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Thoughts On Valuing TZero's ICO

|Includes: Overstock.com, Inc. (OSTK)

T-Zero is currently on the ambitious path to be the first ICO issued by a publicly traded company (put another way, the most "legit" ICO to date).

ICO's are a very interesting security and I've been giving thinking about them quite a bit of lately.  I've decided to write a little blog post as a work-in-progress .

First of all, I'm very excited by these developments because we may be witnessing the birth of a brand new type of financial security.  We're used to seeing Equity, Debt, and Preferred (debt-equity) like securities, but with company-issued coins, there's a whole host of interesting features and issues to consider.

Second, my initial reaction to ICO's was that they're worthless scams and that the people buying them are foolish/naive (don't know what they're going to get), or they're philanthropic (don't care if they get anything in return), or greedy (are buying them purely on the speculative potential of making more money, i.e. greater fool theory).  Lets tackle those 3 in a little more detail:

1) Foolish/Naive/Trusting.  I find it very hard to grasp that people are buying ICO's with very little details about what the coin will actually represent.  The majority of these companies do not have working products, so while they promise "access or use of the product when it's live", it's not clear at what ratio or value the coins will give access.  If I own 1 filecoin, do I get to store 1 gigabyte or 1 terabyte of data?  How much bandwidth (publicly shared links) can I use? etc.  It's just very strange to think people are paying for access to something without knowing what exactly they're getting in return.

2) Philanthropic.  A lot of people have made obscene amounts of money by investing in Bitcoin "early".  Many, have more money than they can spend over many lifetimes.  We also know from IRS statements, that very few people have declared significant gains from bitcoin holdings on their taxes.  I can imagine the situation where individuals with millions of dollars of bitcoin, that they don't want to ever turn into fiat currency, be willing to throw some around to support ventures and technologies that they believe in.  At the same time, they might make some money.  This logic is no different than the playbook that they followed in 2010 by swapping some valuable US Dollars for "internet money called bitcoin" and magically they became millionaires as a result of the punt.

3) Speculative.  I haven't done the numbers myself, but I've seen enough charts and read enough articles that show that buying a portfolio of ICO's for the past 6-12 months has generated 500%+ returns.  So there's probably a significant amount of speculative money in play that simply buys ICO's purely to anticipate future upward moves.

4) Lastly, some people may participate in ICO's due to their promise of future cashflows coming from the company.  This is the rarest case, since, as far as I know, no company has ever paid any type of cashflow dividend to coin holders, and most coins do not promise any cashflows.  However, TZero is currently contemplating paying cashflows to coin holders and because of that, we can try to determine a value for it.

Some people talk about tokens/coins as being used as the exclusive 'currency' available for use by some services/networks.  I probably lack imagination, but I just don't really see how this is going to work.  There will always be secondary markets for exchange coins into fiat (or other coins, say BTC).  These secondary markets should fall into equilibrium with the optimal usage cost for the network.  Take filecoin for example, say they decide that it costs 1 coin for cloud storage per month (and that coin is then distributed to the storage providers).  If the coin is trading on the secondary markets for $50, then the implicit cost of accessing the network is $50/month!  Given comparables like box, dropbox, skydrive, etc. charging $10 per month (or thereabouts), it seems that these coin values will ultimately be pegged to their fiat and "non-coin" competitors.

At the moment I can't really wrap my ahead around the 'utility token' so I'm going to ignore it.  Instead lets talk about the cashflow token, because it looks a lot more like a financial security.

Overstock's CEO Patrick Byrne said on the last conference call that they're still finalizing the % of revenues that will be shared with TZero ICO holders.  He said they were thinking about 10%, but they were still playing around with it and finalizing it.  Lets stick with 10% for now.

So as an asset class, the TZero ICO holders (500 million coins are to be issued) will receive 10% of all future revenues of the TZero enterprise.  This is really interesting to me.  Let's review capital structure for a moment.

Bond holders contribute capital, and they get the first rights to a company's assets (in event of insolvency).  Otherwise they get paid back their principle plus interest.

Share holders contribute capital, and they get whatever is left of the enterprise value after paying back bondholders.  This can be in the form of retained earnings, dividends, share buybacks, etc.

ICO holders contribute capital, and they will get the first claim on a percentage of revenues coming into the company.

Buying a cash generating ICO from a company that is linked to revenues, is essentially buying a royalty agreement from the company.  You agree to give them some fixed amount upfront in exchange for a perpetual revenue stream.

To me, this is really cool.  Imagine being able to invest in an ICO of Amazon, and getting a percentage of their revenues, instead of a percentage of their profits?  It becomes a much cleaner investment because you don't have to think about how efficient they are, or whether they're squandering money, or their capital structure decisions, you're just betting on their top-line growth.

Back to TZero, to value their ICO, you ultimately need to forecast their future revenues, discount it, then divide by 500 Million (coins being distributed) to determine the expected value per coin.

Since the company is still in its infancy, it's extremely difficult to forecast their future cashflows, so I don't think it's a worthwhile exercise.  That being said, I've thought of a semi clever way to value their ICO on a relative-value basis.

First, we have the OSTK parent currently worth $1.25B.  For the sake of using easy-ish numbers, lets assume the Ecommerce division is worth $500M, leaving $750M for Medici.  Medici holds Tzero, as well as a portfolio of blockchain startups, but Tzero is by far the largest, lets split that value into Tzero being $600M and the rest of the Medici portfolio being $150M.

Under those assumptions, the market current values the entire TZero entity at $600M.  TZero equityholders will get a certain % Net Margin on future revenues (the only way equityholders get paid is if the company eventually is profitable).  Initially, the company will obviously lose money as costs far exceed revenues, but eventually, at scale, the equityholders will make incremental profits for every $ of revenue.  I've reviewed other exchanges (Nasdaq, ICE, CME, etc) and ballpark that, at scale, they get a margin of around 30%.  In other words, the equityholders are getting 30%, and the coinholders are getting 10%.  However, by introducing the coin, you're increasing COGS by 10%, so with a coin issued, the equityholders get a margin of roughly 20%.  If you assume that the cost of the coins being issued cover the retained losses during the time it takes for the company to get to scale, then you end up with a nice 2:1 ratio in terms of value.  In other words, if the TZero equity is currently worth $600M, then the TZero coins should be worth $300M (or $0.66 per coin).

This calculation is pretty rough but I don't think it's too far off.  If I have undervalued E-commerce, then the coin is worth less, and if I've overvalued the e-commerce division, the coin is worth more.

Big picture, assuming you could buy "parts" of the company, you can choose to buy the equity, which will generate cashflows (profits) of about 20% of revenues in perpetuity, or you buy the coin which will generate cashflows (royalties) of 10% of revenues in perpetuity.  Keep in mind that the riskiness of the ICO is much lower than the equity, but the equity has upside (if the company is more efficient they will get more than 20% margins).

These calculations will be a lot easier once the e-commerce division is sold off or they spin-off Medici.

Happy to hear your thoughts in the comments.

Disclosure: I am/we are long OSTK.