Incentive Compensation, Bitcoin and Beyond: same as always, just warp speed

If you tear a bank note into two and hand the other half to someone else, you have a transaction. Each half validates the other, and the whole banknote represents a promise to pay a specified sum. Nobody has any value until those two halves come back together again. Bitcoin is like that, but what Satoshi Nakamoto started on the 3^rd January 2009 when he mined the genesis block will eventually transform the way we all conduct transactions. This is not just for nerds, so please read on.

For the uninitiated, which is most of us, the only way to understand Bitcoins, Block Chains, Ethereum, DeFi, Tokenisation and so forth is to use ‘old world’ analogies, and that’s what we will do here. Our purpose is to illustrate how emerging trends in the ‘crypto’ world have roots in old fashioned business practices, just like e-mail could be explained using ‘snail mail’ by way of example, and use of analogous language: “addresses”, “posting”, “tracking” and so forth. A glossary of terms relevant to the crypto-asset industry is attached, and hopefully that will answer most of your questions.

It is true that bitcoin can be mined out of thin air but there is a protocol (a peer-to-peer network) and a public transaction ledger (‘the blockchain’) which limits the total bitcoin in the world to just under 21 million in number. Most have already been created - the final coin will be “mined” by around the year 2140, according to estimates. The whole thing is far more regulated than you might have imagined, with ‘consensus rules’ and ‘proof of work algorithms’; it’s just decentralised (rather as Alcoholics Anonymous is an astonishingly successful institution, without having any centralised organisation).

Before contrasting crypto companies to their traditional counterparts, let’s consider how bitcoin ‘digitalises’ asset classes we are used to:

Stocks, Bonds and Real Estate (Capital Assets) have a source of value which provides a stream of monetary reward. The ‘value’ is the future discounted back to today.

Oil, Wheat, Cattle (Consumable Assets) have economic value and can be consumed directly or transformed into other assets (plastic, cereal, leather), but do not yield an ongoing stream of value.

Art, Collectibles, Gold (Store of Value Assets) cannot be consumed or valued through discounted cash flow, but are generally not expected to deteriorate, may even appreciate.

Bitcoin is potentially applicable to any of these asset classes, and the debate over its status as an asset class is not settled (neither by regulatory bodies nor by convention). But it is most commonly seen as a digital “store of value” asset, a durable, non-consumable, zero cash flow, low correlation alternative to traditional assets.

The Bitcoin network was a trailblazer and - by design - inherently limited. However, its limitations created problems which inevitably led many players to attempt new approaches. Ethereum (a ‘second generation’ approach to Cryptographically Secured peer-to-peer networks) was created, and later many others. These new generation networks, with their almost exponentially increased functionality, created an expansive frontier into which legions of developers and entrepreneurs have flooded, establishing the foundation for new economic sectors, new political and legal frameworks, a trusted digital identity and much more.

In this way bitcoin (the asset) and Bitcoin (the network) laid the foundation for a vast multiplication and amplification of fast-growing companies working within and around the Web3 (see Glossary below) and crypto-assets sector.

If we’ve lost you already, don’t worry. Please remember this point: digital assets are here to stay, and they will increasingly stabilise. So, get used to that fact, and come back to this page later once you have renewed energy!

Not surprisingly, our work in the area of remuneration and incentive design has therefore grown at a rapid rate. The purpose of this article is to look at the implications for the digital world of incentive compensation design: how do you design rewards in this rapidly emerging world?

It is a question of enormous importance because just as we once had a world filled with small merchant banks that each had a role in the financial world, and then they merged into the financial machine we call ‘Wall Street or The City’, so we now have a rapidly flowering world of crypto ‘players’ – companies that offer much that used to be thought of as ‘banking’, but in a digitally transformed way. These companies, just as in the City or Wall Street, are struggling to manage the resources they need: their talented, footloose, constantly disruptive, creative workforce. The winners will digest the losers, and so we have a race on our hands.

Comparing Old Fashioned Incentives with their Crypto Equivalents:

Shareholders of large financial institutions in the 80s and 90s would have felt very much like the shareholders of companies in this new digital business world. The opportunity for cross-fertilisation of creative ideas is dazzling, it's just that - for those less familiar with some of the technology - the story may be the same, but it is just happening incredibly fast.

For example, over the last four years a bitcoin’s value rose from $10,000 to a high of nearly $65,000 then fell back to $19,164[1] very recently. The challenge for those responsible for finding and keeping talent is to create an incentive structure that aligns individuals with their business priorities, as well as the strategy of investors seeking shareholder value creation.

Let’s consider how an old-fashioned financial services company with investment banking, asset management and wealth management divisions would incentivise their people, and why, and then compare that to the new digital world.

Investment banking: the goal is to create value through transactions, deal management, funding tactics. This division hires people who are experienced in a range of business situations and who have a wide range of skills: accounting, finance, strategy, comfort around 'owners'.

Success is measured in fees, and spreads over lending.

