Article: Evaluating Governance Tokens: A Framework by Outerlands Capital
Governance tokens have long been a complex and controversial topic among cryptocurrency investors, with varying opinions ranging from “innovative” to “unnecessary”. We lean towards the former and believe that well-structured governance tokens can add significant value to a project.
Key Points
In this article, we present a four-quadrant framework for evaluating governance tokens based on the reliability of token holders’ rights and their control over economic value.
After introducing the framework, we provide case studies for tokens in each quadrant, and finally offer recommendations for builders and investors on how to construct and evaluate governance tokens.
Introduction
Governance tokens are typically defined as tokens that grant holders voting rights over certain project parameters, which may include implementing product updates, fee/revenue generation, and business development decisions, among others. While market participants often describe governance tokens as a distinct category, it is more accurate to consider governance tokens as a characteristic or attribute that any token can possess. From Layer 1 to DeFi, infrastructure to gaming, every crypto submarket has examples of governance tokens.
In this article, we explore the utility of governance tokens and under what circumstances they can successfully or unsuccessfully unlock the underlying value of a project. We first outline the role governance tokens play in the cryptocurrency space, address common criticisms, and demonstrate their rationale. This initial analysis reveals two key features necessary for governance tokens: control over economic value and the reliability of control.
From these key features, we derive a framework and apply it to case studies to illustrate the differences between projects that meet and do not meet our criteria. Finally, we summarize how projects and their potential investors should consider the design and valuation of governance tokens.
Should Governance Tokens Exist?
Chart 1: Performance of newly listed Binance tokens since November 2023. Source: @tradetheflow_, Outerlands Capital Research
Some market participants and builders argue that governance tokens have no reason to exist, or at least should be much fewer in number than they are now. The recent underperformance and high valuations of newly launched venture capital-backed tokens have fueled this viewpoint, as they struggle to compete against large-cap tokens and meme coins.
Common criticisms include: protocols operate just as well, if not better, without decentralized governance (or even tokens), and the presence of tokens only adds inefficiency. Many teams launch tokens solely for early profit-taking without a real reason to create utility. The utility provided by governance tokens often has little impact on smaller investors who lack sufficient influence to truly shape the direction of a project’s strategy.
It is worth noting that those who widely criticize governance tokens are not always influential individuals. Respected figures like Ethereum co-founder Vitalik Buterin and Flashbots strategist Hasu have expressed doubts about the benefits of governance tokens.
Chart 2: Vitalik Buterin’s comments on governance tokens
While there is some truth to the above statements in certain cases, we believe that all these claims are not universally true. Projects that use governance tokens can retain aspects of centralization that are typically advantageous for startups, while unlocking additional value through decentralized governance, provided the structure is sound. For example, teams can retain control over the project’s strategic direction and product development while granting governance token holders control over other important parameters such as protocol revenue distribution or approval of new upgrades. Projects can also strategically distribute tokens through airdrops and other community distribution plans to align long-term interests with the protocol. We believe governance tokens can add value through two main avenues:
Governance tokens can help applications manage the inherent risks in their business models. Importantly, they can do this better than non-token governance systems because they provide the incentive to do so. For example, governance tokens can help mitigate vulnerabilities from centralized attack vectors within protocols. While layer 2 networks like Optimism and Arbitrum are developing their own techniques, they have already collectively onboarded billions of dollars in TVL on-chain. If centralized actors like Offchain Labs (developer of Arbitrum) could freely upgrade contracts or modify system parameters, it would introduce significant risks to the network. In other words, if certain contracts suddenly receive malicious code upgrades, funds could be stolen. However, the technology is still in development and requires upgrades to remain competitive. By delegating these decision-making powers to a decentralized governance process, projects become more resilient as there is no single entity for malicious actors to target.
Governance tokens can provide tangible economic value to their holders. One use case is GMX, a crypto derivatives platform that pays a portion of platform trading fees to those who purchase and hold its token. Many centralized exchanges also offer fee discounts to their token holders. Tokens can provide similar utility to other projects to offer economic incentives in exchange for development funding or adjustments to incentive mechanisms.
There are many governance tokens that meet at least one of the above criteria, and we are optimistic that there will be more in the future.
