Companies pay Goldman Sachs millions of dollars to answer the question, “What should we do with our excess cash flow?”
I didn’t sleep for two years as a Goldman banking analyst… but it did teach me one thing – automated buybacks are an inefficient mechanism for returning value to tokenholders.
How did we get here?
Investors questioned, “will protocol profits go to holders of the token or equity?” Uncertainty damaged token prices.
Inspired by MakerDAO, teams addressed the question by instituting token buybacks. It was the simplest solution – fully automated and auditable on-chain. But, simplest does not equal most efficient.
How to allocate capital
Companies (and protocols) can use excess cash flow for value creation or value distribution.
Value creation:
Invest in R&D, marketing, etc.
M&A and minority stakes
Strengthen the balance sheet
Value distribution:
Dividends
Buybacks
Companies allocate capital where ROI is highest.
Buybacks are a capital allocation decision.
So, why are token buybacks bad?
1. Reinvesting in the business for value creation should drive larger returns.
Assume a protocol business per the below. It’s generating $40M in earnings, growing 100%, trades at 25x future earnings, and has 100M tokens outstanding. It’s worth $2B ($80M x 25x = $2B) and its token trades at $20 today.
Now let’s add in the token buyback dynamic. Assume the protocol uses all its earnings to buy back the token, and it can do so at current market prices. The protocol buys 2M tokens, making the new total tokens outstanding 98M. The token is now worth $20.41. The protocol is still valued at 25x future earnings ($2B), but every token holder now owns more.
That sounds good until you ask the question, “how much could the protocol grow its earnings by investing $40M into growth?”
Base Case: No change in growth rates and no share buybacks. $20 per token.
Bull Case: Investing in product and marketing drives growth to 110% vs. 100%. Same multiple as base case. $21 per token.
Tail Case: Investing in product and marketing drives growth to 150% vs. 100%. Markets assign a higher multiple because of an improved growth profile. $30 per token.
It’s clear that there is upside to token holders by reinvesting profits back into the business.
What’s the breakeven? If instead of using $40M for token buybacks, you could grow earnings by an additional 2% (4% YoY) you’re at breakeven.
So... buybacks are inherently pessimistic.
2. Buybacks can drive the price up in the short-term… but that’s not always good in the long-term.
The example above assumed that token buybacks would have no impact on token price. That’s not true. The announcement of a buyback raises token prices, and the perpetual buy pressure changes market structure.
Let’s assume that launching a buyback mechanism increases the token price from anywhere between 10% to 50%.
That’s great in the short-term, but the price increase is due to market structure not fundamentals.
Fundamental investors will still value the protocol at 25x future earnings for a $2B FDV. They sell on the way up, and the protocol buys.
Exit liquidity for some, but the long-term holder base is punished.
The protocol ends up buying back fewer tokens, the fair token price is lower, and the mechanism ends up being inefficient.
What should we do instead?
We need to run protocols like businesses. This includes capital allocation decisions.
Institutional investors will demand this… and to get to the next level of scale, our industry needs institutional investors.
What does that look like?
We need transparency. @Blockworks_ has been leading the charge on this with their dashboards.
Founders need to reinvest capital into product and marketing. The success of these initiatives should be documented publicly (or maybe to some tokenholder board).
Some founders are already starting to do this:
Investors need to hold teams accountable. Push teams to better allocate capital, propose new initiatives.
