The Cost of Crypto Capital

The following is an adaptation of an article I wrote for my Managerial Finance class at the University of Virginia's Darden School of Business. I learned a lot in writing this piece and figure you might too. It's more technical than my usual style - this is the one where I do math - but it was too much work not to share.

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Decentralized Finance (DeFi) is an emerging financial hub built on top of blockchains and cryptocurrencies. According to a 2021 Morning Consult poll, 1 in 6 U.S. households own a token secured by a blockchain.[1] One Wells Fargo investment report claimed that, from invention to adoption, blockchain is growing at a similar pace to the internet in the 1990s.[2]

Despite record growth and innovation, regulatory uncertainty and other factors have kept integration with the traditional financial system limited. For this reason, despite handling billions in settlement volume, understanding of traditional financial management principles remains comparatively immature at blockchain startups. This fact is compounded by the ideological nature of the blockchain industry and the atypical prevalence of nonprofits as industry-leading organizations.

This piece will adapt the traditional financial (TradFi) concept of a cost of capital for nonprofit entities (foundations) in crypto and advocates for its use as a guiding benchmark.

Technology in Brief

Blockchains are a new foundational technology providing individuals and businesses new ways to access, record, and validate digital activity online. While still in its infancy, blockchains are disrupting a number of industries throughout the world.

A blockchain is a linked list of transactions stored on a network of computers. Blockchains are composed of groupings of data (blocks) linked together cryptographically (chain). Blockchains are decentralized, immutable, and open. Decentralized means that transactions or interactions are stored on a network of computers called nodes. Immutability means that once a transaction or interaction is logged on the blockchain, it cannot be changed. Open means that transactions or interactions can be viewed by anyone. These features - decentralization, immutability, and openness - mean that users can trust the cryptography of the blockchain even if they do not trust other users.

Two foundational blockchain concepts are tokens and smart contracts. A token is a representation of information encoded on the blockchain. This information could represent a collectible like a digital baseball card, a state-issued driver’s license, or any number of financial products like bonds, equities, and other securities. While most tokens are representations of assets originated on-chain, new firms are beginning to bridge the divide between TradFi and DeFi by tokenizing traditional securities.[3]

A smart contract, not to be confused with a legal contract, is a program which lives on a blockchain and executes when certain conditions are met.[4] Through creative software engineering, smart contracts can be used to build decentralized versions of popular consumer applications and financial services offerings. These decentralized applications are called dApps or protocols.[5]

For more on blockchains, you can read my explainer below:

Blockchain and Web3 Explainer

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ByteLegMichael Cameron

Dual-Entity Structure

Many blockchain organizations have adopted a dual-entity structure consisting of a foundation and a separate labs entity. The Foundation entity typically serve as the nonprofit arm of a project and is often charged with grant-giving. The Foundation is typically responsible for:

• Governance: Overseeing the project's overall direction and decision-making processes.
• Treasury Management: Managing and allocating funds for the project's development and growth.
• Community Engagement: Fostering relationships with the project's user base and stakeholders.
• Ecosystem Development: Supporting the growth of the broader ecosystem around the project.

Lab entities typically operate as the for-profit arm of the project. The Lab entity is often responsible for:

• Technical Development: Driving the core technology and protocol improvements.
• Product Development: Creating and maintaining user-facing applications and tools.
• Partnerships and Integrations: Establishing collaborations with other projects and companies.
• Marketing and Growth: Promoting the project and expanding its user base.

One benefit of this structure is legal, with foundations often being established in jurisdictions with friendly regulatory environments for blockchain companies. Another benefit is a clear delineation of responsibilities. Blockchain projects are often platforms that derive much of their value from the applications outsiders build. Creating a nonprofit charged with supporting this ecosystem reduces internal conflicts of interest and promotes a credibly neutral development environment.

This dual-entity structure means that many leading organizations are nonprofit entities. Examples of this structure include the Solana Foundation and Solana Labs, the Helium Foundation and Nova Labs, and the Filecoin Foundation and Protocol Labs, to name a few.

An organization’s cost of capital is defined as “the expected return on a portfolio of all the company’s outstanding debt and equity securities.”[6] More intuitively, the cost of capital is the return an organization must offer to its investors in exchange for their funds. In TradFi, the cost of capital is used to determine if a project should be pursued by comparing the expected return of the project compared to the cost of the capital used to finance it. If a business invests in a project which is expected to return more than the cost of capital, the manager is creating economic value. Vice versa, if a business makes investments with expected returns below the cost of capital, they are destroying economic value.  

Components of the Cost of Capital

There are two types of investors in any given company: debt investors and equity investors.[7]

Debt.

