For those of you who’ve been through multiple crypto market cycles, extended bear markets can seem to take years off your life. But the relatively recent excitement surrounding bitcoin and other cryptoassets (and correlated price appreciation) has been a worthy vindication of your tireless efforts. The financial rewards for being an early adopter, among the multitude of other less tangible benefits, have been substantial.
However, many industry experts and enthusiasts alike still believe we have a long way to go — a sentiment likely echoed in the projects in which you invest. Armed with deep knowledge of this emerging technology, you took the risk to invest capital in projects whose goal was to build software and design intricate digital economies that will stand the test of time. With these ambitious blueprints in hand, organizations have collectively secured billions of dollars of funding since 2017 to see these visions come to reality.
Over the last several years, while the price of bitcoin and the public interest has fluctuated violently, teams have been laser focused on execution, devoting countless hours in pursuit of a trust-minimized and decentralized digital future that is better for all. Finally, the world is beginning to see the start of that hard work pay off. High profile projects have begun to launch their protocols to the public and with them, much to the delight of early investors, the distribution of their native protocol tokens. Projects such as Filecoin, Polkadot, Algorand, The Graph, Solana, and more have all recently launched, reinvigorating the public’s interest in what the future has in store for cryptoasset protocols.
This much desired liquidity has provided an opportunity for early investors to capture significant unrealized gains. However, these gains typically aren’t captured all at once, as many Simple Agreements for Future Tokens (SAFTs) have lengthy lockup or vesting provisions. In these instances, SAFTs will dictate a schedule wherein a percentage of an investor’s allocated tokens will be released over the course of time. This makes sense, as, similar to traditional private market companies exiting to public markets, projects are attempting to discourage a glut of supply being thrust on the market at launch, severely depressing the price of the token. This is not only a bad optic but can cause lasting damage on the long-term stability of the price.
Which brings us to the topic of the day: despite an active market for your tokens, how should you accurately estimate their fair value if there is a large swath of them you physically can’t sell? Below we highlight three things to keep in mind.
1. Discounts for Lack of Marketability
A discount for lack of marketability (DLOM) refers to the concept of using a valuation adjustment to match the price of a security without an active market to one which is actively traded. The lack of marketability has two dimensions: 1) the volatility of the price a willing buyer will pay for the investment and 2) the time necessary to find a willing buyer at that price. All else equal, logical deduction as well as empirical evidence supports the claim that a seller will accept a lower price for an investment that is illiquid compared to the same asset that is freely tradeable. But how does one go about quantifying this discount?
2. “Put Option” Pricing Models
One of the most widely used techniques in the professional world today is called a put option pricing model (POPM). In 1993, David Chaffe introduced this concept, stating that a securities owner could theoretically purchase marketability for their nonmarketable securities by purchasing a put option to sell those shares at the then current stock price. Therefore, the price of the put option would be equivalent to the DLOM. Chaffe relied on the Black-Scholes-Merton option pricing model to estimate the price of the option, using the stock price, the strike price, the time to expiration, the interest rate and volatility. In addition to the Chaffe model, several other POPMs have emerged, including the Longstaff, the Finnerty, the Ghaidarov and the Asian Geometric Average, to name a few.
While all models are constructed with a similar goal, not all of them are created equal. For example, each model can produce more or less exaggerated results based on the given inputs. While some industry experts have voiced concerns about the inherent assumptions and their exact applicability in this situation, those in the industry still regard the use of POPMs as one of the few available ways to quantify a given DLOM with limited qualitative or subjective support.
3. Applicability to Partially Illiquid Cryptoassets
Tokens that remain locked up are logically not worth the same as tokens that are freely tradeable. Therefore, if you are an investor in a project where a portion of your token holdings remain subject to lockup provisions, consider how these varying POPMs can help you estimate a DLOM. A small sample of things you may need to consider:
- Frequency of vesting (daily, monthly, quarterly, yearly);
- Vesting schedule parameters (multiple tranches, varying dates of unlocking, varying number of tokens); and
- Volatility estimates (use of the asset’s actual volatility, using another asset as a proxy, what time period to consider).
The deployment of these large scale protocols can be considered a major milestone in the relatively short lifespan of this burgeoning industry. Although there is much work to be done over the coming decades, people all over the world can finally interact with, build upon and benefit from the early visions of industry pioneers. However, the emergence of any new asset class can bring many challenges, especially as they relate to valuation. We hope the information above arms you with more knowledge to overcome this particular challenge moving forward.
Contact Josh Lecfowitz at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.