How web3 tokenomics and rewards work over time - and why they can make or break a project

Blockchain is a transformative technology and web3 is a once-in-a-generation opportunity to create a world that re-empowers users. Over the last weeks and months, however, we've seen too many projects rely on questionable business fundamentals. Especially in the way they set up their tokenomics models.

This is scary, people will lose money if they don't know how to understand tokenomics! In this article, we want to explain how tokenomics work, why they are important and what to look for to make better decisions.

Bad tokenomics means projects will fail

// Before we go into the details of how projects get away with bad tokenomics and bad business models, we want to do a brief intro into what tokenomics are. If you know about this, feel free to jump over this part!

Tokenomics are without a doubt the most important, but also most often overlooked aspect when trying to understand if a project will become successful in the long term.

💡 Tokens + Economics = Tokenomics

What is it that makes a coin or token valuable? More often than not, that discrepancy between coins is caused by its tokenomics. Tokenomics are the equivalent of the business model for the crypto project.

Tokenomics can make or break a project, even if it has a great team, groundbreaking technology and an engaged community.

Think of it as a micro economy

Each crypto project has its own micro-economy with the goal to become self-sustaining. Rules like inflation rate, allocation and rewards are set by the code or smart contracts which govern the protocol.

Wrong tokenomics can therefore render the project useless: the rewards might be not attractive enough to ensure participation in the network, or the scarcity could be too high so that the prices go up too high for the network to be attractive for general users (e.g. high gas fees of Ethereum).

The simplest way to think about it is to understand supply and demand!

💡 If demand is higher than supply over time, the price will go up!

Supply Side

On the supply side, we look at the token allocation of the project and how they are being distributed. Allocation and distribution are transparent and block explorers can be used to get facts! Inflation and vesting are (should!) also be public and accessible, which means the required information should be on the project’s website or whitepaper (if not, that's a RED flag).

Allocation & Distribution

Most new crypto projects have only a small percentage circulating and available for the public to buy on exchanges. The remaining ones are locked up or remain unmined and will be distributed according to the pre-defined vesting and inflation rules over time. The more centralised the token distribution is, the more risk exists for individuals to manipulate the market.

Inflation & Vesting

Tokenomics also include vesting schedules which define who gets which amount when. Through vesting, tokens can be guaranteed to someone but to receive them, they must remain part of the project - it's an incentivation mechanism. For example, the founders are normally given ~10% of the token supply, but vesting happens over 4-10 years. Which means they have no access to most of their tokens for some time. The same counts for advisors and investors, whose tokens normally vest over 4-5 years.

This is a critical thing that is often overlooked: If the vesting period is short, or not well balanced, there might be supply shocks if suddenly a huge percentage of tokens is unlocked for an individual. At any moment they could cash out, cripple the market, but they don't need to care anymore because they are now unbelievably rich.

And despite being transparent and regulated by smart contracts, most people who invest in projects by buying a few of their tokens don't look at these elements. The great return of >1,000% is just too good looking.

Demand Side

The supply side is only half the story though. It is also critical that there is sufficient demand for the project, today and in the future. This is where your critical thinking and reasoning skills are most required and which is the reason why there are no “guaranteed successful investments”.

Use Cases

First and foremost, the project needs to solve a real problem. That's how sustainable value is generated! And it needs to be a problem that people are willing to pay for to get solved.

Examples of use cases are with good underlying problems are

• storing value (BTC)

• Paying for gas fees (e.g. ETH)

• Moving tokens around to use Dapps

• Contributing to governance

• Getting discounts

• Staking

Did you notice how staking is the last item? That is intentional. The use cases have to be beyond staking and making interests in holding coins, otherwise, the project will fail once the money printing stops, as seen in the utility chart below.

Good use cases are the only thing that can overcome the supply shocks from vesting schedules and inflation!

Investor types

There are two types of investors: professional ones and "retail" investors (i.e. everyone who is not an expert/professional investor). Projects backed by institutional investors tend to be less... crazy. Those investors make rational decisions and are less driven by the herd, whereas retail investors trade very emotionally.

The type of investors can be an indication of volatility and project success, especially in the latter stages of projects where most of the "money printing" has happened already. For earlier stages, this is an irrelevant factor as rational investors would invest if they can profit from the rewards structure, even if there is zero chance for long term success!

How tokenomics work in one chart

In the beginning, founders talk about their vision and a better future. About how their product/project will transform/disrupt/revolutionise this or that. We know that from startups and anyone who's heard a founder pitch their startup to investors knows what we are talking about. The thing is: there is A LOT of uncertainty whether or not they will be able to achieve their goals and build a good, sustainable business with valuable offerings.

To start, an MVP is built, first customers are attracted, product utility is low but the team iterates quickly to respond to customer feedback, adjust to market trends and solve real problems. They search for product-market fit and then scale up. This is how every (well, maybe there are outliers) successful tech company became successful. And for every very successful company, there are at least 100 that fail. And for every billion-dollar company, thousands of companies will never get there.

Enter: tokenomics. Through tokenomics, founders don't need to convince sophisticated investors to give them money to build an MVP. They can build rewards structures that handsomely reward early adopters. How: by giving them more of their tokens. The earlier a participant gets in, the higher the rewards.

The "beauty" (read: RISK) of that is that it can work completely detached from product utility. The worst product will be adopted and thrive by using a few tactics and a playbook which we'll describe in the next chapter. Rewards are paid in the projects own tokens, which cost them NOTHING to produce. And as long as the value of the token doesn't crash, the party continues.

This means the most important thing for the founders can easily become to keep the price up, not to build a great product. Selling the vision and combining it with juicy staking rewards paid in free tokens is much easier than building a successful business!

