The Coded Income Model

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A DeFi-Inspired Model to Bridge the Crypto Economy and the Real Economy

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One of the leading trends in the world of blockchain and cryptocurrencies is the rising interest in Decentralised Finance also called DeFi¹. DeFi is a space of active innovation fostering a growing number of crypto finance platforms and products combining crypto assets as stake², collateral, derivatives, and yield-generating tokens. At the time of writing, the total value locked in DeFi platforms is USD1.74Bn as per DeFi Pulse. The crypto credit industry, including DeFi and private lending, exhibited strong growth in the first quarter of 2020, as per Credmark’s Crypto Credit report³. The increasing number and adoption of stablecoins⁴, pegged to and collateralised by fiat (government-issued) currencies or cryptocurrencies, also contributes to innovation in the space. Through numerous DeFi platforms and applications, users can earn revenues by lending or staking their crypto assets.

The operators and users of DeFi platforms often describe this type of income using the umbrella term ‘passive income’. To differentiate it from other classes of financial revenues I propose to call this type of income, coded income. Coded income is earned via a smart contract⁵, self-executing code on a blockchain that automatically implements the terms of an agreement between parties⁵.

The term coded income could be applied to any income received by an investor, a staker or a lender in the form of smart contract-generated cryptocurrency payments representing dividends, rewards or instalments, respectively.

Coded income, in its current form, is disconnected from the real economy as it circulates in the closed loops of crypto finance platforms. I will not expand here on the different crypto finance products and DeFi platforms, yield farming and the risks attached to their circular models; instead, I wish to explore a model at the intersection between crypto finance and venture or project funding, the coded income model.

Traditional Funding Methods

Funding methods for new projects and ventures are limited. Early-stage ventures and new projects typically do not qualify for bank loans⁷ or lines of credit and venture capital firms have a narrow scope. Funding from professional investors has drawbacks such as strict terms meant to give them preferential treatment over other shareholders and a lengthy legal process which can cause a delay in the go-to-market plans. Initial Public Offerings and access to public markets are usually reserved to more mature companies and entail lengthy and costly processes. Moreover, these sources of funding are not always available to entrepreneurs as they presuppose the existence of a sophisticated and accessible financial infrastructure which is not necessarily true in emerging markets where funding alternatives can be scarce and ill-suited to finance new ventures and small businesses.

On the funding side, early-stage investors are required to take on a high level of risk as it is a generally accepted rule that nine out of ten startups fail; but even those who pick successful ones will not be rewarded until they manage to sell their shares at a higher price. The wait can be long as “the time to exit for the average venture-capital-backed company has more than doubled, from 3.3 years to 6.8 years.”⁸ It is also important to note that investors in early-stage ventures are exposed to the whole company risk and not to the specific financial performance of an application, a product or a service.

Token-based Funding Methods

Throughout 2017 and the first half of 2018, entrepreneurs in the crypto space have been fortunate to source significant funds through token sales⁹, also known as Initial Coin Offerings or ICOs. ICOs started early, the first one occurred in 2013¹⁰. However, the ICO hype cycle which started in 2017 did not last beyond 2018 for several reasons, including these:

  • Following exceptional increases in the price of some digital tokens, the expectations of the token buyers soon became unrealistic and generally unmet.
  • There is no direct correlation between the token price and the financial results of the project and token holders have no recourse if the issuing token entity fails.
  • The regulatory environment for token sales remains undefined.

By the end of 2018, security token offerings¹¹ (STOs) were purported to take over where utility token sales were failing but security token offerings have proven expensive to undertake (high legal costs), impose more restrictions on eligible investors and have suffered from the poor liquidity of the security token markets. Nevertheless, several platforms are working to overcome these drawbacks.

The Coded Income Model

When comparing the multiple barriers to access to capital and the high level of friction in the traditional funding models with the ‘superfluidity’ of a multi-million dollar, collateral-based, crypto loans contracted daily on DeFi platforms, I see an opportunity for a new model, inspired from the framework of DeFi platforms, to build a bridge (or an aqueduct) between the crypto economy and the real economy to irrigate the dry, liquidity-thirsty fields of the real economy businesses.

