Proof of Profit (PoP)

How tokenized income changes everything

1. Peculiarities of the current instruments of ownership

These days it’s not uncommon for a single company to issue multiple different classes of shares (e.g. Class A, Class B, Class C).

If you were to look at all the different classes of shares for the same company, you would most likely find that their ticker prices differ. Typically, all else being equal, the class of shares with more voting rights is worth more. The assumption behind this is that investors are willing to pay a premium on top of the normal share price in order to get voting rights. What if it is more complex than that?

2. Blockchain as an instrument of ownership

Recently, there have been discussions within the cryptocurrency community about ways to represent ownership of companies using blockchain tokens. While most people probably see this as a mere convenience (e.g. to make it easier for millennials to acquire stakes in companies using their favorite crypto trading platforms), it’s possible that this trend could have a far more significant impact on the way markets operate than most people realize.

There are a few key features of crypto which are likely to make crypto markets behave very differently from share markets:

• The blockchain is immutable; therefore, unlike shares it’s not possible to convert one kind of token into another (I.e. unlike shares which can potentially be converted from one class to another). It’s possible to exchange one token for another, but this is not the same as conversion. It’s also not possible to arbitrarily dilute the holdings of existing token holders.
• Blockchain tokens are lost permanently if the owner loses their passphrase, disappears or dies without any succession plan. This permanently reduces the circulating supply of tokens.

These two characteristics are going to introduce a new dimension to markets which the current market system has neglected. It also has something to do with a 4-letter word which is popular in the cryptocurrency space: HODL. The reason behind this should become clearer towards the end of this article.

In order to discuss company ownership, it’s important to define what it means ‘to own a company’. The most popular instrument of ownership today is the share. A share is a fungible instrument; this means that it is not connected to any specific physical part or aspect of the underlying company; all shares (within the same class) are exactly equal; so then what does a share concretely represent? At its core, it represents a percentage of all current and future net income of a company.

Ultimately, what investors care about is income. There are currently two main ways through which a company can distribute income to its shareholders:

• Dividends: Profits are sent to shareholders’ bank accounts. Dividend distribution is usually a taxable event and so tax must be taken out immediately from the amount sent to each shareholder.
• Share buybacks: Profits are used to buy back shares from the markets (to remove them from circulation); this is usually not a taxable event except for the subset of shareholders who end up selling their shares back to the company; in this case, these specific shareholders typically pay capital gains tax (which is usually much lower than income tax).

Many companies these days have already figured out that share buybacks are a much more capital-efficient way to distribute value back to shareholders. Not only are capital gains taxed at a lower rate than income tax, but it also gives shareholders the option to hold onto their shares longer so they can delay paying taxes until a later time — Or they can hold forever; if they never receive income, they never need to pay tax; in accordance with the law of supply and demand, the value of their own holdings would simply go up as the total circulating supply of shares goes down.

Many big companies today have already committed themselves to never distributing any dividends; they only either re-invest in their business activities or they buy shares back from the market.

3. Token buybacks as a profit distribution mechanism

With this in mind, a buyback mechanism appears to be the most efficient way to represent ‘ownership’ of a company via blockchain tokens. A simple approach which has been used by the Leasehold* project (https://www.leasehold.io/) is to commit to using all net profits of the underlying company to buy back tokens from existing token holders on cryptocurrency exchanges (or better; on Decentralized Exchanges for better transparency) and then to burn any purchased tokens by sending them to a special ‘burn address’ on the blockchain — This removes the purchased tokens from circulation permanently. Using company profits to execute buybacks creates continuous market demand for tokens which puts upward pressure on the token’s price. Token buybacks have some major advantages compared to share buybacks:

• Permanence: When tokens are bought back and destroyed, they are permanently taken out of circulation. Company directors cannot have a meeting in the future and agree with each other to issue new tokens (as they can do with shares). They cannot tamper with the ledger of who owns how many tokens or dilute ownership in an unexpected way; the code simply does not allow this.
• Transparency: Any movement of tokens or burning of tokens is visible on-chain to everyone. Nobody has to trust anybody else about what the profits were for a particular month and how many tokens in total are in circulation; all this info can be seen and independently verified by anyone by looking at the blockchain. It costs real money to buy tokens from the open market so a buyback is an irrefutable proof of profit.

4. A thought experiment (red pill)

At this stage, it might not be obvious how blockchain changes anything (let alone everything)… Companies have been doing share buybacks for decades, how does moving profits to a blockchain market instead of a share market change the dynamics of how the markets work?

To answer this question, we need to recall the following points from section 2:

• The blockchain is immutable.
• Blockchain tokens are lost permanently if the owner loses or forgets their passphrase…

We can use the concept of ‘share classes’ from section 1 to draw a comparison.

Imagine that there is a company with 2 different classes of shares (Class A and Class B). Assume that Class A shares are owned by the family of the company founder and they represent 50% of all outstanding shares of the company. Assume that Class B shares are owned by regular investors and represent the remaining 50% ownership stake in the company. Assume that the two classes of shares are kept completely separate from each other and are traded on different markets.

Assume that, each month 50% of the company’s profits are used to buy back Class A shares and 50% of profits are used to buy back Class B shares on their respective markets (at the market price).

Assume that Class A shares are divided between a total of 10 shareholders (the family members). All of them are wealthy; they have income streams from other businesses and they happen to have relatively modest lifestyles relative to their incomes. On the other hand, Class B shares are divided between a total 100K different shareholders (regular investors); most of them are regular people with slightly above average incomes, some of them are company employees (or ex-employees) or are retired or heading into retirement .

