How to Evaluate Tokenomics and Avoid Becoming Exit Liquidity

You’ve found it — the crypto project that ticks all the boxes: innovative tech, a committed team, strong product traction, quality VCs, and the potential to go mainstream. You’re an active member of their community and buy the token as soon as it’s available. But sadly, because of how predatory tokenomics can be, the opportunity for your investment to go up is limited.

This scenario is becoming all too common in the crypto world, where tokenomics sometimes favor insiders and venture capitalists (VCs) over the average investor. The problem is systemic, and goes something like this:

1. VCs pour 10s of millions (or more) into emerging projects, even those without clear traction or usage.
2. Founders are incentivized to sell before the token goes live through OTC deals.
3. The project launches with inflated valuations, designed to draw hype into an overvalued airdrop.
4. Market makers maintain these lofty valuations through strategic agreements, keeping prices artificially high.
5. When insiders and VCs cash out, the price plummets, and you’re left holding the bag.
6. Rinse and repeat.

If you’re considering whether or not to buy a crypto asset, understanding the tokenomics is an incredibly important step in helping you make a good decision.

Here are 10 factors to consider when evaluating tokenomics and common red flags to look out for:

1. Use case

What purpose does the token serve in the ecosystem, and will it appreciate as the network grows? Let’s be honest — there are plenty of tokens in existence that don’t do anything imperative for the product they serve. While tokens can be effective for bootstrapping customer acquisition, if the product doesn’t have true product-market fit, then you are inevitably going to see a massive drop off in activity when token incentive campaigns end (see all major airdrops of 2024). Be wary of tokens from projects without product-market fit.

2. Total supply

How many tokens will ever exist? Are there any mechanisms in place to reduce the total supply (e.g., token burns)? Burning tokens can increase scarcity and, theoretically, value over time. Bitcoin, for example, has a hard cap of 21 million on total supply, which contributes to its deflationary nature. Ethereum, on the other hand, is considered an inflationary asset but has a mechanism to burn a portion of the transaction fees, which helps limit inflation.

3. Circulating supply (float):

How many tokens are in circulation now versus locked up? Tokens with a low float are highly susceptible to large price swings. With fewer tokens available for trading, even minor buy or sell orders can cause significant price changes. This heightened volatility can make it challenging for investors to predict price movements and can lead to substantial losses in a short period, especially if large token holders dump.

4. Fully Diluted Valuation (FDV)

A project’s Fully Diluted Valuation (FDV) is calculated by multiplying the token price by the total supply, giving an estimate of the potential market cap when all tokens are in circulation.

If a project’s FDV seems too good to be true, it probably is. Compare the project’s current valuation with what VCs paid in the previous round. While some premium is normal, a drastic difference should raise red flags — are you paying a premium for empty hype? A good resource to find out a project’s prior valuations in CryptoRank.

Examples of recent high FDV launches: Dymension (DYM, $4.7 billion), Starknet (STRK, $27 billion), Arbitrum (ARB, $13.2 billion), and Wormhole (W, $14.25 billion). The average FDV of these four projects at launch is $14.78 billion, a 13.3x average premium to their previous private market valuation.

If retail could participate around the same price as the last VC round, everyone would be happy.

5. Insider allocation

How much of the token supply is allocated to the team, early investors, and advisors? A high percentage allocated to insiders might indicate potential sell pressure once tokens vest if these individuals prioritize short-term gains. Apart from the exit scam concerns, large insider allocations undermine the decentralized nature of a project, as a few entities can wield disproportionate influence over decision-making.

6. Token distribution

Users of a project should receive the majority, if not all, of their tokens before the team and pre-launch backers. If early insiders are getting their tokens first, it might be a sign that you’re being set up as exit liquidity. If retail investors receive their tokens first, it ensures they aren't at a disadvantage compared to insiders who may have bought tokens at a significant discount. It also encourages insiders to focus on long-term growth and project success, further benefiting retail token holders.

7. Vesting schedule

Are tokens locked up and released gradually? A clear vesting schedule prevents dumping by insiders and maintains price stability. Gradual token release helps maintain a more stable market environment, allowing for organic price discovery rather than being disrupted by massive token sales from insiders.

8. Competition

Tokenomics don’t exist in a vacuum. Compare projects within the same sector to get a clear picture of their potential. Metrics like total value locked (TVL), active wallets, transaction volume, and number of integrations can be used to compare projects in the same category. There are excellent free tools available that can help with such analysis, including Nansen, DeFi Llama, and Dune.

9. Incentives

Properly designed token incentives encourage participation, long-term engagement, and drive demand for the token. Does the project offer staking rewards? Are there rewards for participating in liquidity pools or other decentralized finance (DeFi) mechanisms? This can incentivize retention and reward token holders for actions that contribute to the project’s growth. Note: Be wary of high, unsustainable yields or rewards, which may be a sign of Ponzi-like structures.

10. Regulatory risks

Are there regulatory challenges that could affect the token's legality or usage in certain jurisdictions? Consider whether the token could be classified as a security, how the project handled its token sale, whether it complies with local and international regulations, and how decentralized the control and governance are. Projects with well-defined utility, clear legal opinions, compliance with KYC/AML requirements, and transparent governance structures are less likely to face regulatory challenges.

By analyzing these factors, you can form a well-rounded view of a project's tokenomics, helping you assess its potential for long-term success.

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