How to make investment decisions based on FDV and token unlocking events?

Author: Cobie, a well-known Twitter KOL

Original Title: 《On the meme of market caps \& unlocks》

Translation: Gu Yu, Chain Catcher

Here are some thoughts on market caps, valuations, token economics, and unlocks. I've noticed that even many seasoned crypto participants still don't know how to use this data to make investment or trading decisions.

The market cap of a crypto asset is the price multiplied by the current circulating supply/token quantity.

FDV stands for "Fully Diluted Valuation," which is another valuation metric. FDV is the price multiplied by the total supply of tokens that will exist (for that asset).

Market cap is always less than or equal to FDV.

FDV is larger because the term "market cap" only accounts for the tokens that are currently buyable and sellable, ignoring certain locked tokens that are waiting to vest or unlock. These locked tokens typically come from a variety of different categories—they can be team tokens and investor tokens, which are relevant in the coming weeks to years, or they can be tokens from mining schedules that will be issued over the next 100 years.

Market Cap = Demand, FDV = ??

You can think of "market cap" as the total public demand. This will rise and shrink with price increases/decreases and changes in demand—but market cap is essentially the total dollar amount wanting to buy tokens at the current price.

Market cap is a measure of public buying demand, while FDV is not a measure of demand at all. Instead, it is a measure of supply. This is why fully diluted valuations can become confusing.

As demand for unlocked tokens increases and market cap rises, FDV increases proportionally, even if demand for those locked tokens does not necessarily increase. Therefore, even if these locked tokens might find willing sellers at much lower prices, FDV will increase market cap at a 1:1 ratio.

Scamnario

Imagine a scenario where a project raises $2.5 million from private investors at a $50 million valuation in January. Private investors can buy tokens at $0.01 each, but their tokens are locked for a year.

The project launches in February, and early users receive airdrops in March. This project is under the radar, with only a few people discovering it. Because it is still unknown, only $5 million of public buyers want to allocate to this new token. The token only reaches a $5 million market cap in March.

However, the airdrop only accounts for 1% of the total supply. The market cap is $5 million, and FDV is $5 million * 100 = $500 million (since the $5 million market cap represents 1%). The token price is now $0.10. The seed investors' returns have increased 10 times.

Now imagine that by May, this project has become the biggest hype project in existence. They are listed on all major exchanges. There are rumors of integrations with Apple, Disney, Oprah Winfrey, and God.

YouTubers are making videos about the project. Now more dollars want to allocate to this token, so they go to Binance to buy it. The public amount willing to allocate to this token has increased from $5 million to $100 million, a 20-fold increase.

No new tokens are unlocked because the team and seed tokens are locked for a year. The current market cap is $100 million. The price is $4. FDV is now $20 billion, and the seed investors' returns have grown 400 times.

Market demand increased by $95 million, leading to a $20 billion "valuation" increase. The $2.5 million invested in the seed round is now valued at $1 billion in market cap. The team's tokens are now "worth" $4 billion.

However, seed investors holding locked tokens are willing to sell to any buyer at a diluted valuation of up to $5 billion, which gives them a 100-fold profit. This means that even when their tokens are unlocked, they are still happy sellers, even if their price drops 75% from the current price.

The team is willing to sell tokens at any valuation above $1 billion to ensure they have enough long-term funding. Even after their tokens drop 95% post-unlock, they are still happy sellers.

Bullish Unlock Events?

So, if token unlocks increase supply but do not increase demand, how do bullish unlock events actually happen?

In reality, locked tokens can have their own active markets. Professional and seasoned investors use trust and legal guarantees to trade locked tokens. Essentially, they buy or sell locked tokens at a discount below market price and sign contractual obligations with counterparties to send these tokens when they unlock. Sometimes, these locked tokens even extend their lock-up period during OTC sales (especially if the team is the seller).

Imagine some initial seed investors selling their locked positions at a 10-fold profit to another VC, who then sells their position at a 5-fold price. Now the cost basis of the "unlocked" tokens is not far off from the current market price, and some market participants expect the holders' profits to be 100 times. Since some investors expect the unlock event to be bearish, but it is actually neutral, removing the bearish catalyst could lead to a net bullish event.

If the OTC market for locked tokens is very active, and less confident investors have sold to more confident investors, then the unlock event merely removes the "fear."

This is what happened with Solana, where locked SOL tokens were sold at a 66-80% discount before the unlock in December 2020. Holders of locked tokens were very concerned that the unlock would lead to a price drop, while more confident buyers purchased large amounts of these locked tokens. When the unlock occurred, these professional investors had a P/E ratio of 3-4 times, rather than a higher multiple.