What’s interesting about this setup is that the people who own Class B shares are going to be selling more shares back to the open market (and also to the company itself as part of share buybacks) in any given month than those who own Class A… Why? Simply; there are more of them and they need the money to pay their bills. The rich family members who own Class A shares are not so constrained. If we were to assume that Class A shares and Class B shares could not be converted into one another (or diluted or manipulated in any way), it’s safe to assume that Class A shares would appreciate in value faster than Class B shares; this would be in accordance with the laws of supply and demand — If the net surplus demand for shares (driven primarily by buybacks) is the same for Class A shares as it is for Class B shares but the supply of Class A shares is lower (because fewer are being sold on the open market), then the price of Class A shares should go up faster! This also assumes that people who own Class A shares are more likely to sell their shares to other people who are in a similar financial position.

Why then is it the case that, in the real world, the difference in value between Class A shares and Class B shares is rarely very significant and doesn’t diverge much? There could be multiple explanations but underlying most of them is the false assumption (shared by the majority of modern investors) that the value of a share is based solely on:

• The percentage ownership of the company which the share represents; based on current income and expected future income for the shareholder over x number of years.
• Plus some premium to take into account voting rights (which can carry strategic benefits for activist investors).

What isn’t factored into the equation may be just as important:

• Investor peer demographics: The number and the kinds of people who own a particular class of share (the number of shareholders, their spending habits, the size of their incomes, their economic productivity and their level of commitment to the company/project).

At the end of the day, the shares of a company must help to support the lifestyles of its shareholders. If the shareholders do not have sufficient external income to sustain themselves, they will be forced to sell some of their shares; this will put down-pressure on the share price. If there are many shareholders with small incomes, they will collectively create more sell pressure and this will drive the share price down. Also, if the shareholders have overly expensive lifestyles, this can also create downward pressure on the price.

What happens in the real world to prevent share class price divergence is likely one or a combination of the following:

• Companies manipulate the company share structure (e.g. expand or dilute the quantity of certain classes of shares or execute buybacks unevenly) to ensure that shares within different classes maintain approximately the same relative price (company executives make judgement calls, possibly without regard for moral hazard).
• Arbitrageurs believe the mantra that Class A shares are worth the same as Class C shares plus a premium (they ignore the demographic factor); so when they perceive a gross imbalance in the prices of two different classes of shares, they sell their Class A shares to buy Class C shares (and this equalizes the price)…

Imagine if it was impossible for companies to artificially manipulate the structure and supply of shares to keep the prices of different share classes in sync? What would happen to the prices of different classes of shares? If we try to apply the dynamics of lost blockchain passphrases to shares: How would it affect the sell pressure (supply) of a particular class of shares if a big shareholder (who is also a big-spender and net-seller of shares) disappeared (or died) without leaving behind a succession plan (e.g. if the shares were locked forever)? How would that affect the price?

Once you can answer these questions, you may start to understand why blockchain is an ideal instrument to represent ownership. You might also better understand what role HODL and community demographics play in the cryptocurrency space and in the general economy. Community demographics cannot keep being ignored; the frugality and productivity of a community (your peer investors) matters and must be factored into the prices of all financial instruments.

Keep in mind that this dynamic also exists between shares of different companies — Looking at different share classes of the same company was done for illustrative purposes as it is the closest thing that we can get to a ‘twin study’.

It’s surprising that modern financial assets do not seem to take into account both underlying economic value and investor peer demographics when valuing assets… Currently, it seems to be one or the other; Bitcoin seems to be almost 100% about demographics (community HODL) while corporate stocks seem to be 100% about underlying economic value. Why is there such a bifurcation of investment strategies in the markets?

You may also want to take a look at this question on Quora about Alphabet (Google) shares (note that the difference in price between Alphabet Class A shares and Class C shares as of the date of this article is over 2.5% which is even greater than the question implies; this may suggest that they have further diverged since then):

Why is Alphabet Class C (GOOG) selling higher (approx $1.50, 0.11%) than Alphabet Class A (GOOGL) when the Class C doesn’t have voting rights but Class A does? https://www.quora.com/Why-is-Alphabet-Class-C-GOOG-selling-higher-approx-1-50-0-11-than-Alphabet-Class-A-GOOGL-when-the-Class-C-doesnt-have-voting-rights-but-Class-A-does

This seems like a possible explanation: https://seekingalpha.com/article/4423829-alphabet-is-discriminating-against-voting-shareholders-buyback

This divergence suggests that demographic-based investing may have already started to become a reality.

If you’re interested to learn more about this effect, you can try running a simulation I wrote which shows how a token buyback-and-burn scheme works in the long term (Node.js is required): https://gist.github.com/jondubois/910824286cc7d217fb0a70a23d0de3e8#file-leasehold-deflation-simulation-js

^ The initial state of the simulation is randomized each time you run it, so you can run it multiple times and change some of the values to see how they affect the final token market cap. An interesting one is USER_DAILY_SELL_PROBABILITY — A lower sell probability means that market participants are less likely to sell shares on any given day (which means lower overall sell pressure) — Try dividing USER_DAILY_SELL_PROBABILITY by 10 and see how it impacts the final token market cap — Also, if you run it multiple times, you may notice some interesting things about how the sell probability correlates to price volatility. Another interesting value is USER_SALE_QTY_DIVISOR—A higher value means that users will sell a lower volume of tokens on average.

* For more detailed info about Leasehold’s buyback and burn model, check out https://jonathangrosdubois.medium.com/how-leasehold-achieves-decentralization-8e311c6e55f