Practical Protocol Funding on Ethereum

Jonathan Tompkins

Decentralized protocols have many strengths

  1. Composability (money legos!)
  2. Ability to attract large amounts of liquidity
  3. Regulatory insulation for founding teams

To me it has looked like so far there has been a tradeoff between being able to launch a truly decentralized protocol and having financial upside for the launching team. I believe the main issue with this comes down 3 things which are not usually explicitly mentioned when discussing decentralized protocols.

  1. Need for seed capital to build & launch
  2. Desire for monetary upside by founders
  3. Desire for monetary upside by investors

Below is my proposal for a new model that can be deployed widely for large or small scale protocol development.

Options For Launch

Examples for how protocols have launched in the past.

ICO — Needs big $ to ensure compliance if its even possible. Big expectations on token accruing value.

Traditional Funding — Not much investor desire for small money fundraising. Large raises mean large expectation for return.

Grants — Great but is a very inconsistent method and the grantor may want some control over the project

Self Funded — Few founders can do this for an extended period of time

If the asset sold in the first two options is a governance token than there is a large expectation for that to accrue value and it is still unclear if pure governance tokens should or do accrue value in the long term. It has been made clear that they do not in the short term. I think the main job of governance tokens should be governance, not value accrual.

There are more complex systems like Maker that use the governance token to also align incentives and actions of participants. I think that makes sense for protocols that require active participation (like maker adjusting stability fee and DSR rate) but for more simple protocols where most proposals are for upgrades, or changes needed for new integrations there isnt a shared “goal” the protocol is trying to meet (like making 1 DAI = $1) that requires second level incentives.

Definitions

Terminology can get murky

Protocol — Maker is a Protocol, Compound is a Protocol, Uniswap is a Protocol, etc. Basically any smart contract based system that can run autonomously and facilitates value storage and transmission. For this post I am talking about protocols built on a base chain (Ethereum).

Application — uniswap.io is an application, app.compound.finance is an application, dharma is an application that uses compound protocol. There is generally an application launched on top of any protocol built by a team. Often the app idea comes first and then a protocol is built to make building the app possible.

Tools

I am not advocating for changing any existing or creating new components. The change is a matter of distribution and incentive alignment. This proposal would not have been possible without the countless experiments that have already been tried (with various levels of success). There are two common elements that I am advocating for continuing to use but in a different way.

Protocol Fee A % of value of transactions on or assets held by the protocol (dydx, uniswap v2). There was a time when any protocol fee was frowned upon but it seems like the attitude has shifted to appreciating the cost in time but also value (infrastructure costs, audit costs, etc.) associated with launching and maintaining a protocol (at least until it is ready to be handed off to decentralized management).

Governance Tokens — Required for voting on enacting proposed protocol changes (MKR, COMP). Governance tokens and DAO shares can really be used interchangeably but tokens are easier to manage if you are going to have a large number of holders/participants.

Below are the three main problems I see with the funding of new decentralized protocols and specific solutions to address each of them.

Problem — Founder & Investor Upside

It is beneficial for founders to take risks, thats how great things are created. Some will take the risk inherent in building a new protocol even without a monetary incentive. The reality is that there will be more experimentation if there is a path to similar startup-type upside building a protocol as there is starting a traditional company.

Solution — Founder Pool

A smart contract that receives a portion of the fees built into a protocol. The founders of the protocol are sole owners of the founders pool. They can issue new shares thus diluting themselves, sell their tokens, burn + redeem them, etc. Controls put around those decisions can be managed as strictly or loosely as needed. Founder tokens have no special voting rights, and they can be sold/minted to investors at founders discretion.

The size of the protocol fee and they % that flows to the founder pool is set at the outset of the protocol and can be managed by protocol governance (either from the outset or after time/milestone X) or locked forever (although this may incentivize forking if the founders stop bringing value).

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