Incentives are largely designed with the following in mind:

• Higher salaries for more experienced ‘talent’ - these are ‘stars’ who attract clients
• Significant variable cash-based, short-term compensation - this is a cyclical business and it is expected that bonus pay-outs will ebb and flow with the economic tides
• Limited participation in long-term incentives, which are used to retain key individuals - far more weight is placed upon short-term cash (even deferred cash) pay

Although there are companies operating in the crypto market in similar ways to, let’s say, traditional Venture Capital (cataloguing good projects, investing early), the difference is the level of maturity. In the digital world, there is a need to “move fast and break things” such that risks are higher. If we look at the typical funding cycle [pre-seed, seed, then Series A, B, C] where pre-seed is often barely an idea with funds raised from close friends, seed is testing viability with the barest initial competitor analysis and the beginnings of pitch decks and series A is where the product is validated, growing but ‘early stage’, crypto projects often never make it past the first two rounds. Very few reach maturity, and few companies have fully validated business models.

What also makes investing in Crypto Businesses - and specifically crypto-currencies - different is that they often raise money through issuing new crypto-assets or tokens rather than via sale of equity. The offer of Tokens for the earliest investors means early cash out and exceptional returns when it goes well, but such ‘token sales’ and ICO’s (Initial Coin Offerings’) often do not ‘go well’.

So, incentives are largely going to be designed for crypto business in the same way as our ‘old-fashioned-financial services firm’, but with these differences:

• There may be the promise of higher salaries for more experienced ‘talent’, but cash is often in very short supply, so base pay is kept at lowest levels possible
• In the end variable rewards have to be very short-term in nature and cash-based
• There is significant scepticism about participation in long-term incentives

For those who might be regarded as ‘Founders’ (a term that is used far more widely in crypto than in almost any other sector, financial or otherwise) rewards may be in ‘native coin’[2], sometimes with vesting schedules attached. While it would appear to be the obvious ‘alignment’ of management with stakeholders, the realities are problematic. To begin with, the release of vested tranches onto the open market creates market volatility. But the main issue is that expending huge effort on a complex project may only leave you with a worthless bag of tokens if a market slump coincides with vesting. No wonder there is resistance to the concept of long term incentivisation!

Asset management: Success is measured in an objective manner, relative to the performance of others: higher growth, higher returns. This division hires people who are fund managers, investment professionals.

Incentives are largely designed with the following in mind:

• Modest salaries, market-based
• Capped bonus, linked to Key Performance Indicators
• Significant (particularly in the case of senior individuals) long-term incentives

The ability to buy and sell crypto assets has never been easier, so Asset Managers offer products with blended complex returns to add value. These are managed in much the same way as a classical investment portfolio offering lower risk.

Crypto is only different from traditional asset management in that it includes assets where the value has been transferred to the blockchain. The process is similar to managing any other asset class (managers track, buy and sell assets to generate returns) but - given the liquidity crunch in crypto - asset managers must find new ways to offer returns to investors, such as lending stable coins.

Bitwise, for example, offers multiple index funds consisting of different layers of token and crypto-asset, as well as blended index funds. Their fees are based on the scale of Assets under Management (‘AuM’).

Wealth Management: Clients are wealthy individuals, clients of the company, who have many types of assets.

Success is measured in fees, client quantity and quality. This division hires people who can get along, personally, with such clients, help them build their investment portfolio and consider new, innovative ideas.

Incentives are largely designed with the following in mind:

• High ‘headline’ market-based salaries for ‘known players’
• Uncapped bonus linked directly to selling
• Some long-term incentives, largely tenure based

The “Innovative Idea” here is merely investing in digital assets in the first place. Family Offices (the epicentre of a multi-generational wealth creation project) typically respond to two types of client; the ones that lack understanding, but have a significant amount of FOMO (fear of missing out) and the ones that have more understanding and are going out on their own (without an advisor). Many family office managers don’t have the access, knowledge or the tools to include digital assets as part of a client’s portfolio. Therefore, their clients don’t have any other choice but to invest in crypto or other digital assets on their own terms. This is beginning to change. There are also new companies offering wealth management advice in a specific Crypto focussed way.

Conclusion

In the same way that the relatively slow-moving, under-invested, union-dominated, grim ‘70s gave way to an investment banking ‘Big Bang’ in the City of London during the 80s, we are under-going a profound digital transformation today. The laptop-focused executive working from a home office, receiving home food deliveries, conducting business over video links and tearing up that precious airline ‘gold card’ is not going away. It is a permanent change, and it brings both good and bad. Less contact with colleagues, but more free time. Lower costs of shopping, lower emissions, but new suppliers expecting a minimum of digital capability.

Digital currency, and digital transactions are part of this shift. It may be volatile, but it is permanent. It is not simply a Dutch Tulip market on steroids.

The power of incentives in any business is a fact of life. An Ugly Truth, as it were. People do what they are paid to achieve, so it makes sense to line up incentives towards a few goals that make the difference. Rather as traditional car manufacturers can make e-cars, traditional incentives can be adapted in the same way.