Using Token Incentives to Beat the Chicken and Egg Problem

How Web3 platforms can use tokens to build positive network effects and get to critical mass without raising capital.

What came first, the chicken or the egg?

This is a question that has plagued both biologists and startup founders for centuries (okay, maybe not centuries for the founders).

An early business example of this problem was the advent of barcodes in the 1970s.

While an ingenious way of enforcing universal inventory control, barcodes without RF scanners have little value.

And as a retail proprietor in the 1970s, investing in expensive scanning technology when only a subset of products had barcodes didn’t make sense. In fact, in order for cost savings from better inventory management to kick in, retailers needed about 75% of their products to be tagged. It also didn’t make sense for manufacturers to tag their products if most retailers weren’t investing in RF scanners.

Chicken meet egg.

This problem forced Business Week to declare that it all amounted to The Supermarket Scanner That Failed in 1976.

By 1977, five years after the Radio Corporation of America (RCA) started testing the barcode in commercial settings, there were still only 200 grocery stores with RF scanners installed across the United States.

However, the few retailers that had adopted scanners increased sales by over 10%, decreased operating costs (and prices with it), and subsequently grew market share. This forced the market’s hand, and by 1980, 8,000 stores were converting per year.

It all started with what Andrew Chen (UBER’s former Head of Growth) calls an atomic network — a small, stable, engaged network that can self-sustain.

Once positive network effects kick in, and an inflection point is reached — such as a critical mass of users, networks can take on a life of their own. This was definitely the case with both eBay and Cragislist.

So what are network effects?

Network effects essentially exist where the greater the number of participants, the greater the value of the network.

The concept boils down to a simple formula proposed by the founder of Ethernet, Robert Metcalfe. He proposed that the value of a network is the square of the number of nodes, or V=n².

For a primer on the different types of network effects, check out this article.

Fast forward to today and myriad examples of the chicken and egg problem show up in popular parlance.

  • Ride-sharing apps need both riders and drivers to show up.
  • Social media networks need content creators and users.
  • Lodging marketplaces like Airbnb need hosts and guests.

But building both sides of the market in tandem can be incredibly difficult and perilous.

If I’m trying to use UBER to book a ride, but there are no cars about, then I’m going to be waiting a long time and the value proposition falls over. Ergo, I will call a cab.

If I’m using a new social media network but the quality and quantity of content is poor, or none of my friends are using it, I’m likely to bail.

If I’m booking a trip to Vegas, but there are only seven apartment listings on Airbnb, I’m probably going to head to a hotel booking site instead.

And on the flip side, if these apps are struggling to maintain a solid user or demand base, then I, as a supplier, have little incentive to keep using them.

So, which side comes first, and how do you keep them engaged?

Modern tech companies have used various techniques to overcome this problem. We won’t be covering all of them in this article, but here are a few.

Atomic Network

Starting with an atomic network, as mentioned above, is one.

This was true of both Facebook and Tinder which started on select college campuses, before expanding out.

Incentives and Bonuses

Others have essentially used handouts.

  • PayPal initially used a $20 sign-up and referral incentive.
  • Dropbox used 500mb free cloud storage referral incentives.
  • And UBER used, among other things, discounted rides and driver bonuses.
Dropbox’s early user incentives

But giving away cash, storage, and free rides is easier for the venture-backed company with a giant war chest at its disposal (UBER had raised over US$5 billion by January of 2015) than it is for the company that is bootstrapping or hasn’t raised all that much.

Building the Supply Side

Andrew Chen argues that we should solve the hard side first, which he conflates with the supply side (drivers, hosts, content creators, and attractive women on dating apps).

In my experience, this is not always the case.

Sometimes, it can be easy to build the supply side, especially if:

  • they are under-served by existing solutions, and
  • you can make it zero-cost and near zero-effort for them.

Back in 2013, I built a two-sided marketplace called Hotdesk, which billed itself as an ‘Airbnb for office space’.

My supply-side was offices with vacant desk space who were being underserved by existing solutions. This included privately held offices as well as public office spaces such as Servcorp and Regus (now IWG).

I made it easy and free for suppliers to list their space, and Hotdesk essentially became an additional distribution channel for them. By 2014, I had over 1,000 locations on the platform but did not have the demand to match it.

Here, the problem was cash.

I literally raised just $150,000, and had a limited war chest to invest in marketing and acquiring the demand side. Transactions were being made, but they were few and far between, and not enough to cover my meager $6,000 monthly burn rate. And two years into the journey, I decided against raising a larger round of funding because I came to the conclusion that I didn’t want to be a glorified real estate agent.

Multi-Tenanting

This supply-side phenomenon is apparent on freelancer marketplaces such as UpWork, and Fiverr, as well as job boards like Monster and Indeed. The same freelancers and jobs are on all of the platforms, because they have a need to fill, and the cost of listing is either free, or low, relative to the potential upside. They are multi-tenanting.

While some platforms have tried to design ‘lock in’ mechanisms so that their suppliers don’t multi-tenant, this rarely works well. Just look at all of those rideshare cars with Uber, Lyft, and Didi stickers on their windows.