Without an OTC market and without demand for locked tokens, the only way locked investors can realize profits is to dump them into an AMM or Binance at the time of unlock, which could be somewhat like a chicken game among seed investors.

I can imagine that 90-95% of unlock events in 2022 were bearish.

How to Identify if an Unlock is a Bullish Event

Typically, professional funds decide whether to buy locked tokens or public market tokens at a discounted price as a better risk-adjusted trade. Long-term investors often try to get in at the lowest possible price, so they don't mind buying locked tokens.

The main way to determine whether an unlock might be bullish is simply to assess "Is this project good?"—good criteria might include active users, TVL, or product-market fit.

If any token has institutional interest, it is likely that funds are trying to buy locked tokens (if available).

Long-term investors also tend to have more complex valuation models, so imagine they are more like "smart money." They try to buy at what they believe is the best valuation they can achieve over a 10-year timeframe, so if they think they can buy at a lower price in a few years, they might wait. They are less likely to buy at parabolic prices like retail investors.

This means that as prices move towards parabolic, the valuations of locked tokens and public market tokens diverge, as smart money is less likely to buy at inflated valuations, and holders of locked tokens become increasingly motivated to sell (and become happier due to larger discounts). In contrast, when the market grows organically and steadily over time, the cost basis of locked tokens is more likely to rise to approach public market valuations.

As the bull market generally enters its later stages, smart money may take risks and prefer liquidity, so this could also be a factor—unlocking in the later stages of a bull market is more likely to have not changed hands recently.

Unlock Timelines

Understanding unlock timelines and estimating the current cost basis of OTC tokens is also important.

Bitcoin currently has a market cap of $970 billion, with a fully diluted valuation of about $1.07 trillion. However, as part of the continuously decreasing block rewards, this additional $100 billion will unlock over the next 100 years. If you were to plot a chart of Bitcoin's "tokens" being "unlocked" throughout its historical mining process, it would look like this:

Bitcoin starts with a supply of 0, then increases by 50 tokens per block, approximately halving the reward every 4 years. This will continue until all 21 million tokens are mined.

On the other hand, projects that raise funds through private financing and issue tokens to investors after lock-up vesting may have a supply timeline that looks like this:

In this example, the token supply starts at 0 (perhaps they sell to the public or airdrop), and then internal tokens unlock in large batches each year.

There are many other possible examples with different inflation timelines; I have only used the two ends of the spectrum as examples.

The most common form of team or investor token vesting timelines I have seen is usually X years locked, Y years linear unlock, where 0.5 < x < 1 and 1 < y < 3. The great projects I have seen most commonly have a 1-year lock and a 2-year linear unlock. If founders are struggling to raise funds, they can make the vesting conditions more favorable (less lock-up/faster vesting).

Why is this important?

Throughout the duration of a trade or investment, being able to figure out any changes in supply and demand is very important. "Small cap gems" can quickly turn into large caps, and you don't know when their unlock timing is inappropriate.

But similarly, tokens with high FDV and upcoming catalysts can occasionally be good trades because locked tokens may temporarily exit the market, and other traders may be scared off by high FDV.

Understanding market cap and FDV is important, so you can also compare both with similar "peer" projects. It is important to try to obtain information about the cost basis of locked token holders or good estimates, as this can help inform whether there is additional bidding demand from professional investors or if there are many eager sellers at high profit multiples.

Every high FDV project's fully diluted valuation will eventually unlock—people should consider when and how this situation will occur. Sometimes, to maintain and prove that horizontal pricing is reasonable, projects must perform very well.

Conclusion

Crypto valuation models are difficult because the ceilings are very high, and the direct financialization of 24/7 liquid markets is a new way. Due to some anchoring effect, relative valuations can also be misleading.

Projects, investors, and founders seem motivated to maximize their fully diluted market cap by putting as much public market money into as little circulating supply as possible (thereby expanding private wealth). By doing so, a project can create significant paper profits for investors and the team.

Some projects will attempt to enforce price-agnostic demand through threshold mechanisms, such as "you must own it to participate," which can mostly be identified in gamefi but is common in cryptocurrencies. Typically, in these projects, the gap between public valuations and private valuations, as well as reality, is the largest.

If a project's "fully diluted" valuation exceeds some of the larger tech companies in the world, it may be worth considering: who holds such a massive new wealth, at what price did they acquire it, and to whom will they sell it?