The key question for long-term success, therefore, becomes: Will the product be good enough to be self-sustainable (i.e. the revenue - yes, revenue is required!! is larger than the cost) once the money printing has stopped. If yes, it will be a good business and remain a good investment. However, this will rely on many factors, first and foremost whether the team has startup and industry experience in the field and understand the iterative product development process. (among others like great UX, awesome support, sustainable pricing, marketing and sales and a good portion of luck...)

Most web3 projects are young and have just started their vesting schedules. A lot of locked up tokens are still reserved for their "community", i.e. users. Or in other words, most are not good enough to survive without handing out presents yet. This doesn't mean they will fail, it just means one cannot be certain about future success and understanding their tokenomics is of utmost importance for any investor.

And because tokenomics are complex models, project teams can mask the issues for a long time. Way past the point that they and their early investors became rich, and retail investors carry the weight and will be hit if things go south. But how do they do that?

Unsustainable projects use common marketing tactics that work

As we mentioned above, Web3 projects require a large community to be successful because to sustain a token price through inflationary times, a project needs to rapidly grow its supporters, champions and network. Twitter followers and Discord members are the lifeblood of many initiatives.

Simply put: Community growth is needed to generate demand, which is then carefully matched with limited, controlled supply to increase prices, fully transparent through their “tokenomics” model. (Just too complicated for many to understand if they care at all. We will explain soon why they might not even want to care..)

Most new projects use a "whitelisting" process. Whitelist access (WL) allows people to buy into the project earlier than the general public at a fixed, low price. The whole idea is that demand is higher than the supply and whitelisted people get a sweet, sweet deal, much cheaper than the expected "market price" at the public sale. Makes sense, once many more people can buy something, the price is poised to go up!

The early tactics are something like this: A founding team member writes an extremely positive, exciting, promising post on Twitter (as any startup founder would do all the time). No issue with that.

The issue comes in the second half of the message: "Giving 1,000 whitelist spots for the first 100 people who like, retweet, and tag 2 friends in the comments"

So the message spreads like wildfire and reaches thousands of people who share the message again for their chance of a good deal. And as we all know, if you hear something often enough, you start believing it.

No reason to do due diligence as long as you are early enough

The problem: projects gather thousands of supporters that way, none of which are incentivised to care about what the project does and whether it’s a sustainable business or tokenomics model. As long as you get in early and demand generation tactics are continuing, the price will rise and you will have a chance to take off some juicy profits - independent of whether the project succeeds in the long term or not. And once a project has 1,000 or so people bought in at a cheap price, guess what they’ll do: keep talking about how great the project is because that’s how the prices will keep going up. And everyone who buys in is incentivised to do the same to get the next people excited and so on. Web3 is a mostly unregulated environment and there are certainly elements of the bad “P” word visible (we tried to not mention Ponzi, because it's different, but...)

Again, that’s not a problem if the project solves a fundamental problem and can achieve sustainable success. There are many great projects out there that use these same tactics to get to critical mass. But if growth is simply generated by clever marketing tactics and distributing rewards (printing new tokens), drumming up artificial demand through lofty promises (1,000% return per annum are quite common promises), then the music will stop playing once all tokens are in circulation. And the early founders and investors will look at the sinking ship from a safe distance of their newly purchased private island.

No solid business model means failure in the long run

We cannot stress enough that the fundamental need for continued demand generation is the same for web3 as it is for any other product: If you don't solve an important problem that people are willing to pay for, your product or business or project will fail! If the costs are higher than the revenue, it will fail.

Many people seem to not care or take into consideration that most of the high return promises are "paid for" by distributing more tokens. This is the equivalent of printing money! And there is a fixed time where it will stop (defined in the whitepaper of each project). Handing out rewards that previously was on printing free money means that the cost base goes up dramatically. The point in time where all tokens are in circulation is going to be the moment of truth for many projects. We expect to see many projects failing (read: prices crashing, market caps wiped, money lost).

Reward distribution and “vesting schedules” are normally planned for a couple of years, which means that projects can continue printing money for several years and throw it at users as rewards for using the platform/service/product. So why care about the end game today, if everything looks fine, right?

Always do your own research - understand the tokenomics!

It is too easy to lose track of the fundamental value that the projects provide, the core problem they address and the economics that will guarantee sustained growth. Prices rise if demand increases faster than supply. However, if demand increases just because of the promise of nice returns, people will LOSE MONEY as the reward structure will fall apart once the ‘money printing’ stops!

The biggest problem is that legit projects that do solve fundamental problems and will be able to become self-sufficient are hard to differentiate from the ones that don’t - because you have enough people who don’t care, buy-in early, try to reap the rewards and help feed the beast. What remains is a thriving community of supporters, rising token prices and positive news coverage.

Even though we see questionable, yet currently very successful projects thriving without a clear pathway to becoming self-sustainable after all tokens are distributed and the free money printing stops (of course the founders and early investors would beg to differ!), we have decided to not include any examples because this ultimately is a decision any investor has to make for themselves. We are here to inform and educate, not to provide financial advice.

As the web3 space grows and new, inexperienced people start investing, there is an ever-growing risk of them being caught up in a bad project. Education is the prime response to avoid that risk! So please, please, please do your own research to avoid these projects unless this fits your investment strategy and risk tolerance. We know that this is A LOT easier said than done.

Tokenomics are hard to understand, they are complex and difficult to interpret over a long horizon. Bad actors know that and use it to their advantage, lure you into their amazing vision with their charismatic charm and storytelling, pretty pictures and a raving community of champions. The goal for long term investors is to understand if there is a sustainable business that supports the hype.

If you want to learn more about how to analyse a crypto project practically, even without experience in the crypto world, we're offering a short course that helps you assess a crypto project’s risk, including how to look at tokenomics.