Key Takeaways

1. In this paper, we propose a four-quadrant framework for governance token evaluation based on two spectrums: reliability of token holder rights and control over economic value.
2. We follow our proposed framework with sample case studies of tokens in each quadrant, before concluding with recommendations for builders and investors on structuring and evaluating governance tokens.

Disclaimer: The discussion contained herein is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained herein constitutes a solicitation, recommendation, or endorsement to buy or sell any token. Nothing herein constitutes professional and/or financial advice, nor a comprehensive or complete statement of the matters discussed or the law relating thereto. You alone assume the sole responsibility of evaluating the merits and risks associated with the use of any information or content herein before making any decisions based on such information or other content. Investors should be aware that investing in digital assets involves a high level of risk and should be undertaken only by individuals prepared to endure such risks. Any forward-looking statements made are based on certain assumptions and analyses based on historical trends, current conditions, and expected future developments, as well as other factors that are believed to be appropriate under the circumstances. Such statements are not guarantees of future performance and are subject to certain risks, uncertainties, and assumptions that are difficult to predict. Please see Disclaimers for more information.

Introduction

Governance tokens are typically defined as those that grant holders voting rights over certain project parameters, which may include implementing product updates, claims on fees/revenue, and business development decisions, among others. While they are often described as a distinct category by market participants, governance is more accurately a feature or property that any token can have. There are examples of governance tokens in every single crypto niche, from Layer 1s, to DeFi, to infrastructure, to gaming.

In this paper, we explore the utility of governance tokens and the instances in which they succeed or fail to unlock the value of their underlying projects. We start by introducing the role that governance tokens play in crypto, addressing common criticisms, and justifying their reasons for existence. This initial analysis illuminates two key traits that are desirable in a governance token: control over economic value and the reliability of that control.

We derive a framework from the key traits and apply it to case studies to illustrate the distinctions between projects that do and do not conform to our criteria. We then conclude with a summary of how projects and their prospective investors should think about governance token design and valuation.

Should Governance Tokens Exist in the First Place?

Exhibit 1: Performance of New Binance Token Listings Since November 2023

Source: @tradetheflow_, Outerlands Capital Research

Some market participants and builders argue that governance tokens have no reason to exist, or at least ought to be far lower in number than those existing today. This has been exacerbated by the relatively poor performance of newly launched venture-backed tokens1 which have launched at high valuations and struggled mightily against large caps and meme coins.

Common criticisms include:

1. Protocols would function just as well, if not better, without decentralized governance (and potentially without a token at all), which only adds inefficiency.
2. Many teams only launch tokens to realize a liquidity event long before they otherwise would with equity ownership and don’t have a real reason to create utility.
3. The utility offered by governance tokens is often not impactful for smaller investors, who lack the scale to meaningfully influence the strategic direction of projects they invest in.

Notably, it is not always random influencers making broad criticisms of governance tokens. Respected figures like Ethereum co-founder Vitalik Buterin2 and Flashbots Strategy lead Hasu3 have expressed doubt over their benefits.

Exhibit 2: Vitalik Buterin’s comments on governance tokens

Although there are some situations where the above are true, we think all are incorrect blanket statements. When properly structured, projects with governance tokens can retain the aspects of centralization that typically benefit startup businesses while unlocking additional value from decentralized governance. The team, for instance, can retain control over the strategic direction of the project and product development while offering control of other important parameters (such as protocol revenue distribution or approval of new upgrades) to governance token holders. Projects can also strategically utilize airdrops and other community distribution programs to get tokens into the hands of those aligned with the protocol’s long-term interests. We see two main avenues through which governance tokens can add value:

