Meta Governance & The Lack of Consolidation In A Bear Market
Meta Governance & The Lack of Consolidation In A Bear Market
Big shark eats small fish
Welcome, Anon! Today we are discussing the lack of consolidation in the DeFi industry when it would arguably be the best time to capitalize. Remember that I am just a degenerate sensei on the internet and this is not financial advice.
We have seen instances of M&A taking place with decentralized protocols as Uniswap acquired Genie and ventured into the NFT market. However, in a market environment where token prices are cheap, there are opportunities to find undervalued protocols that generate high revenue.
It’s been surprising to not see larger protocols capitalize on this opportunity and that should also raise questions in regards to their risk management policies. Especially for protocols that operate through growth-by-acquisition models (the closest thing we have to this are meta-governance protocols such as Redacted Cartel, Convex Finance, PlutusDAO, and Index Coop).
M&As in DeFi
As the DeFi industry matures, I have no doubts that M&A will become a more prevalent matter as acquiring protocols to get access to their treasury, team, and community becomes an attractive prospect instead of building from scratch. While you might argue that forking is an option, the credibility and know-how built by communities can’t be overstated. If you think you can fork the knowledge of top devs such as Sam Kamezian, TzTok-Chad, banteg, X, and the list goes on, you’re in for a rude awakening.
This makes me think that acquisitions in this mold will almost be closer to
acqui-hiring than mere acquisitions as these talents will be able to bring their ideas to larger protocols while both can leverage each other’s brands. Win-Win? Sure, but that’s not all that there is to it.
Especially concerning meta-governance protocols that develop a growth by acquisition model. The model in most cases works in a flow similar to this:
Use tokens from the treasury to acquire protocols —> short-term burst of growth
Pushes token price higher —> makes the native treasury even more valuable
More targets are now available as tokens have increased in value and not as many need to be sold
More tokens of other protocols get acquired
This is a positive feedback loop that can generate incredible value in a bull market. However, market dynamics don’t stay the same all the time and a lot of protocols weren’t equipped with the change that was forced upon them.
Life comes at you fast, huh?
Market dynamics change and protocols weren’t equipped with change. Especially when you invest in correlated assets. Token prices have fallen and people can’t use their tokens anymore to make as good deals anymore. This means that acquisition-driven growth drastically falls. The consequence is that growth expectations fall and the token price falls further. Now we’re in a negative feedback loop.
This makes meta-governance protocols more inflexible as it’s harder for them to deploy capital (capital should be deployed wisely and not be traded on the open market). What was previously a strength now becomes a weakness. Now we have angry bagholders and questions that need to be asked regarding the tokens the protocols have added to their treasury.
However, it’s very easy to be critical on a short-term horizon when the market environments are terrible. This might work out fantastically in the long run and they look like geniuses. The active need for productive treasuries and “passive income” (don’t get me started on the phrase “passive income”) led us here.
To be fair, the whole industry has been struggling for growth. However, it becomes more critical when your economic model is dependent on growth-by-acquisition as it becomes a tough environment. This is why protocols such as Redacted Cartel were hit very hard in the market. It can be hard to convey a negative sentiment to token holders and indicate that you will make fewer deals when in fact it’s the most profitable time to make deals.
However, this is not a knock on meta governance protocols by any means. This only refers to surviving and risk management. If protocols can survive, it might present an amazing opportunity as the market environment changes and the growth-by-acquisition model leads to explosive growth.
Simultaneously, one bad deal can have a critical effect and kill your protocols treasury if it’s not deployed right. Thus, it’s even more important to get it right in this environment. This should lead to higher scrutiny of Treasury Managers and the importance of teams that have M&A experience (especially in Due diligence) to increase the likelihood of a good deal taking place. Also, many protocols lack solid Risk Managers that are fundamental if the protocol wants to survive in the long run.
Things to consider in a M&A deal
Due Diligence
Performing proper due diligence is a must during a deal of this manner. Due Diligence in M&A refers to the verifiable background research that concerns finances, the customers, and contracts involved (in this case it would be smart contracts and doing an Audit to confirm everything is secure and works as it should). Considering that Rari Capital was exploited once again after the Rari-FEI merger when they already had a prior debt due to an exploit, it’s an example of failed DeFi due diligence.
Hostile Takeover
A hostile takeover is what it sounds like. An acquiring protocol attempts to take over the target protocol without the leading team’s wishes. This can be done by attempting to buy out large token holders OTC or acquire tokens aggressively until they control more than 50% of the tokens and can direct governance in their direction. However, what’s important here is how the governance structure works and who executes it. Is it the team or on-chain through a smart contract? Token votes are not binding and are solely based on faith so the setup is critical here.
Example of an attempted hostile takeover that didn’t pan out as planned.
