Product Profitability Model v1

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Title: Product Profitability Model v1

Authors: @PrairieFI, @JosephKnecht, @Cavalier_Eth

Abstract:

Index Coop is seeing an increase in potential product launches and we believe it would be helpful to provide a standardized tool for evaluating the potential profitability of each product. The benefits of this tool include:

  • Ensure that each product has transparent modeled inputs, considering costs such as rebalancing or the opportunity cost for the Coop to provide initial liquidity.
  • Help Methodologists evaluate the effect of certain parameters, such as rebalancing size, on profitability.
  • Educate the broader community on IC’s business model at the product level.
  • After a product launch, provide benchmarking opportunities to see where actual results vary to assumptions to continue to improve the evaluation process.

We are not suggesting anyone is required to use the tool. Rather, we hope it will be a useful aid.

Background:

@JosephKnecht prompted this discussion by seeking a way to evaluate the NFT Blue-Chip Index (JPG) and created the initial model. After further discussion and generalizing the inputs for broader use, we believe it is appropriate to bring the tool to the community for consideration for feedback, improvements, and general sentiment check.

Motivation:

We are seeking community feedback on the proposed use of this calculator to evaluate Index product launches.

The calculator includes a forecast of revenue and expenses by month, as well as a trad-fi approach to discounted cash flows to evaluate the Internal Rate of Return (IRR) and the Net Present Value (NPV) of the project over various horizons, with the latter measure dependent upon the Required Rate of Return input.

While it is challenging to estimate 3 months of crypto, much less several years, this approach could provide a framework for consistently evaluating projects. If, for example, the Coop is resource constrained with respect to Engineering or capital to fund the initial liquidity to launch two new products, this process could help prioritize or determine how much one or more variables would need to change in order to launch both products.

Link to file

Calculator Inputs:

  • Starting Net Asset Value: the expected size of the product at launch, as the primary driver for the revenue and the base on which growth assumptions are applied
  • Index Coop Funding: affects the IRR and NPV, and becomes increasingly important if we are capital constrained
  • Start-up and Issuance Costs: affects early net income
  • Rebalancing Costs: affects net income in perpetuity (not designed to change through time, though could be changed if there is a good suggestion)
  • Rebalancing Cost split between Coop and Methodologist
  • Streaming Fees and Fee Split between Coop and Methodologist
  • Other expenses, including liquidity mining and/or market maker
  • Minting growth rates (staged, with different growth rates applied at different points)
  • Token price growth rates (also staged)
  • Required return rate

To be clear, the variables supplied shown in the current model are not meant to be interpreted as proposals. Further, we are not proposing a rigid financial prioritization of products. Rather, we hope it will be a useful tool for evaluating product profitability, profit optimization, and broader education.

We’re mindful there are many factors missing from the model. This is very much a work in progress. If you feel there are any important factors missing from the model, please feel free to add those to the To Do sheet.

Sentiment Check:

I think this is worth pursuing if we can use to develop high level guard rails of what is required to be successful, i.e. “with $X AUM starting, keeping rebalance costs under $Y, and growing to $Z AUM” we can be profitable

or

Scrap for an alternative approach.

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Curious, any idea what this would look like for products currently in the pipeline?

Asking not as a request (idk where this stacks in terms of priorities), and more of a, “could be interesting to see how the model stands up to see if it is a useful tool”

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To be clear, were you thinking a product like DATA that’s relatively recent launch to compare to the early months of actuals and project forward, or a product that’s maybe at DG1 / 2? I think maybe we could do both, to ensure we’re looking at the right variables.

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Hi Greg, Prairie,

I made a first stab at this for JPG. See JPG - profit model

The figures are illustrative only and may change substantially. The ‘Months to profitability’ and ‘Months to breakeven’ are probably the most useful outputs. Feedback very welcome.

Cheers,
J

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Sent some minor formula changes in Discord, but overall my (admittedly biased) opinion is that this is useful framing for setting clear expectations on a product launch and having a point of reference for over- / under-performance to benchmark progress.

As you note, “Months to breakeven” is a key output (15mos for those not looking at the file) and likewise with profitability (8mos, which is shorter because it’s measured as on a single month basis instead of an accumulation since launch). Acknowledging at launch that it might take 15 months to breakeven should help manage expectations vs if there was a lack of information and perhaps someone assumes we make money right away or within 1-2 months. It also gives us a measure to consider on what is an acceptable duration to breakeven to compare against other projects, and can be a relatively easy sensitivity test to evaluate (if NAV growth is X% vs Y%, what happens to breakeven date).

I would welcome feedback from others who are more deeply involved in Product WG (paging @Cavalier_Eth ) or Engineering to poke holes in anything here. I imagine it’s very unlikely we have all of the considerations without your input.