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There are key differences between project funding and crypto loans, let’s look at some of these:

  • Crypto loans have fixed repayment instalments which do not take into account the borrower’s current or future revenue streams.
  • Crypto loans require collateral; this removes the need for a lengthy due diligence process.
  • Project funding requires a good understanding of the project and trusting that the team can execute, hence the preference for revenue-generating candidates.
  • Projects present economic models (not pure financial play) which create value in the real economy.

New ventures and projects cannot put capital as collateral for a loan. That will be the assumption here. We can imagine that, in the future, a group of supporters made up of individuals and private or public entities, could contribute to a pool of funds as collateral to facilitate this funding model in a particular market. This contribution would carry a lower risk than directly providing funding to the venture. I may elaborate further on this hypothesis in a later post.

Following the review of the common issues with traditional seed funding for entrepreneurs and investors, and the short-lived success of token sales, I would like to submit these questions:

Could a smart contract-based revenue share model become an effective alternative to traditional funding methods for operating companies with live (or soon to be live) applications, products or services? And,
Could this model create a bridge between the crypto economy and the real economy?

I believe a smart contract-based revenue share model, the coded income model, is best suited for projects needing fresh capital to roll out a new product or service in the near term or funds to support a product or service with an existing customer base.

This model is meant as an alternative to equity funding, crowdfunding and conventional lending. Coded income here is in reference to the income automatically distributed by a smart contract to the blockchain address of the capital contributor and directly collected as a share of the revenues of the company, or a specific project thereof. However, it would not be suitable for companies or projects with a long gestation period before recording the first sales.

The real economy must fulfil its basic premise of real income. In this model, coded income stems from the project’s economic model, not from a forward-looking, hypothetically exponential sales curve nor from the minting of a new token with a price arbitrarily set by its issuer. To source funds through this model, entrepreneurs would need to convincingly demonstrate the viability and solidity of their revenue structure and accept terms which match the funders’ desirability criteria.

As a result, the coded income smart contract should be deeply rooted into the core of the business operations of the company. This model shares common characteristics with the basic economic structure of a term loan or a ‘streaming’ or royalty-granting mechanism (popular in the traditional mining industry) but in this case funds are repaid through a digitally enforced revenue share mechanism. The use of blockchain technology, smart contracts and cryptocurrencies brings flexibility, transparency and adaptability at a level unseen in traditional revenue share models.

My definition of the coded income model: the provision of capital for an operational project whereby, in exchange for funds, the project owner agrees for a share of the project’s revenues to be automatically distributed via a smart contract to the blockchain address(es) of the capital provider(s).

Although it would logically be easier for this model to be applied by teams familiar with blockchain technology, the coded income model should be applicable to project funding in a wide range of industries. However, to avoid falling into speculative schemes, it is recommended for projects generating revenues at the time of funding or soon after. The model is focused on ‘projects’ rather than entities as the funding is secured thanks to the project’s anticipated revenue streams. An organisation could apply this model to each one of their cash flow generating product lines or services.

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As with any financing activity, there are several risks to assess which can impact the operations’ perennity and earnings. Capital providers should perform adequate due diligence on the projects and analyse the risks entailed. In that sense, this model is not as fluid as a crypto loan with crypto assets as collateral. However, I could imagine a business opportunity whereby, in a similar manner to equity crowdfunding platforms, the projects presented have successfully undergone a screening process by a third party and can be compared on the basis of the financing terms.

There are also specific risks linked to blockchain technology and smart contracts. DeFi platforms are the targets of frequent hackers’ exploits resulting in crypto asset losses¹². Storing and exchanging cryptocurrencies via crypto wallets¹³ carries a level of risk and parties should be familiar with standard cryptocurrency security protocols.

Stablecoins are the best suited class of cryptocurrencies to connect the crypto economy and the real economy as they can directly represent real economy, fiat-denominated earnings.

Unless the project revenues are earned in a cryptocurrency (other than a stablecoin) acceptable to the project funder, using cryptocurrencies with volatile market prices would call for the smart contract to access exchange rates via oracle¹⁴ services and this adds an extra layer of complexity.

It is recommended to choose a stablecoin fit to minimise slippage from potential disparities between the currencies of the capital contribution, the project’s revenue stream and the coded income. For example, if the project’s funding and earnings were denominated in USD then one of the USD-pegged stablecoins could be used such as USD-pegged, bitcoin-backed, Dollar on Chain¹⁵ (DOC).

