Before looking at the importance of the hard cap, there are three distinct categories of coin distribution that’s often used in investing.
This is the amount of coins that are actively being traded in the market. In some instances, projects could have all their tokens pre-mined and released all at once through the ICO. The circulating supply will, therefore, be the same as the maximum supply.
Other times, tokens have to be mined over time or coins are released on a schedule. In this case, the two supplies will differ. Either way, circulating supply tells you how many coins are doing the rounds at that very moment.
This is the amount of coins that actually exist, including the ones that are not in circulation. Why would coins exist but not be in circulation? It could be for a number of reasons. A team might have mined coins but kept them back without putting it on the market. Or developers are required to hold their portion of the ICO for a set number of months which is to prevent coins being dumped as soon as it gets listed. The coins therefore exist but are not yet in circulation.
This is also known as the hard cap and is the most important one of the three. It will tell you the maximum number of coins that will ever be created (Bitcoin’s hard cap is 21,000,000 tokens). Not all cryptocurrencies have a hard cap. Ethereum, for example, has no maximum supply limit of ether.
Why is the hard cap important?
There are two main reasons to have an adequate hard cap.
The first has to do with scarcity. Think about diamonds for a second, we know the scarcer they become (i.e. there are only so many diamonds in existence) the more valuable they become. It’s the same with cryptocurrencies, simple supply and demand. If there’s a finite supply of a particular token, the value of the coin is likely to increase over time.
This, will in turn, protect the integrity and value of the underlying network. There is, however, a fine balance in getting this number right. Too low a hard cap and you won’t be able to raise enough funds to develop and grow the network.
On the other hand, if the network is flooded with tokens that don’t have a purpose because the hard cap is too high, the value of the coin will become diluted, causing a drop in the integrity and value of the network.
The second reason is closely connected to the project roadmap. For every amount raised, the startup should make sure there is a clear and concise purpose for it. Basically, if we raise so much, we plan to do this, if we raise more than that, here is where the funds will be applied.
However, we’ve seen projects raising hundreds of millions of dollars with no set objective of what to do with all that money. There have been instances of startups setting a funding target of $20 million but then go on to raise over $200 million because they didn’t set a hard cap. There’s no predetermined plan for the excess $180 million. If funds are not put to work effectively, especially within young startups, investors will never see their expected ROI.