Debt is borrowed money and can be created through a number of instruments like loans and bonds. For many organizations operating in DeFi, debt is uncommon. Similar to software-as-a-service (SaaS) startups, venture capital investments are used to fuel growth until tokens can be sold to the public in what is often called a Token Generating Event (TGE). As a general rule, DeFi startups need less debt capital than traditional organizations. Building a DeFi protocol or dApp has few up-front fixed costs and instead requires investing in variable costs like the salaries of software engineers. While there are large categories of blockchain companies such as miners, staking infrastructure, or Decentralized Physical Infrastructure Networks (DePIN) which require large investments in fixed assets, they are the exception, not the rule.

Equity.

Equity, as it relates to cost of capital, refers to the funds provided by shareholders or owners of a company in exchange for ownership stakes.[8] It represents the residual claim on the company's assets after all liabilities have been paid. The equity structure of blockchain organizations varies significantly, largely arising from the uncertainty regulatory status of tokens. Some blockchain organizations have a dual equity-token model where team members and early investors receive equity and tokens, but the public only receives tokens. Other organizations initially create equity but require team members and investors to destroy their equity stake in exchange for tokens. Still other organizations operate exclusively using a token. For the purposes of this article, tokens can be thought of as equities.

Opportunity Cost.

Opportunity cost represents the potential return the organization misses out on by choosing to invest in one project over another. Using the opportunity cost as a guiding principle, the cost of debt and equity can be estimated using proxies or benchmarks. Opportunity costs are calculated within bands of risk to ensure that an apples-to-apples comparisons are being made.

Adapting the Cost of Capital Formula

The Cost of Capital is typically estimated using a weighted average cost of capital (WACC). This ensure that the opportunity costs of both buckets of investors, debt and equity, are properly accounted for. The WACC formula is:

• E = Market value of the organization’s equity
• D = Market value of the firm’s debt
• V = Total value of the organization (E + D)
• E/V = Percentage of capital that is equity
• D/V = Percentage of capital that is debt
• R_e = Cost of equity
• R_d = Cost of debt
• T_c = Corporate Tax rate

Cost of Debt.

The cost of debt is relatively straight forward. If a company has outstanding debt instruments, the cost of debt can be calculated. If a company has outstanding debt but the interest rate of that debt is unknown, the cost of debt is calculated by examining the interest rates of debt for similar companies. In DeFi, lending protocols like Aave, Maker, Frax, and Compound can be used to generate a loan on-chain with a programmatic interest rate. In this way, the cost of off-chain, traditional debt can be calculated using comparable companies and while the cost of on-chain debt can be obtained through the relevant lending market.

Cost of Equity.

The cost of equity is more complicated to calculate than the cost of debt given the nature of the instrument. The most common method to estimating a cost of equity is to use a risk-premium approach. Introduced in the 1960s, the Capital Asset Pricing Model (CAPM) is the most common method for this approach.[9] There are three components of CAPM: a risk-free rate, the correlation between the equity or token and the broader market (β), and the unique or specific return of a given equity or token.

• R_e = Cost of Equity
• R_f = Risk Free Return
• β = Correlation between a token and broader market
• R_m = Expected Market Return

Beta (β)

Beta is a is a measure of the volatility of an equity or token compared to the broader market. While the Cost of Crypto Capital is a general formula, to operationalize the formula for any given token, β must be calculated. Beta can be calculated using the following formula:

• R_i = The return of an individual token or equity
• R_m = The return of the overall market

While the return of an individual token can be quickly calculated, selecting the appropriate benchmark (R_m) can be challenging. For blockchain organizations, it is tempting to compare expected token returns against a crypto index. However, such a limitation would assume that investors are limited to investing in exclusively blockchain-related tokens when in fact they can diversify their portfolio should they like to do so. For traditional calculations of a cost of capital, the S&P 500 is used as a representation of a broad market portfolio. For a crypto cost of capital, this article recommends use of the S&P 500 as a proxy for the market (R_m).  

Risk Free Rate.

In TradFi, the risk-free rate is relatively easy to determine by selecting the yield on long-term government bonds. For most investors, U.S. 30-year bond yields are used as the risk-free rate. This assumes that of all entities, the U.S. government is least likely to default on its debt, and thus used as a proxy for a ‘zero risk’ investment.

However, in blockchain selecting the risk-free rate is more nuanced. For many blockchain organizations and enthusiasts, mistrust of the U.S. government and other global institutions is a foundational pillar of their worldview; they do not believe that the U.S. government is ‘risk free.’ Further, as the U.S. continues to run fiscal deficits and accumulate debt, prominent investors such as Blackwater’s Ray Dalio are beginning to publicly worry about a U.S. debt crisis or default.[10] Such a default would lead to a serious undermining of confidence in the U.S. dollar and the level to which an investor could consider it ‘risk free.’ While this article continues to recommend the use of U.S. 30-year debt as the risk-free rate, this situation should be closely monitored by those calculating a given blockchain organization’s cost of capital.

Market Risk Premium.