Leveraged Buyout
A leveraged buyout (LBO) indicates that a protocol takes on a significant amount of debt in order to have the capital means to acquire a protocol. However, I struggle to see how this would work in an on-chain world where everything is transparent. If a protocol takes a loan to buy out another protocol other parties will look at where their liquidations lie and hope that they get liquidated. While not wanting to use your valuable tokens in your treasury to deploy capital, overcollateralized loans do not work in protocol’s favor in regards to M&As. It doesn’t encourage positive behavior and would probably signal a lack of trust as they don’t have the finances to afford the protocol without going into debt. Also, undercollateralized loans aren’t a thing in DeFi yet and no sane lender would even consider providing capital for a LBO of this mold with so much risk on the table.
Free Cash Flow
Free Cash Flow (FCF) is the cash the protocol generates after subtracting operating costs and capital expenditures. These costs are normally very low in DeFi as it’s more or less operated by a smart contract. However, it is something that there is a lot of obscure information about and would need more clarity for deals to take place. Free Cash Flow is the capital that generates value to token holders as it leads to growth improvement of the protocol if the FCF is growing at a strong rate.
Working Capital
Working capital simply refers to the protocols Current Assets - Current Liabilities, it’s the available capital that can be used for day-to-day operations and is critical since it indicates what the protocol can maneuver with.
Indemnification
Any time a buyer acquires the equity of a business, there will be some known and unknown risks that come with that transfer of ownership. Buyers usually required some amount of purchase price to be set aside with an escrow agent.
Indemnity is legal security and protection from financial liability. When someone buys a business, they assume some risk and will therefore require that the seller makes some assurances that if untrue, must be covered (financially) by the seller. In most deals, buyers and sellers will agree to leave a certain portion of the deal proceeds with an escrow agent so that the buyer can more easily access that money to cover any breaches to representations made. If no escrow account exists, then the buyer would have to personally obtain the money from the seller.
This should actually be easier in DeFi as there is more transparency. Assuming that the team acts in good faith (don’t trust, verify). Although it would be a potential deal breaker as well as it acts as extra insurance and leads to capital inefficiency.
Multiple of Earnings
Multiple of earnings are hard to calculate considering the volatile nature of the crypto market and its cyclical nature. While I have seen valuations that project growth in the typical 100-75-50-25% YoY model. A more conservative approach should be adopted here that perhaps focuses on quarters over years as 1 year in the crypto world essentially equals 10 in the standard financial market considering how quickly it moves. Projecting your cash flows over 4-5 years is dystopian in the world we find ourselves in. Most of the protocols that existed 4 years ago are non-existent. Browse through Coingecko/Coinmarketcap and you’ll find some ghosts that will never return to life again.
Few protocols can guarantee recurring revenues since a locked subscription-based model isn’t something widely adopted in DeFi. The closest thing we have to this is the ve-Token model which adheres to locking of capital for up to 4 years to receive non-discounted token rewards. This essentially only guarantees that there won’t be a lot of liquidity on the market waiting to be dumped on other people. To be cynical here, you get paid in token rewards (depending on how they distribute it) to not sell your tokens.
Where to next?
All these factors raised in this article should leave room for a wave of DeFi M&A professionals to emerge in the market and steer deals in the right direction. Having these people's expertise in this manner should also include how to manage a community during mergers as it would also become an important context in deals. However, DeFi is composable and it allows us to build on top of the Rari-Fei merger and identify what went right or wrong and what could be done better.
Better teams, stronger protocols, and a healthier market will be the result of consolidation taking place and that’s what we all want.
On another note, meta governance protocols such as Redacted Cartel and PlutusDAO have been approaching the market differently. Redacted is exploring other revenue-generating models such as Pirex, fees from Hidden Hand, and launching their own stablecoin.
PlutusDAO has been looking toward more strategic partnerships and has partnered up with Sperax which is an auto-yield-bearing stablecoin on Arbitrum during this time period. The intention behind this is to give their token holders more governance power and bootstrap their treasury while still hedging with a non-correlated asset.
Different strategies with different goals and time will tell which one will benefit their token holders the most.
Well done if you managed to congest all that information, I hope you enjoyed the post. Don’t forget that you are more than welcome to leave feedback as well.
Sharing this post helps it reach out to more readers which would be great. If you are interested in future posts from me, do not hesitate to subscribe. Thanks for taking the time!
Disclaimer: All Content on this site is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing on the site constitutes professional and/or financial advice, nor does any information on the site constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. I am just a random degenerate sensei sharing an opinion.
Intriguing read. Question: Would token holders knowing that the protocol has been acquired in itself (no leveraged buyout, etc, just a straightforward buying of 51% of the tokens) cause token values to drop?
The thing I struggle to understand wrt a lot of these M&As is that they heavily compromise decentralization, whereas the point of blockchains is to be decentralized in the first place. Though my understanding is that they compromise on decentralization for easier development of the protocol in the short-term?
Relatively new to this space, so feel free to clarify any misconception I may have. Thanks for the work!