Potential Solutions to Crypto's Vesting Problem

By Ro Patel, Partner at Hack VC

The Status Quo of Token Vesting

A trend in this current market cycle is tokens launching with high valuations and low initial circulating supply (in other words “low float / high FDV tokens”), which has raised concerns in the crypto community about sustainable upside for public market investors. A significant amount of tokens are expected to be unlocked by 2030, which could pose potential selling pressure unless balanced by increased demand.*

Historically, contributors* to a protocol network typically receive some percentage of a token’s fully diluted supply that vests* on a term structure. Contributors should be adequately compensated for their efforts, while balancing said compensation with the interests of other stakeholders, namely public market token investors. This is critical because if the portion of vesting tokens represents too much of the market cap of a token, and in turn available liquidity, vest events can have adverse effects on the price of the token, harming all token holders. On the other hand, if contributors are not adequately compensated, they will no longer be incentivized to work on the project, and that ultimately harms all holders as well. 

Classic parameters for token vesting include: percentage of tokens allocated, cliff, vesting length, and frequency of payments. All of these parameters operate exclusively on the dimension of time. 

However, solely using the quintessential parameters above limits the scope of the solution available to a narrow dimension. Integrating new parameters can unlock previously untapped value.

In this article, I suggest the addition of liquidity and/or milestone-based dimensions to augment and improve on the existing token vesting schedule model we most often observe today. 

Liquidity

Consider a liquidity-adjusted token vesting schedule. This idea extends normal vesting constructions by implementing a single new parameter: liquidity. Defining liquidity is not an exact science; there are many ways to quantify it.

One measure of liquidity is the bid-side depth available on a token, both on-chain and on centralized exchanges (CEXs). The cumulative sum of all bid-side depth has a notional figure that we can consider “bLiquidity” (bid-side liquidity). 

Contributors could be given one additional parameter in their vesting terms, which is “percentage of bLiquidity,” or “pbLiquidity,” and this figure could theoretically be anywhere between zero and one.

When a vesting claim is initiated, the contract could output:

min(tokens to be claimed under normal vesting output, pbLiquidity * bLiquidity * token unit FDV)

Here’s an example to illustrate how this could work: consider a token with 100 units of total supply, 12% (12 tokens) allocated to contributors under vesting, and a price of $1 per token. Say that vests linearly over 12 months from the token generation event with no cliff, and the token price stays constant for the sake of simplicity. Normally, vesting would allow 1 token to be redeemed every month with nothing else considered. Now, say there was a pbLiquidity figure assigned to the vest of 20% and that the token over the course of the 12 months had at least $10 in bLiquidity. At the first month of the vest, the contract would look at the $10 bLiquidity figure, multiply by the 20% pbLiquidity figure, and get $2. Given the min function described above, the 1 unit of the token would vest normally since 1 token * $1 is less than $2. However, change the above figures to have $2 in bLiquidity, in that case 20% of $2 is $0.40, so instead of 1 token worth $1 vesting, only 4/10ths of a token would vest. This is a liquidity-adjusted vest. 

The Benefits

• Vesting claims previously really only cared about time and perhaps indirectly that there will be sufficient liquidity to absorb vests at a given price. This construction explicitly defines that contributors should focus on building liquidity in their token and aligns that objective with a tangible incentive.
• Holders of the token that are not under a vest (i.e. liquid market buyers before an unlock date) can rest easy knowing that a single vesting claim won’t tank the price into thin liquidity. Previously, public token holders just had to trust the good faith and intentions of those claiming the tokens. With this improvement, they now have an explicit reason to feel comfortable.

The Drawbacks / Challenges

• It could introduce volatility around payments for contributors if a token never achieves sufficient liquidity and could ultimately lengthen vests considerably. 
• It complicates the simple frequency of payments that contributors are accustomed to.
• It could incentivize spoofing bid-side liquidity. However, there are many ways to combat this. For example, one could consider bLiquidity that is within a certain percent of mid-price or with LP positions that have some time-locked element to them.
• People can claim tokens from vesting but not sell them immediately, allowing them to accumulate a large balance. Later, they might sell all their tokens at once, which could significantly impact liquidity and cause the token price to fall. However, this situation is similar to someone gradually acquiring a large amount of a liquid token. The risk that a large, concentrated liquid token holder might sell and cause the price to drop always exists.
• Getting a bLiquidity figure for a decentralized exchange in a trust-minimized way is a lot easier than for CEXs where the order book data is published by the CEX itself.

Before moving on to the milestone-based dimension, how does a project ensure there is sufficient liquidity to support a reasonable vesting schedule? One idea is to reward locked LP positions of a token with incentives. Another is to engage liquidity providers. As we wrote about in “10 Things to Consider When Preparing for your Token Generation Event (TGE),” engaging liquidity providers can help create a stable market by borrowing tokens from the project’s treasury and pairing them with stablecoins on exchanges.

Milestone-Based

An additional dimension that could improve token vesting schedules are milestones. Milestones, such as number of users, volume, protocol revenue, total value locked (TVL), and similar data points, capture a protocol's overall traction via quantifiable numbers.

Naturally, a protocol can set binary thresholds or gradients for the above parameters that factor into a vesting schedule. For example, a protocol must have $100M+ in TVL, 100+ daily active users, and/or $10M+ in trailing 90 day average daily volume to vest 100% of the normal time-related vest. Should those numbers fall short, the amount that vests either fully stops (binary-style) or is lowered proportionally (gradient-style) relative to the initial threshold target. Between binary and gradient, gradient seems to make more sense. 

The Benefits

• This milestone method ensures protocols will have certain traction and liquidity when vesting occurs, resulting in a healthier protocol over time.
• Milestones apply less emphasis on time. 

The Drawbacks / Challenges

• Certain statistics like active users and volume can be gamed. The TVL metric is less gameable but arguably less important, especially for protocols that are more capital efficient. Revenue is also more difficult to game, but certain activities like wash trading can translate to more fees and thus revenue, so transitively it’s still gameable. When judging the likelihood of manipulation, it’s important to note the incentives at play. It is the team and investors (i.e., anyone on a vesting schedule) that are incentivized to game the statistics. Public market buyers are less likely to game statistics because they have little reason to motivate accelerated vesting. Further, strongly worded token warrant clauses in off-chain legal agreements could significantly mitigate malicious behavior by the incentivized parties. For example, if a team member or investor is caught wash trading or pumping user activity, they could forgo their tokens, creating a severe penalty for breaking the rules.

Conclusion

The current market trend of high valuation, low initial circulating supply tokens has spurred concerns about sustainable returns for public market investors. Traditional time-based vesting schedules may not fully address the complexities of token liquidity and market conditions. By integrating liquidity and milestone-based dimensions into vesting schedules, projects can better align incentives, ensure adequate market depth, and foster genuine traction. Although these methods introduce new challenges, the benefits of more robust vesting mechanisms are significant. With careful safeguards, these enhanced vesting models can improve market confidence and create a more sustainable ecosystem for all stakeholders.

*Endnotes

• Source: Binance.
• Contributors include anyone on a token vesting schedule, which could include the team, advisors, and early investors.
• For purposes of simplicity, I use the term “vesting” throughout this article to represent both “vesting” and “lock-ups,” which are similar concepts that restrict employees/consultants and investors, respectively, from selling tokens for, at least traditionally, certain periods of time.

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