1. Governance tokens can help applications manage the risk inherent in their business models. Critically, they do it better than a tokenless governance system can, as they provide an incentive to do so. As an example, governance tokens can help mitigate vulnerabilities from centralized attack vectors within the protocol. Although Layer-2 networks like Optimism and Arbitrum are continually developing their technology, they already, collectively, house billions of dollars of TVL on-chain. It would present a significant risk to the network if a centralized party like Offchain Labs (Arbitrum’s development company) could upgrade contracts or modify system parameters on a whim. Namely, funds could be stolen if certain contracts receive a sudden and malicious code upgrade. However, the technology remains in development, and it will need upgrades to remain competitive. By delegating these decisions to a decentralized governance process, the projects become more resilient, as there is no single entity that a malicious actor can target.
2. Governance tokens can offer utility to their holders in the form of tangible economic value. One use case is GMX⁴, a crypto derivatives platform that pays a percentage of platform trading fees to those who buy and stake its token. Many centralized exchanges also offer trading fee discounts to their token holders. Tokens can offer similar utility for other projects, providing economic benefits in exchange for funding development or aligning incentives.

There are a multitude of governance tokens that fulfill at least one of the above criteria, and we are optimistic that more will do so over time.

The Outerlands Capital Governance Token Evaluation Framework

We view governance tokens on a four-quadrant spectrum. The Y-axis indicates reliability, defined as the strength of the rights given to token holders. Tokens with strong reliability define clear rights for holders that cannot be easily changed, giving them more certainty over their control of the given parameters. Meanwhile, tokens with weak reliability give holders voting power only nominally, with significant uncertainty over whether holder rights will be respected by the team or protocol. Chris Dixon makes a similar point in Read Write Own, highlighting the importance of a protocol’s ability to make strong commitments5. The X-axis indicates control, defined as the economic value or other utilities commanded by token holders. Tokens with strong control give ecosystem participants (users, investors, etc) many reasons to own them, while tokens with weak control offer little incentive to do so.

Exhibit 3: Four-Quadrant Spectrum of Token Governance

Source: Outerlands Capital Research

Properties of Tokens with Strong Reliability

Below are properties that Outerlands Capital looks for in tokens with strong reliability:

1. A strong constitution that aligns with the core ethos of the project’s model.
   1. Changes to the constitution should have a higher bar than other governance votes (for instance, a 2/3 supermajority and a 10% quorum).
2. A fully fleshed out governance process, including:
   1. Multiple tracks for proposals that balance efficiency and democracy, depending on urgency and importance:
      1. Everyday business functions (grants, payroll, etc) should either be controlled directly by the team or run by specific subcommittees with the latitude to make decisions faster than standard governance would allow. Token holders should still have transparency into these functions and the option to object if they desire.
      2. Critical decisions, such as major tech deployments, treasury investments over a certain dollar value, or risk management functions deserve multiple stages of discussion over a longer (1+ week) timeframe.
   2. A dedicated forum and voting platform that is easy for token holders to access and interact with.
   3. Ability for token holders to delegate their governance power to knowledgeable/aligned parties.
   4. A democratically elected emergency DAO/security council so that critical events like hacks can be responded to. The DAO should be able to modify or remove this council.
   5. On-chain execution/enforcement for important decisions (so that token holders do not need to trust the team to honor the results of a vote). This must be heavily audited and structured properly to avoid governance attacks, and on-chain execution should include reasonable time locks.
3. A foundation or other legal entity that represents the DAO in the real world, when possible (this may not make sense for fully anonymous teams). This limits legal liability for governance participants and makes it easier for others to do business with the DAO (since they can interact with a more traditional corporate structure).
4. Strongly enforced control over any specific utilities promised to token holders, such as revenue distribution or regular token buybacks. Ideally, this is accomplished directly at the protocol level or through smart contracts (for the strongest commitments), but legal protections are also an option.

Properties of Tokens with Strong Control

Broadly speaking, a token with strong control gives holders power over significant economic parameters. The most obvious mechanisms for investors to look for are those with parallels to traditional equity ownership. A project that distributes revenue to holders (and where holders have governance power over how distribution works) or buys back its tokens on the open market can be easily evaluated based on its cash flow. As the underlying business grows, the token shares in its success, meaning an investment in the token is an easy way to bet on the business. Investors can use traditional metrics such as a discounted cash flow analysis or relative valuation based on revenue/profitability multiples here.