The market risk premium can be thought of as the additional return investors require to take risk (i.e. to hold an equity or token instead of government debt). By averaging the incremental return generated by equities over the risk-free rate, the MRP can be estimated. For example, if U.S. 30-year government debt offers a return of 2%, and the S&P 500 returned 8% over a similar timeframe, an MRP of 6% can be calculated. The 2014 Ibbotson SBBI Classic Yearbook calculates the arithmetic average Market Risk Premium Based on Long-Term Risk-Free Rate from 1926 to 2013 as 6.2%.[11]

The Cost of Crypto Capital Formula

As discussed above, most blockchain companies do not have debt and so it will be omitted from the final formula. The cost of capital for most blockchain organizations can be calculated as follows:

• E = Market value of the organization’s relevant token
• R_f = Risk-free rate
• R_i = Return of an individual token or equity
• R_m = Market return

Due to the dual-entity structure that is very popular in the blockchain industry, many of the largest blockchain organizations are nonprofits. As previously discussed, these nonprofits are charged with tasks that are hard to quantify such as governance, community engagement, and ecosystem development. At the same time, these nonprofits are charged with managing and allocating the treasury of the ecosystem.

The treasury is typically initially composed of large numbers of the project’s tokens and the proceeds of the sale of those tokens to the public during the token generating event (TGE). In this way, many blockchain organizations find themselves sitting on a pile of tokens with volatile value and charged with pursuing hard to quantify goals such as ecosystem development. The most common way blockchain foundations accomplish their goals is through the giving of grants denominated in their token.

Despite the large amount of value flowing through the system, the blockchain industry remains relatively young, with smart contract platforms like Ethereum being invented in 2015. As seen with other young industries, blockchain companies tend to led by, and employ, risk-tolerant people. The blockchain industry also tends to be composed of outsiders who are drawn to the message of decentralization first articulated by Bitcoin. While the blockchain sector will certainly mature as it grows in importance, the majority of people working in the sector do not have a traditional financial background, are comfortable with risk, and are ideologically driven.

Grant-giving, mission-driven nonprofits, led by risk-on outsiders without traditional financial backgrounds, enables many value-destructive decisions and investments to be made.

However, by using the cost of crypto capital formula as derived by this article, leaders at blockchain foundations can more easily evaluate possible grant opportunities. Instead of going with their gut feeling on if a given grant will "develop the ecosystem," a leader can ask themselves if a grant will generate a return greater than the crypto cost of capital.

A project which generates a return above the cost of capital is value generating; a project which generates a return below the cost of capital is value destructive. This is a basic question all capital allocators must ask themselves prior to making an investment. Sometimes, there are no good investments.

While nonprofits have the freedom to evaluate decisions independent of their profitability, they still face the challenge of raising and deploying capital efficiently. For this reason, the cost of crypto capital formula should be used by blockchain leaders as a guiding benchmark to ensure the sustainability of their organizations.

-Michael

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[1] The Crypto Report: Our Analysts on the State of Cryptocurrency, Morning Consult (July 2022),

https://pro.morningconsult.com/analyst-reports/state-of-cryptocurrency.

[2] Wells Fargo Investment Institute, February 2022, Cryptocurrencies - Too Early or Too Late?

https://saf.wellsfargoadvisors.com/emx/dctm/Research/wfii/wfii_reports/Investment_Strategy/cryptocurrency020722.pdf

[3] Securitize, BlackRock Launches Its First Tokenized Fund, BUIDL, on the Ethereum Network (March 20, 2024) https://securitize.io/learn/press/blackrock-launches-first-tokenized-fund-buidl-on-the-ethereum-network

[4] Ibad Siddiqui, What is Smart Contract?, Medium (April 27, 2018),

https://medium.com/coinmonks/what-are-smart-contract-and-whats-so-smart-about-them-a-beginners-guide-4228999305b.

[5] Corwin Smith, Introduction to dApps, Ethereum (May 30, 2022), https://ethereum.org/en/developers/docs/dapps/.

[6] Brealey, Myers, Allen, Principles of Corporate Finance, 12^th Edition, McGraw-Hill Education (2017)

[7] Michael J. Schill, The Cost of Capital: Principles and Practice, The University of Virginia Darden School Foundation (2014).

[8] Supra Note 6.

[9] W. Todd Brotherson, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins, “‘Best Practices’ in Estimating the Cost of Capital: An Update,” Journal of Applied Finance 23, no. 1 (Spring/Summer 2013)

[10] Ray Dalio, Principles for Dealing with the Changing World Order: Why Nations Succeed and Fail (November 30, 2021) https://www.amazon.com/dp/1982160276/

[11] Ibbotson SBBI 2014 Classic Yearbook: Market Results for Stocks, Bonds, Bills and Inflation 1926–2013 (Chicago: Morningstar, Inc., 2014)