Outerlands Capital’s Governance Token Evaluation Framework
We view governance tokens through four quadrants, where:
The Y-axis represents reliability, which indicates the strength of the rights granted to token holders. Tokens with strong reliability establish clear rights for holders that are not easily changed, giving holders a greater sense of control over a given parameter. On the other hand, tokens with weak reliability only nominally grant voting rights to holders, with significant uncertainty as to whether holders’ rights will be respected by the team or protocol. This aligns with Chris Dixon’s viewpoint in the book Read Write Own, emphasizing the importance of a protocol’s ability to make strong commitments.
The X-axis represents control, defined as the economic value or other utility that token holders possess. Tokens with strong control provide ecosystem participants (users, investors, etc.) with many reasons to hold the token, while tokens with weak control have little to no incentive to do so.
Chart 3: Four quadrants of token governance. Source: Outerlands Capital Research
Attributes of Tokens with Strong Reliability
Below are the attributes that Outerlands Capital looks for in tokens with strong reliability:
A robust charter that aligns with the core ethos of the project. The threshold for modifying the charter should be higher than other governance votes (e.g., a supermajority of 2/3 and a quorum of 10%).
A comprehensive governance process that includes: Providing multiple tracks for proposals that balance efficiency and democracy based on urgency and importance: Daily operational functions (e.g., fund allocation, salaries, etc.) should be directly controlled by the team or delegated to specific committees to allow for faster decision-making than standard governance permits. Token holders should still have visibility into these functions and the option to dissent when necessary. Key decisions (e.g., major technical deployments, financial investments above a certain amount, or risk management functions) should undergo multi-stage discussions over a longer period (1 week or more). A dedicated forum and voting platform that is easily accessible and interactive for token holders. Token holders should be able to delegate their governance power to knowledgeable/incentivized parties. An emergency DAO/security committee elected democratically to respond to critical events such as hack attacks, with the ability for the DAO to modify or remove the committee. On-chain execution/enforcement of important decisions (so token holders don’t have to trust the team to follow through on voting results). This must be rigorously audited and constructed correctly to avoid governance attacks, and the on-chain execution should include reasonable time locks.
A foundation or other legal entity that represents the DAO in the real world (may not apply to fully anonymous teams). This limits the legal liability of governance participants and makes it easier for others to transact with the DAO (as they can interact with a more traditional corporate structure).
Strong control attributes for tokens
Broadly speaking, tokens with strong control give holders the power to control important economic parameters. The most obvious mechanisms investors look for are those akin to traditional equity. Projects that distribute income to holders (with holders having control over the distribution method) or buy back tokens on the open market are easily assessed based on their cash flows. As the underlying business grows, the tokens also share in its success, meaning investing in the token is a simple way to bet on the business. Investors can use traditional metrics such as discounted cash flow analysis or relative valuations based on revenue/profit multiples.
However, apart from capturing equity-like value, there are several important control factors that may incentivize holding tokens. These include: Other forms of economic utility, such as protocol fee discounts or priority access to the platform for users holding a certain amount of tokens. Control over the deployment of technical upgrades and new protocol versions, which may affect stakeholders’ economic interests. Control over changes to the tokenomics, including inflation/deflation and distribution, which can impact voting rights for existing token holders. Influence over business development decisions that may affect the financial success of the protocol, such as team salaries, partnerships, incentive programs, fees paid to third parties like exchanges and market makers, etc.
Evaluation Framework Case Studies
The following case studies demonstrate tokens in each quadrant that can enhance and/or diminish the fundamental value of a project. Strong control, strong reliability: dYdX
Decentralized derivatives exchange dYdX (token: DYDX) is an example that falls under the quadrant of strong control and strong reliability. Founded in 2017, dYdX offers perpetual contract trading for 66 trading pairs (as of June 2024). In November 2023, dYdX upgraded to its v4 version of the trading software, which included a migration to its own Cosmos app chain and significant improvements to the tokenomics through changes in the governance process, token utility, and revenue accrual.
Today, the DYDX token provides the following control mechanisms:
DYDX is the staking token for the app chain, meaning stakers earn fees from transactions as compensation for providing security to the network. Similar to most PoS blockchains, DYDX stakers earn fees in proportion to the amount of tokens they stake, creating a linear relationship between earnings and token ownership. Token holders who do not wish to stake can delegate their DYDX to others in exchange for a small portion of the earnings they generate. At current activity levels, the chain generates over $43 million in annualized fees for validators.
DYDX holders have the right to propose and vote on decisions that directly impact the development direction of the dYdX chain. Recent proposals include the introduction of new perpetual contract markets, trading incentive programs, funding for the dYdX Foundation, and technical upgrades.