However, there are several important control factors beyond equity-like value capture that could incentivize holding a token. These include:

1. Other forms of economic utility, including protocol fee discounts or preferential access to products for those that hold a certain amount of tokens.
2. Control over technological upgrades and deployments of new protocol versions, which may affect the economic interests of stakeholders.
3. Control over changes related to tokenomics, including inflation/deflation and distribution, which may affect the voting power of existing token holders.
4. Influence over business development decisions that may affect the financial success of a protocol, such as team salaries, partnerships, incentive programs, payments to third parties like exchanges and market makers, and more.

Evaluation Framework Case Studies⁷

The following case studies illustrate tokens on each corner of the spectrum where governance can enhance and/or detract from the fundamental value of a project.

Strong Control, Strong Reliability: dYdX

The decentralized derivatives exchange dYdX (Token: DYDX) is an example of a project in the strong control, strong reliability quadrant. Founded in 2017, dYdX offers perpetuals trading for 66 pairs (as of June 2024). In November 2023, dYdX upgraded to v4 of its exchange software, which included migrating to its own Cosmos appchain and significantly improving the tokenomics through changes to the governance process, token utility, and where revenues accrue, among other changes.

Today, the DYDX token offers the following control mechanisms8:

1. DYDX is the staking token of the appchain, meaning that stakers earn a yield generated through transaction fees as compensation for securing the network. As is true of most PoS blockchains, DYDX stakers earn fees proportional to their amount staked vs others, creating a linear relationship between yield earned and tokens purchased. Token holders who don’t wish to stake can delegate their DYDX to others in exchange for a small piece of the yield earned. At current activity levels, the chain generates annualized fees upwards of $43mm for validators⁹.
2. DYDX holders have the right to introduce and vote on proposals, directly influencing the direction of dYdX Chain’s development. Recent proposals have included the onboarding of new perpetuals markets, trading incentive programs, funding for the dYdX Foundation, and technological upgrades.

With the above upgrades in place, the DYDX token offers stakeholders many benefits, including access to and control over protocol revenue through governance, as well as significant influence over future project development.

On the reliability side, the new token is also critical to the project in multiple ways. Beyond its technology, one of the core reasons the dYdX team cited for its move to Cosmos from an Ethereum-based rollup was its superior decentralization10, which is enabled by a distributed PoS validator set. This not only reduced the regulatory risk from running a centralized sequencer but also made it possible to distribute revenue to token holders directly through the protocol (in the form of staking yield), a strong commitment that will be difficult to turn back compared to a revenue share system run by the team. The same holds for other proposals outlined in the third bullet point above, all of which are executed on-chain following a successful vote.

Weak Control, Strong Reliability: Ethereum Name Service

An example of a project in the weak control, strong reliability quadrant is the Ethereum Name Service (ENS), a decentralized naming service for crypto wallets, websites, and operations.

On the surface, ENS is one of the more successful projects in crypto, having generated $16.57mm in revenue over the past year (as of May 2024), putting it inside the top 25 projects by revenue, as tracked by Token Terminal11. Despite this, the ENS token trades well outside the top 100 by market cap (although only ~31.5% of the supply is circulating12). This outcome is largely due to the DAO’s stated mission in its constitution, which stipulates (among other things), that:

1. Fees are an incentive mechanism to prevent large-scale squatting on domain names and to fund DAO operations. Excess profit generation is not a priority. The average ENS name costs $5/year to renew¹³, less than half of what the most popular Web2 providers charge. ENS could likely double fees and experience a minimal loss in demand.
2. Income accrued by the ENS treasury should fund the development of the ENS ecosystem and ensure its long-term viability. Any excess income should fund other public goods within the Web3 ecosystem.