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@ElliottWatts For the launched projects, is there any data on the monthly or quarterly income and expenses (rebalancing and LMI) by project? In the financial reports I don’t see a line item for rebalancing costs. Are all of those costs borne by Set, even for composite indices? This information would be very helpful for optimizing the profitability of future products. Cheers.

cc: @Cavalier_Eth @prairiefi @Matthew_Graham

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tl;dr
(1) It’s extremely hard to make a profitable product, in fact much much harder than the community realizes
(2) Profit margin is independent of AUM
(3) Gas fees are the devil

As many of you know, @prairiefi , @Cavalier_Eth and I have been thinking about the profitability of our products. For the non-spreadsheet folks in the community, I’ve written some rules of thumb to help evaluate the profitability of a project. On a monthly basis,

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where

MonthlyTurnover is how much of the portfolio allocation changes every month, typically 20-30%

GasFee is the transaction fee for a trade, typically $100-200 on Ethereum

TradingDepth is the trade size that will cause a 0.5% (= 50 bps) price impact. For rebalancing, IndexCoop typically makes many small trades of 0.5% trade depth each in order to minimize the net price impact. The TradingDepth can be found by plugging different trade sizes into a Dex. For medium to high liquidity tokens the trading depth at 50 bps is typically $10,000-$50,000 and upwards.

LMUptake is what fraction of the AUM participates in the LMI program. This depends on the LMAPR but we can use 0-10% as a range. For simplicity, this factor incorporates the fact that the APR is paying out on the token:ETH pair.

LMAPR is the APR of the LM program. This varies widely but as an example we can use 30%.

PR is what we call the profitability ratio. If PR>1 then the project is profitable and if the PR<1 then the project is loss-making. Very interestingly, the profitability ratio is independent of the AUM, ie, if the project is losing money, increasing the AUM will only increase the loss.

Let’s do an example. Imagine a project with the following:

AUM = $10M
Streaming fee = 1.8%

Monthly Turnover = 25%
Gas fee = $200
Trading Depth = $25,000

LMUptake = 10%
LMAPR = 30%

The monthly Income is then $10M x 1.8% / 12 = $15,000
The rebalancing costs are ($10M x 25% x $200)/$25,000 = $20,000
The LM incentive cost is $10M x 10% x 30% / 12 = $25,000
The PR is $15,000/($20,000+$25,000)=1/3

So even before LM incentives this project would be losing $5k/month. To give benefit of doubt, this model ignores a lot of major expenses including adding and removing components, methodologist fee, assuming perfect trading on rebalancing, operational expenses, etc.

I appreciate that the rebalancing costs will dramatically drop in the future if we move to L2, implement rebalance auctioning, socialize the gas fees, etc, but the model is relevant until then. I think we’ve been able to side-step the rebalancing costs so far b/c as far as I can tell these costs are externalized to Set even though they’re still evaluated at the project level.

I’m very new to the Coop and I may have missed a lot of important considerations so please do comment if I’ve overlooked or misunderstood anything.

I’m posting this to stimulate a discussion on …
(1) whether the profitability ratio PR could be a useful litmus test to evaluate the profitability of potential projects
(2) a much deeper and robust discussion on how to improve the profitability of our products. In a follow-up post, I’ll make some suggestions on how that can be achieved. In the meantime, I look forward to comments.

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Thank you Joseph et al for your hard work to educate the community on what goes into product profitability. However, I don’t believe it’s correct to conclude that profit margin is independent of AUM.

The way you have your calculations, you assume that Liquidity Mining fees scale proportionally with AUM. This isn’t going to be the case since not all products will have liquidity mining and even if they do, the LM programs are meant to bootstrap initial liquidity, not be a permanent ongoing cost providing a fixed APR to LPs.

Rebalancing costs are more complex. There’s a lot of variables that affect rebalancing costs, but there are plenty of scenarios where rebalancing costs would increase sub-linearly with AUM.

Hope that makes sense. I don’t any want readers to assume a product will never be profitable if it isn’t from the outset.

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Thanks for the useful feedback.

It’s fully understood that the LMI’s are temporary. In the full profitability model spreadsheet, one can specify at what month the LMI is stopped.

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That’s also why in the example I pointed out that that project would be unprofitable even before LMI costs. The rule of thumb was intended as exactly that. If the LMI doesn’t scale with AUM is there an alternate rule we can use? How big should a LMI program be?

Is the rebalancing process described anywhere? Knowing this would greatly help Methodologists design the products to minimize rebalancing costs. If for whatever reason you can’t disclose how the rebalancing is done, some rules of thumb (beyond multiple 50 bps trades) or past examples from launched products would be very useful.

Absolutely. That’s why in the profitability model we’ve included ‘Months to profitability’ and ‘Months to breakeven’ and the profit margin by year.

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In the example above, the profit margin changes b/c LMI is stopped in Year 1.

I agree that the products can be profitable but the purpose of the post was to point out that it’s much harder and takes much longer than the community realizes. The parameter space for profitability is very narrow. Has anyone looked at how long it will take for our launched composite index products to become profitable? We should be evaluating profitability and optimizing for it much more than we are right now.

I’m not a staunch profit-monger but it’s the best path to sustainability, growth and greater rewards for Coop members.

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