Potential Benefits of the Coded Income Model

Potential benefits of the coded income model as an alternative to other forms of investing or project funding:

  • As coded income is, by design in this model, intrinsically correlated to the actual earnings of the project, this should contribute to improving the cash flow velocity and optimising capital allocation of the funding party.
  • For the project, the flexibility of payments correlated to the actual earnings represent a much better alternative to fixed instalments which can weaken and even endanger a project at times of lower or nil earnings.
  • The project may receive funds from multiple parties as smart contracts can easily handle multiple beneficiaries of the coded income. I would advise the beneficiaries to set up human-readable aliases for their addresses using a name service such as RIF Name Service.
  • Both parties may benefit from a streamlined process: following completion of the KYC and AML procedures, ideally using blockchain-based digital identity solutions, the funding terms could be agreed upon and integrated into a smart contract (more information about the smart contract parameters is presented in the next section).
  • Parties to this model could use pre-built and pre-tested smart contract templates to reduce the smart contract design costs.
  • Parties would not need to agree on a company valuation as it is not a requisite for this model. The coded income model is a non-dilutive form of financing.
  • The project does not need to issue a new crypto token, try to sell it or list it on exchanges, nor hire costly service providers to complete these tasks.
  • As parties would likely cap the value of the total coded income to be collected and/or limit the payments in time, this should remove the risk of speculation.
  • The project owner would not be able to amend the smart contract payments nor unilaterally stop the payments. This is an important security feature for the recipient of coded income.
  • The model brings more transparency to the relationship as both parties can rely on the blockchain to securely store a chronological record of the history of transactions. These records can easily be accessed via blockchain explorers¹⁶.

Examples of Coded Income Smart Contract Parameters

I am listing here a preliminary set of sample parameters which could be included in the coded income smart contract (please note that additional parameters would be needed in order to make the smart contract functional and compliant with the specific terms agreed between the parties):

  • The revenue share ratio is a key element of the smart contract. I would recommend to the project owner to build a simple model using the revenue forecasts and applying various scenarios to determine a range of ratios that could be financially supported by the project. This range would then be proposed to the potential capital providers and the final, agreed upon ratio would be integrated into the smart contract.
  • The revenue share payments may be triggered only after a certain time period or above a minimum revenue level. The smart contract could check that the minimum revenue condition is met before making a payment.
  • Smart contracts would include a variable premium paid to the coded income recipient(s) in addition to the original value of the contributed funds, similar to interest on a loan or the cost of capital for the project.
  • The frequency of the coded income payments may vary depending on the project’s revenue model. For example, a platform charging transaction fees is likely to earn fees multiple times in a 24-hour period. In this case, the smart contract could distribute a share of these revenues on a daily basis.
  • The parties may wish to use a form of financing emulating a line of credit where funds are paid in a scattered manner, possibly scheduled to match the project’s operational expenses or milestones. I would recommend the design of a separate smart contract governing the capital inflows which can be referred to as ‘coded investments’ (this can be further explored in a subsequent post). The coded income smart contract would have to account for the value of the capital inflows, or coded investments, on designated blockchain addresses before making payments as per the contract logic.
  • The duration of the relationship would be another key parameter of the coded income smart contract. The smart contract may be programmed to make payments until the sum of these payments reach a preset value or until a certain point in time as per the terms agreed between the parties.
  • If the project revenues were collected in fiat (government-issued currencies), a process should be put in place for the project to regularly convert fiat money into cryptocurrencies, such as stablecoins, to replenish the crypto assets available for payments via the smart contract.
  • Instead of capital, the project owner may decide to accept in-kind contributions such as development, consulting, design, marketing or other professional services. For this variant, as long as the parties agree on a value for these services, the smart contract can treat this value in a similar way to a capital contribution.

The above is a non-exhaustive list of parameters and I recommend anyone who may wish to experiment with their own interpretation of this model to do so with the help of developers with experience in writing (and possibly auditing) smart contracts as these programmes will technically govern the entire financial relationship between the capital provider and the project.

Final Recommendations

Depending on the size and development stage of the entity running the project seeking funds and its team’s understanding of blockchain technology, this model could represent a challenge for the entity’s organisational structure, especially for the larger ones. Before integrating this model, the redesign — and possibly, digitisation — of certain business processes may be required and this preparatory phase should not be neglected.