This is not an explicit critique of the way ENS Labs (the non-profit responsible for core software development) codified the constitution before turning it over to the DAO. They have several qualities necessary for strong reliability, including vote delegation, on-chain execution, and different proposal tracks. A Cayman Islands foundation represents the DAO in the real world, providing limited liability to participants (addressing the legitimate legal concerns brought up by the OokiDAO case14). If other projects wish to run themselves in a not-for-profit style, ENS is an excellent model to emulate.

However, its public good-aligned ethos limits the potential control that token holders have over the project. Due to the low possibility that ENS will increase future fees or distribute revenue, the token does not have broad appeal to investors and lacks a compelling upside story. Even if domain name sales increase significantly, token holders should not expect to receive a share of those fees. The ENS constitution is structured to make it a difficult target for activist investors. Because of this, only a few groups of participants are interested in purchasing the governance token, including:

1. Those with an altruistic interest in contributing to the DAO. These people may also be more likely to become delegates rather than amass large amounts of the token supply for themselves.
2. Projects that seek to partner with ENS, which must acquire or be delegated at least 100k (~$2mm at current prices) tokens to create a proposal.
3. Existing projects integrated with ENS that are interested in keeping the protocol as free public infrastructure.

While not driving zero demand, these groups alone do not combine to form the robust economic flywheel that dYdX has, for example.

Strong Control, Weak Reliability: Hector Network

A project in the strong control, weak reliability quadrant is Hector Network, one of the many forks of Olympus DAO, a project that rose to prominence in 2021 by claiming15 to be the future reserve currency of DeFi.

Originally a copy of Olympus DAO on the Fantom blockchain, Hector evolved into an on-chain asset manager over time. New investors could deposit money into its treasury and receive new tokens through a rebase mechanism16 while existing stakers maintain the value of their current claims. The team could then use the treasury to build new projects and invest in assets to generate returns. Meanwhile, token holders were granted control over significant protocol parameters, including treasury investment decisions17, helping the token rank highly on the control portion of our framework.

The Hector Network team attempted to drive value to the treasury, building several DeFi-focused products. However, these failed to pan out due to poor execution18 and market declines in 2022. Community members became increasingly upset with the team, which despite its failed roadmap, paid themselves generous salaries (reportedly $52mm over 18 months19).

When token holders clamored to exercise their governance rights over the remaining treasury funds, the Hector Network team began censoring20 individuals in the project Discord and imposing governance restrictions. The lack of legal or smart contract-enforced protections for HEC holders enabled them to do this. By the time the team was finally convinced to propose21 a treasury liquidation, only ~$16mm remained, and the HEC token had lost 99% of its value from all-time highs.

Stronger governance protections for HEC holders might have pushed the project in a different direction. Implementing protections inspired by traditional equity investment vehicles would have been a strong start. Certain redemption periods (i.e., a contract opens for a week once per quarter), regular return distributions, and/or smart contract-based lockups upon investment could have enabled HEC token holders to exit their investment at par value before the treasury declined as much as it did. Many were sounding the alarm months before the DAO finally dissolved but were unable to do anything about it with the poor reliability of their governance power.

Weak Control, Weak Reliability: Aragon²²

In some cases, governance tokens fail to offer control over the underlying project and are unreliable in protecting the rights they grant. A pertinent example of a project in this quadrant is Aragon: a project that provides legal, technical, and financial infrastructure for DAOs to run their operations. Several major crypto projects, including Lido, Decentraland, and API3, have used its services.

While the team explored multiple use cases for ANT early on23, the group pivoted to using ANT as a general governance token after its previous ideas failed to gain traction. Unfortunately, the vague governance power described did not offer much control to holders, as evidenced by its lack of meaningful proposals and sparse community activity24.

In June 2022, this changed somewhat when the Aragon Association and its community passed a proposal25 that would transfer the treasury to a DAO governed by token holders, with a proposed date of November 2022, although this was continuously delayed until May 2023, when the first transfer finally occurred. At this time, the treasury was worth roughly $200mm26 in total, and ANT was trading at a discount due to the delays and holder frustration.