Through the aforementioned upgrades, the DYDX token provides many benefits to stakeholders, including access to and control over protocol revenue, voting rights, and decision-making power. DYDX holders have a stake in the success of the dYdX ecosystem and can actively participate in shaping its future.The Impact and Importance of Governance Tokens in Cryptocurrency
Reliability is crucial in various aspects for a project, and this also holds true for new tokens. Beyond the technical aspect, one of the key reasons why the dYdX team migrated from Ethereum-based rollup to Cosmos is its superior decentralization achieved by a distributed PoS validator set. This not only reduces the risk of running a centralized sequencer, but also makes it possible to directly distribute income to token holders through the protocol (in the form of staking rewards), a strong commitment that will be hard to reverse compared to an income-sharing system operated by the team. Other proposals mentioned in the third point above are equally applicable, and all these proposals are executed on-chain after a successful vote.
Weak control, strong reliability: Ethereum Name Service (ENS)
Ethereum Name Service (ENS) is a decentralized naming service project for crypto wallets, websites, and operations that is an example of a weak control, strong reliability quadrant. On the surface, ENS is one of the more successful projects in the crypto space, with its revenue reaching $16.57 million in the past year (as of May 2024), placing it among the top 25 revenue-generating projects tracked by Token Terminal. However, the market capitalization of ENS tokens is far outside the top 100 (despite only about 31.5% of the supply being in circulation). This outcome is mainly attributed to the mission outlined in the DAO, which includes preventing domain name squatting on a large scale and providing funding for DAO operations as an incentive mechanism. Surplus profits are not a priority. The average ENS domain name renewal fee of $5 per year is much lower than half of what popular Web2 providers charge. ENS might double its fees, but the loss of demand would be minimal. The income accumulated in the ENS fund is used for the development of the ENS ecosystem and to ensure its long-term viability. Any excess income should fund other public goods in the Web3 ecosystem.
However, the public interest-oriented concept of ENS limits the potential control that token holders have over the project. Due to the low likelihood of increasing fees or distributing income in the future, the tokens are not widely appealing to investors and lack an attractive growth story. Even with a significant increase in domain name sales, token holders should not expect to receive a portion of these fees. The structure of the ENS charter makes it difficult to target for aggressive investors. As a result, only a few groups are interested in purchasing governance tokens, including individuals with a strong interest in DAO and are willing to contribute to its development and success. These individuals are more likely to become representatives rather than accumulate a large number of tokens. Projects hoping to work with ENS must have at least 100,000 tokens delegated or entrusted (currently valued at approximately $2 million) to submit a proposal. Projects already integrated with ENS hope to keep the protocol as free public infrastructure.
Although these groups do have some demand, they alone cannot form a strong economic flywheel like dYdX. Strong control, weak reliability: Hector Network
Hector Network is an example of a project in the strong control, weak reliability quadrant. It is one of the many forks of Olympus DAO that emerged in 2021, claiming to be the future reserve currency of DeFi. Originally a replica of Olympus DAO on the Fantom blockchain, Hector evolved over time into an on-chain asset manager. New investors can deposit funds into its pool via the rebasing mechanism and receive new tokens, while existing stakers maintain their current claim value. The team can then use the funds in the pool to develop new projects and invest in assets to generate returns. At the same time, token holders are granted control over critical protocol parameters, including decisions on investment in the pool, which helps them rank high in the control section of our framework.
The Hector Network team attempted to bring value to the fund by building multiple DeFi-focused products. However, due to poor execution and the market downturn in 2022, these products failed. The dissatisfaction of community members with the team grew, despite the roadmap failures, the team paid themselves hefty salaries (reportedly $52 million within 18 months).
When token holders called for the exercise of their governance rights over the remaining pool of funds, the Hector Network team began reviewing individuals in the project’s Discord and implementing governance restrictions due to a lack of legal or smart contract protection for HEC holders. When the team was eventually convinced to propose a pool liquidation, only about $16 million was left, and the value of HEC tokens had plummeted by 99% from its all-time high.
Providing stronger management protection for HEC holders could steer the project in another direction. Inspired by traditional equity investment tools, implementing protective measures would be a good start. Specific redemption periods (i.e., the contract opens for a week every quarter), regular return distributions, and/or investment lockups based on smart contracts could allow HEC token holders to exit their investment at face value before a downturn. Many had already sounded the alarm months before the DAO’s eventual dissolution, but their governance ability was limited due to its poor reliability. Weak control, weak reliability: Aragon
In some cases, governance tokens fail to provide control over the underlying project and are unreliable in protecting the rights they confer. A relevant example is Aragon: a project that provides legal, technical, and financial infrastructure for DAO operations. Several major crypto projects, including Lido, Decentraland, and API3, use its services.
