ultimately shareholder approval. In contrast, it is much easier for protocols to attempt to issue and burn tokens.

From the beginning, the protocol needs to determine how many total tokens will be issued and when. It's a "everything is nailed down on day one" mentality. Corporations and the Federal Reserve do not operate with such rigor. The number of shares in a company and the number of dollars in circulation will rise and fall based on market dynamics. Protocols are required to disclose a certain amount of tokens as their tokens are used as monetary value to remunerate network participants. If the number of tokens is uncertain, participants fear that the value of the currency they receive will be devalued due to token inflation. The cost of allaying this concern is an inflexible token structure.

Inflated Fully Diluted Market Cap (FDMC)

Some agreements overstate fully diluted market capitalization (FDMC). The amount of tokens used to calculate FDMC includes tokens issued to the protocol treasury for investment. The expanded number of tokens in circulation leads to an inflated FDMC. This further leads to more expensive valuation multiples.

For example, Arbitrum and Optimism exaggerate FDMC. Their FDMC includes the total number of tokens that will eventually be issued. In both cases, however, a large number of tokens were issued to the treasury or equivalent. These tokens are earmarked for investing in the ecosystem. Removing these tokens from total token circulation allows for a more accurate adjusted token supply and thus adjusted market cap.

The table below illustrates the adjustments that should be made to the circulation of Arbitrum and Optimism tokens. The adjusted token supply is 45% below the fully diluted figure.

So what is the correct token supply?

The circulating supply is somewhat correct. It reflects the current number of tokens issued. But it ignores the impact of future token offerings. Fully diluted supply is also somewhat true. It reflects the number of tokens that will eventually be issued. But it failed to adjust the tokens issued to the treasury. The adjusted figure should be based on the fully diluted figure and deducting tokens issued to the treasury.

One thing is for sure, fully diluted market capitalization numbers are misleading. A keen analyst should not inflate a protocol's market capitalization based on future token offerings, but dilute existing valuations through the dilutive impact of future offerings.