Declining faith in the team attracted the interest of activist investors, including Arca (a crypto hedge fund), who began purchasing tokens at a discount to the treasury to push for a faster DAO control transition, greater transparency, and token buybacks using treasury funds to return ANT to book value27.

However, rather than let token holders exercise their supposed governance rights over the treasury, the Aragon Association paused transfers of the remaining funds, banned members from the project Discord, and accused28 the activist investors of coordinating a 51% attack, claiming that holders only had governance power over on-chain products and protocols built by Aragon.

Six months of turmoil ensued, during which the status of Aragon was in doubt, until November 2nd, 2023 when the Aragon Association internally decided to dissolve29 and distribute treasury funds to token holders. The team did not allow ANT holders to vote on the plan for supposed legal reasons, despite their previous involvement in the treasury transfer. Predictably, many terms were interpreted as unfair by token holders and skewed in favor of the team, which has led to continued legal battles30.

A governance structure that granted holders greater control and reliability from the start could have helped mitigate much of this pain, possibly by giving holders the power to dissolve the token long before it reached this point or correctly designing it in a way similar to ENS. In the next section, we provide suggestions on how project founders and investors can avoid negative control and reliability situations in governance.

Considerations for Builders and Investors

Our governance token framework and accompanying case studies outline what we think are the general qualities of a strong governance token. However, every token is unique, which means the specific functions and parameters of governance should vary depending on the project.

It is, however, universally important that builders create a roadmap that makes steady progress toward a defined end-state. This means that if a project team decides to integrate decentralized governance, they should strive to make token holder rights robust and clear, ideally protected by strong commitments, such as legal or smart contract-based mechanisms. Offering holders vague governance rights that are later walked back is far worse than waiting until the right time to decentralize decision-making.

Builders should also determine whether it makes sense to have a governance token in the first place before issuing one. Recalling an earlier section, governance tokens can add value through managing risk and acting as a form of equity. On risk management, projects must decide whether certain decisions would be better left to a decentralized group of token holders versus a smaller, centralized team. Then, they can design a governance token that gives holders power over those parameters.

If a governance token is not in the team’s interest, utility could still be offered if there are other forms of risk to be managed. Chainlink’s LINK token, for example, confers no governance power but has a staking feature designed to improve network security. LINK is also a critical resource for bootstrapping Chainlink’s oracle ecosystem and as payment for services.

If there is no risk for token holders to manage, the crypto equity route is still an option depending on jurisdiction and the team’s willingness to navigate regulatory challenges. Investors, however, should be given a clear idea of what they’re getting (control over a portion of fees, ability to institute a buyback, etc) if they choose to invest in a new governance token.

In relation to control, not all projects may wish to design their token for profit-driven investors. This may be due to an uncertain regulatory environment, a desire for public goods alignment (also seen in equities through not-for-profits and public benefit corporations), or something else. Many of these reasons are valid despite detracting from the investment value of a token. Projects going down this path should set expectations accordingly so that investors know what they’re getting into.

Conclusion

The problem of design and implementation of crypto governance is far from solved, but many tokens with governance features today offer a clear value-add to the project they represent. Encouragingly, there are also signs that the market is beginning to price governance tokens more efficiently, with many of the worst offenders (including a few highlighted in the piece) being forced to shut down or remedy their failures.

The goal of our governance token evaluation framework is to further this trend by providing builders and investors with a lens on how to structure their token design and investments, ultimately leading to greater value flows to projects that establish defined token holder rights (control) and actively protect them (reliability).

As a final point, we stress that whether a crypto project is brand-new or established, it is not too late for them to identify shortcomings and make a change. The industry remains young enough that a transition from weak to strong can happen in a short period, especially with the help of a framework like the one outlined in this piece.

