Valuing Open Source: Principles for Acquiring DeFi Projects

Valuing Open Source: Principles for Acquiring DeFi Projects

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As decentralized finance sees its first mergers and acquisitions, we’re left with a big question: How do you value an open-source project in a very new field like DeFi? 

The whole thing is fascinating, almost a contradiction! An analysis of the issues can help us sharpen a toolkit for understanding value creation and power in a world of open source, programmable blockchains and their assets. It can help us understand why things like “number of blockchain patents” are nonsense, and therefore suggest to financial incumbents a better way to be.

The last time we had a corporate development discussion about tokens was in 2018. CEO Ryan Selkis noted that a number of low quality projects sold their ICO tokens and received . So let’s say you sold 10 million of X, and got $10 million of USD equivalent denominated in ETH. As the market realized your project was worthless, let’s say X falls 90% in value. But the treasury still holds $10 million denominated in ETH. So the vulture fund strategy, copying a page from the book of 1980s traders and leveraged buy-out professionals, would be to buy up all the worthless X and somehow get control of the treasury. You pay $1 million USD equivalent for $10 million in treasury assets and profit.

This didn’t work for a few reasons. First, initial coin offering tokens did not have meaningful governance rights, or any enforcement mechanisms. If you buy them all, the only thing you hold is a bunch of digital pets. Yes, you could argue “reliance” to a court and extract damages or file injunctions. But it is highly unlikely that you would find suitable jurisdiction, and by the time you get it done, the house will have burned down. And second, ETH fell from over $1,000 to nearly $100. So the value of the honeypots became irrelevant.

Today, we no longer have ICOs, but we do have decentralized finance. And in the last six months, governance tokens over decentralized autonomous organizations (DAO) have become the standard playbook. 

Let’s unpack that. If you buy a container that gives you economic rewards based on the efforts of others, you are very likely buying a security. If that security is sold to you in a way that is not pursuant to securities laws of your resident jurisdiction, there’s a large liability on the issuer.

There have been some signs from regulators, however, that a token changes nature over the course of its lifecycle. It may add securities-like features, while starting out as an empty container. It may be at first motivated by usage (i.e., like a reward) and then become a participant in cash flow. The biggest lifeline came in 2018, . While far from gospel, many crypto entrepreneurs now believe that turning a protocol/project into a DAO gets the project over the safe line from securities registration. Time will tell whether relying on an SEC speech is valid defense.

It also helps that issuing governance tokens for a DAO creates market capitalizations and enterprise value for token holders. The main DeFi players of 2020 each have $100+ million or more in the market cap of their instantiated tokens. This has accrued from various distribution mechanisms that embedded financial assets as rewards for financial use. As an example, if you deposit your tokens for others to borrow in one venue you get rewards at some interest rate from the borrower.

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