Enter Token Incentives

With the advent of blockchain infrastructure, however, startup builders now have another tool at their disposal that can essentially mimic the effects of raising a big bag of capital.

I’m talking about token incentives — rewarding users with your product’s native token for taking carrying out desired behaviors.

The kicker is that these tokens can be minted for free, but can quickly become valuable either within the context of your local product (as a local currency), or in the public markets.

And these are already being used by a number of web3 platforms to overcome the chicken and egg problem, as we’ll now see.

Tokenized social media networks

The challenge with starting a social media network is that everybody is already using another platform. There’s little value in my using a platform with few quality content creators and none of my friends on it.

For example, I recently downloaded the Signal chat app — thinking it a more secure and superior alternative to Zuckerberg’s WhatsApp, but despite my nudges, few of my friends converted, and I quickly found myself back on WhatsApp and have since deleted Signal altogether

This speaks to the character of network effects products that have already hit ‘escape velocity’ — it’s hard to dethrone them, even with superior products. This was true of VHS cassette tapes in the 80s. Betamax was clearly a superior solution, but VHS had locked in network effects such as its widespread distribution at video rental stores.

Minds is a social media network — which has elements of both Twitter and Instagram, that is using tokens to incentivize and grow its user base.

Users earns MINDS tokens for contributing to the platform, and the more engaging their posts, the more MINDS token they receive. Not only that, but these tokens also form the platform’s native currency, and can be used to promote posts, and feed a flywheel of sorts. Post, earn, promote, earn, and so on and so forth.

Not a bad perk when you consider that you earn doughnuts for contributing content to Instagram, Facebook, or Twitter.

In addition, MINDS holders also earn rewards for holding their tokens (as opposed to selling them), and for being a liquidity provider.

In June of 2021, buoyed by its token rewards model, the platform boasted 14 million users, with almost 2 million monthly active users, and has continued to grow since.

Tokenized 2-sided marketplaces

OpenSea has become the defacto go-to marketplace for NFTs, capturing 60% of 2021’s US$20 billion in breakout NFT sales.

So for new entrants entering the space, it presents a daunting adversary, one that has well and truly hit the inflection point and locked in a critical mass of users.

Why would I sell my tokens on an alternative platform if all of the buyers are on OpenSea?

Sure, there’s the easy and free listing that I mentioned earlier. Perhaps the other platform is an additional distribution channel and it doesn’t hurt to list there, right?

But still, when it comes ot something like NFTs, you don’t want a few thousand on the platform — you want millions, and you want all of the latest collections to list on the platform too.

Enter token rewards.

LooksRare, a competing NFT marketplace executed a ‘vampire attack’, effectively airdropping 125 LOOKS tokens (US$600 value at the time) to OpenSea users that had spent more than 3 ETH on the platform (the transparent nature of the blockchain made it easy for the team at LooksRare to find the wallet IDs of such OpenSea users).

There was a catch though…in order to claim the airdrop, users had to list at least one NFT on LooksRare.

The stunt generated a TON of press, and within days, LooksRare was doing over $800 million in daily transactions.

The supply-side hack worked…for a while. But despite this initial flurry, LooksRare ceded market share, and today — albeit in the bear market — it is doing just three to five million dollars in transaction volume per day (OpenSea is doing about thirty million).

In many respects, LooksRare is superior to OpenSea. For starters, it is decentralized and truer to the ethos of web3 than OpenSea is. It has, subjectively, a slicker user interface. But as with my Hotdesk fumble, LooksRare has not done a great job at locking in the demand side.

Eventually, whether it's cash or token rewards, the value generated by the network needs to keep people coming back, otherwise they will take their free money and run. As Elon Musk put it, “as the (PayPal) network got bigger and bigger, the value of the network itself exceeded any sort of carrot (cash incentive) that we could offer”.

However, the counterfactual — LooksRare not using token rewards to grow its base — would probably see it doing a lot less volume than it is today. Three million dollars in trading volume per day with a 2% commission is still about $60,000 in daily, and $1.8 million in monthly revenue.

Tokenized Games

The team behind Slack learned a tough lesson when building their predecessor product, Glitch — an online multiplayer game.

They learned that multiplayer games aren’t much fun if nobody else is online.

Axie Infinity has arguably been, at least until recently, the poster child for the burgeoning play-to-earn (P2E) games movement, and it used token rewards as a key part of its go-to-market strategy.

It earmarked 20% of its total token supply for play-to-earn rewards, which at its peak token price of US$157, represented a value of US$8.5 billion. Not a bad war chest.

Axie Infinity’s tokenomics

At its peak last year, Axie Infinity had almost 3 million daily active users, and generated $1.3 billion in annual revenue.

As an aside, it has since fallen from grace due to both serious security exploits, and the cooling off in the crypto markets. Network effects are great, but they can also work in reverse if negative sentiment is high.

Final Thoughts

What I have offered here is a rudimentary introduction to network effects and how we might use tokens to get beyond the chicken and egg problem without needing to raise bags of money from venture capitalists (which incidentally, startups are finding more difficult in the current bear market).

Are you familiar with other case studies of products successfully leveraging token rewards to grow their user base, and get to something resembling escape velocity? Let me know in the comments!

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