Footnotes and Sources

1. Flow (@tradetheflow). May 17, 2024.[ X.com](https://x.com/tradetheflow/status/1791382917731762611)
2. Vitalik Buterin (@VitalikButerin). Nov 29, 2022. X.com
3. Hasu (@hasufl). May 23, 2022. X.com
4. Provided for illustrative purposes only and should not be construed as a recommendation to invest in any token.
5. Dixon, Chris. 2020. “Computers That Can Make Commitments.” Cdixon.org. January 26, 2020. https://cdixon.org/2020/01/26/computers-that-can-make-commitments.
6. On-chain execution refers to a process where the relevant smart contract upgrade is deployed on-chain automatically after a vote. Time-locks refer to a short delay period (often a day to a week) where holders who do not agree with the proposed changes are given a chance to exit the system as-is.
7. Case studies are provided for illustrative purposes only and should not be construed as a recommendation to invest or sell any token.
8. Per project documentation
9. See DeFiLlama.com
10. dYdX. 2023. “What Is Cosmos?” DYdX.exchange. June 28, 2023. https://dydx.exchange/crypto-learning/what-is-cosmos.
11. See tokenterminal.com
12. See CoinGecko.com
13. Per project documentation
14. Katten Muchin Rosenman LLP. 2022. “Holders of DAO Governance Tokens Beware: According to the CFTC, Voting May Be Hazardous to Your Well-Being.” Katten.com. September 29, 2022. https://katten.com/holders-of-dao-governance-tokens-beware-according-to-the-cftc-voting-may-be-hazardous-to-your-wellbeing#.
15. Per project documentation
16. A rebase mechanism refers to a smart contract-powered price stability mechanism that automatically adjusts the token’s supply at regular intervals in response to changes in demand. In the case of projects like Hector, new supply would automatically be distributed to stakers at 8-hour intervals.
17. Captured on Internet Archive, since deleted
18. Nelson, Danny. 2023. “Hector Network Votes to Liquidate $16M Treasury Following Multichain, Fantom Losses.” www.coindesk.com. July 17, 2023. https://www.coindesk.com/business/2023/07/17/hector-network-votes-to-liquidate-16m-treasury-following-multichain-fantom-losses/.
19. Avan-Nomayo, Osato. 2023. “Investors Rip Hector Network Team after It Squanders $100m Treasury and ‘Rage Quits’ DeFi Project.” DL News. July 18, 2023. https://www.dlnews.com/articles/defi/hector-network-dao-rage-quits-after-draining-100m-treasury/.
20. Community update captured on@Hector_Network/community-update-addressing-recent-security-incidents-at-hector-network-2fcf4d5c12a2"> Internet Archive, since deleted
21. See proposal “HIP 42: Redemption of the $HEC” on snapshot.org
22. Case studies are provided for illustrative purposes only and should not be construed as a recommendation to invest or sell any token.
23. Per project documentation
24. Per project documentation
25. See proposal “Token proposal” on voice.aragon.org
26. See “Aragon Network Treasury - by Asset Exposure” dashboard on lookerstudio.google.com
27. See “Aragon Open Letter” published by Arca Investments.pdf)
28. See footnote 27
29. The Aragon Association. 2023. “A New Chapter for the Aragon Project.” Aragon’s Blog. November 2, 2023. https://blog.aragon.org/a-new-chapter-for-the-aragon-project/.
30. Reguerra, Ezra. 2023. “Aragon DAO Votes to Fund Legal Action against Its Founders.” CoinTelegraph. November 21, 2023. https://cointelegraph.com/news/aragon-dao-lawsuit-founders-patagon-management.

Disclaimers

The information in this presentation was prepared by Outerlands Capital and is believed by Outerlands Capital to be reliable and has been obtained from public sources believed to be reliable. Outerlands Capital makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this presentation constitute the current judgment of Outerlands Capital and are subject to change without notice. Any projections, forecasts and estimates contained in this presentation are necessarily speculative in nature and are based upon certain assumptions. It can be expected that some or all of such assumptions will not materialize or will vary significantly from actual results. Accordingly, any projections are only estimates and actual results will differ and may vary substantially from the projections or estimates shown. This presentation is not intended as a recommendation to purchase or sell any commodity or security. Outerlands Capital has no obligation to update, modify or amend this presentation or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, project on, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

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