Although the coded income model is not recommended for projects with a long time-to-market period, parties are free to agree on terms taking into account the higher risk (uncertainty) of a project with distant future revenues and the opportunity cost of locking capital for a longer time frame. This would likely impact the premium (or cost of capital) to be paid by the funded party. In that scenario, I would encourage the funding party to monitor the progress of the project in the pre-revenue phase and use a smart contract as described in the aforementioned coded investments scenario. However, parties should be aware that these conditions carry the risk of drifting into speculative models.

It is advised for parties to this model and/or their legal advisors, to research the laws applicable to smart contracts, term loans and revenue share schemes in their relevant jurisdictions. They may also look into blockchain-based dispute resolution solutions such as Kleros or online arbitration solutions like Jur which could be practical to use with this model.

The End Goal

The coded income model can be adapted to fit various business conditions and economic models. You may have noticed that the model combines certain elements from traditional investing, loans and DeFi; the idea is to combine these elements within a smart contract-based model to reduce friction in the real economy financing process while providing additional flexibility, security and transparency.

The intention is to remove hurdles faced by entrepreneurs around the world and to use adequate blockchain and crypto finance tools to bring liquidity to the real economy.

My hope is for the coded income model to be applied to projects of any size, from micro-enterprises to large ventures and, as a result, accelerate financial inclusion.
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This is a theoretical model and I plan to tap into the vast expertise of the talented smart contract specialists at IOV Labs to test technical implementations of this model. I look forward to sharing the test findings and examples of coded income smart contracts in the near future.

In the meantime, I invite anyone who would like to comment or contribute to this conversation to contact me at codedincome@gmail.com. Thank you.

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About the Author

Eddy Travia has been an investor in tech companies globally for 16 years and has first-hand experience with the challenges faced by early-stage company entrepreneurs and investors. For the last six years, Eddy has been investing in early-stage blockchain technology companies as the co-founder and CEO of London-listed Coinsilium Group (AQSE:COIN). Eddy is also the Regional Director Asia Pacific for IOV Labs, an organisation developing the most popular implementations of the RSK Smart Contract Network, a major proponent of DeFi for Bitcoin.

Eddy is a regular speaker at major blockchain events around the world, these are links to his TEDx talks: ‘Our Lives in a Blockchain-Powered Smart Economy’ at TEDxINSEAD (June 2018) and ‘How The Blockchain Revolution Will Change Our Lives’ at TEDxIEMadrid (June 2016).

Legal disclaimer: please note that this is a transcription of the personal views and reflections of the author; the theoretical model described in this post requires more research, analysis and testing and it should not be construed as technical, legal, investment or any other form of advice. The author’s assumptions are not supported by any technical experimentation or implementation of the model at the time of publication. Should you decide to implement your own personal interpretation of the theoretical model described herein, please understand you are doing so at your own risk and the author recommends you seek legal and technical advice, especially in the fields of project financing, lending, cryptocurrencies, stablecoins, crypto assets, smart contracts and blockchain technology before doing so.

Sources:

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⁸ Shane, S. (2015). What Slow Exits Mean to Startup Investors. Entrepreneur Asia Pacific [online]. Available at: https://www.entrepreneur.com/article/253459 [Accessed June 2020]

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¹⁰ Merre, R. (2019). ICO 101 — History of Initial Coin Offerings (ICOs). Hackernoon [online]. Available at: https://medium.com/hackernoon/ico-101-history-of-initial-coin-offerings-icos-part-1-from-mastercoin-to-ethereum-4689b7c2326b [Accessed July 2020]

¹¹ Zaki, I. (2018). Security Token Offerings (STOs) — What You Need To Know. Hackernoon [online]. Available at: https://hackernoon.com/security-token-offerings-stos-what-you-need-to-know-8628574d11e2 [Accessed June 2020]

¹² McIntosh, R. (2020). DeFi Platforms Are ‘Only As Safe As The Code They Have’: Analysis. Finance Magnates[online]. Available at: https://www.financemagnates.com/cryptocurrency/news/defi-platforms-are-only-as-safe-as-the-code-they-have-analysis/ [Accessed July 2020]

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The Coded Income Model was originally published in Coinmonks on Medium, where people are continuing the conversation by highlighting and responding to this story.