While the team initially explored multiple use cases for ANT, they shifted to using ANT as a general governance token due to the lack of appeal of previous ideas. Unfortunately, the vague governance rights described did not provide much control for holders, as evidenced by the lack of meaningful proposals and sparse community activity. In June 2022, this situation changed when the Aragon Association and its community approved a proposal to transfer the funds to a DAO managed by token holders, with a planned date of November 2022, but this process was continuously delayed until the first transfer took place in May 2023. At that time, the total value of the fund was about $200 million, and ANT was trading at a discount due to the delay and the frustration of holders.
The decline in confidence in the team sparked the interest of aggressive investors, including Arca (a crypto hedge fund), who started buying tokens at a discount below the fund’s value to expedite the transition of DAO control, increase transparency, and use the funds in the pool to buy back tokens and restore ANT to book value.
However, the Aragon Association did not allow token holders to exercise their so-called governance rights over the remaining pool of funds, and instead suspended the transfer of remaining funds, banned members from entering the project’s Discord, and accused aggressive investors of coordinating a 51% attack, claiming that holders only have governance rights over the on-chain products and protocols built by Aragon.
The status of Aragon remained uncertain for the following six months, until November 2, 2023, when the Aragon Association internally decided to dissolve and distribute the funds in the pool to token holders. The team did not allow ANT holders to vote on the plan, citing so-called legal reasons, despite their previous involvement in the transfer of the fund. Predictably, many terms were considered unfair to holders, biased towards the team, leading to ongoing legal disputes.
A governance structure that gives holders greater control and reliability from the start might help alleviate much of the pain, possibly by giving holders the power to dissolve the token before it reaches this point, or by designing it in a way similar to ENS. In the next section, we will provide recommendations to help project founders and investors avoid negative control and reliability situations in governance.
Considerations for Builders and Investors
Our governance token framework and accompanying case studies outline the general characteristics of what we believe makes a strong governance token. However, every token is unique, which means the specifics of governance functionality and parameters should vary depending on the project.
Nevertheless, builders generally must create a roadmap that steadily progresses towards the defined end state. This means that if the project team decides to integrate decentralized governance, they should strive to make the rights of token holders robust and clear, preferably protected by strong commitments such as legal or smart contract mechanisms. Providing vague governance rights and then retracting them is worse than waiting for the right time to decentralize decision-making.
Builders should also determine whether it is necessary to issue governance tokens before doing so. As seen earlier, governance tokens can increase value by managing risks and serving as a form of equity. In terms of risk management, projects must decide if certain decisions are more suitable for a decentralized group of token holders rather than a small centralized team. Then, they can design a governance token to grant holders control over these parameters.
If governance tokens do not align with the team’s interests and there are other forms of risk to manage, they can still provide utility. For example, Chainlink’s LINK token does not confer governance rights but has a monitoring function designed to enhance network security. LINK is also a critical resource for launching the Chainlink Oracle ecosystem and paying for services.
If there is no risk that token holders need to manage, a crypto-equity route can still be chosen, depending on the jurisdiction and regulatory challenges the team is willing to address. However, if investors choose to invest in new governance tokens, they should clearly understand what they will receive (control over some fees, the ability to initiate buybacks, etc.).
Not all projects wish to design tokens for profit-driven investors. This may be due to an uncertain regulatory environment, a desire to align with public goods (as seen in non-profit organizations and public benefit companies), or other reasons. While these reasons diminish the investment value of tokens, many are reasonable. Projects going this route should set expectations accordingly, letting investors know what they are investing in.
Conclusion
The design and implementation issues of cryptocurrency governance are far from solved, but many tokens with governance functions today provide clear value to the projects they represent. Encouragingly, there are also signs that the market is starting to price governance tokens more effectively, with many of the most serious violators (including several mentioned in this article) being forced to close or remedy their failures.
Our governance token assessment framework aims to drive this trend, providing a perspective on how to design and invest in tokens to ultimately direct more value to projects that have clearly defined token holder rights (control) and actively protect those rights (reliability).
Finally, it is worth emphasizing that whether a cryptocurrency project is new or mature, it is not too late to discover shortcomings and make changes. This industry is still young and can transition from the weak to the strong in a short time, especially with the help of the framework described in this article.
