Highlights:

• Rari Capital and Fei Protocol merged into a single protocol called the Tribe DAO
• The first large DAO x DAO merger involving two strong, active communities
• The supply of RGT (Rari governance token) was going to be converted into TRIBE and many discussions ensued.
• $10M in liabilities from Rari Capital absorbed by Fei Protocol as a part of the deal

Introduction

This past December, Rari Capital and Fei Protocol consummated one of the largest mergers in DeFi history. It was the single largest DAO merger featuring a governance token integration to date, and set the tone for an industry in the beginning stages of M&A frenzy.

In a space that relies on community and the ethos of decentralization, it has been fascinating to follow the development of the acquisition to see how members of the larger web3 community are responding. However, despite all the anticipated success, it's worth exploring how it could have been handled differently to better ensure a certain degree of fairness and transparency maintained throughout.

The fundamental purpose of this report is to evaluate the merger through an unbiased and independent lens. As a team, we ask ourselves: “was this truly the best move for all parties involved? Who stands to benefit the most from the move? Were both communities fairly recognized in the process?”

Context:

• TWAP: Time-Weighted Average Price (calculated by averaging the entire day's price bar, i.e., open, high, low, and close prices of the day)
• Moat*:*  A moat refers to its ability to maintain the competitive advantages that are expected to help it fend off competition and maintain profitability into the future.
• Fork: "what happens when a blockchain diverges into two potential paths forward", "a change in protocol", or a situation that "occurs when two or more blocks have the same block height"

Elements of the merger to consider

TWAP calculation

RGT holders got completely rekt on pricing. In the merger, there was an exchange ratio of 1 RGT for 26.71 Tribe. This was based on a TWAP calculated 11 days after the merger was proposed (November 27, 2021) which meant that the price of the tokens were already affected by speculation.

If we used the same 7-day TWAP calculated prior to the merger being proposed, the exchange ratio would be set to 1 RGT for 34.94 Tribe. It is completely understandable that RGT holders may have felt aggrieved, and that GFX Labs, the neutral third party involved, declined to weigh in on fair pricing of the deal. Disregarding price creates tension among communities that have invested their capital into the project. The lessons learned from the merger, and deal-making process, provide a framework for a more optimal price discovery.

Price speculation should not have any bearing on any merger. Despite token price being a consideration that is important to any community, there needs to be a clear framework for how to deal with these situations. As more communities merge, more accountability is needed, even when it comes to sensitive issues like these. Turning a blind eye towards price calculations creates and elephant in the room that will have to be dealt with sooner rather than later.

We suggest that proposed future price calculations should be handled prior to merger announcements, and validated by an independent third party, as in traditional corporate M&A. This ensures that speculation taking place while discussions are ongoing have no pricing impact on the outcome for any interested party.

Valuation of Rari and FEI

There are multiple ways to look at the value of the protocols in a merger of this nature. While many people argue that traditional financial models should be left behind in the tradFi world, they were included in this report to add nuance. What has been clear is that both protocols have strong products that provide immense value to the market.

(For the sake of assumptions, these specific numbers are not critical. The methodology behind the valuation is what is important.)

Rari Capital

Starting with Rari, despite a TVL of $1.33B at the time of the merger, the value capture is relatively low, with annualized fees amounting to $5.6M. As demand for the protocol grows, it allows for the imposition of incremental fee increases over the coming years to accrue value capture and protocol sustainability over time.

This model uses a discount rate of 35% which is in-line with the average that is normally used to value early-stage businesses by VCs. Along with this, we accounted for a 2% terminal growth rate in-line with projected global growth.

Prior to the merger in 2021, the Ethereum Money Market was valued at roughly $50B. From this estimate, we calculate that Rari has a TVL of $1.33B, which represents 2.66% of the total Ethereum Money Market. The numbers here are tied to the November top of the market, which has inflated the numbers. This can clearly be seen with the assets under management (AUM) during this period.

Moreover, we assume that Fuse share in the money market will increase significantly in 2022 by 75%, while the increase depreciates by 25% in the coming years as it is a niche segment in the market. In the long term, Rari Capital is expected to grow their money market share by roughly 10% per year.

The fee rates are based on annualized fees generated by the protocol. Considering the currently low value capture, it is expected that the protocol will gradually increase value capture as the industry matures over time. With the fee rate being calculated, the protocol’s earnings can be discerned by multiplying the fee rate by the AUM of Rari Capital.

Taking all of these factors into consideration, we concluded that the RGT had a fair value of $58 per token at the time of the merger, based on the model. Prior to the announcement of the merger, it was trading at a value of $39.

Fei Protocol

Fei’s product works significantly differently as compared to Rari. While it was mentioned that Rari has a relatively low value capture, the same can not be said for Fei. Considering Fei captured more revenue from fees than Rari, along with a PCV (Protocol Controlled Value; a subset of TVL of which the protocol owns the assets locked into the smart contract) of $1.2B at the time of the merger (November 2021), the value capture was significantly higher than Rari’s.

The same assumptions that we held for Rari are relevant for Fei as well. The model uses a discount rate of 35% which is in-line with the average that normally is used to value early-stage businesses by VCs. We accounted for a 2% terminal growth rate in-line with global projected growth.

The Fei market share at the time was around 0.55% and we assume that this will continue to grow by 0.4% in the first year as the stablecoin industry grows and then the market share growth diminishes over time. Meanwhile, the yield on PCV is expected to decrease steadily over time as competition for users in the market increases.

Taking all these factors into account, we concluded that TRIBE had a fair value of $2.40 while trading at $1.25 prior to the merger being announced.

This would decrease the value of RGT/Tribe to $24.16. Despite being lower than the TWAP used in the merger, it would provide a better argument for the price. After evaluating the different options to determine price, we can conclude that using TWAP might have been a better option (acknowledging that the methodology that was used in the merger could be questioned). Taking these different models into account is a sensible and more equitable approach to providing nuance while the process is ongoing.

Value maximization vs fairness

Any traditional merger would see two investment bankers representing each interested side in the deal, trying to negotiate the best deal for their respective parties. While each side may go into the deal with a different set of priorities, the result is typically fair in that it acknowledges the wishes and preferences of both parties. However, exactly how fair that deal ends up being is truly open to interpretation.

At the end of the day, it is important to ask ourselves the question: in aiming to negotiate the best deal, is it right to prioritize value maximization over fairness, or vice versa? When evaluating the deal in question, it is critical to understand the underlying goals of each party (in this case, Rari and TRIBE), to determine how the fallout of this deal might occur. If the goal of the merger is for both parties to maximize their value, then TRIBE holders have succeeded. If the idea is fairness, then RGT holders will feel aggrieved given the slight undercut on pricing. Only when we dig deeper can we understand the full context of the deal, and accurately judge the resulting fairness of the merger.

Considering the roughly $8 difference between the actual and utilized exchange ratio (x% of price), it is easy to see why RGT holders might be disappointed with the outcome. However, pricing is just one piece of the puzzle when it comes to evaluating the fairness of a decision, especially one of this magnitude.

As another core tenet of the deal, Fei also consumed all of Rari’s $10M in liabilities, stemming primarily from an exploit earlier this year. Rather than spending the next year digging themselves out of a financial hole, Rari will join Fei as one of the largest liquidity players in the market. As alluded to above, making decisions in a DAO can be complex and rather tedious, especially when the decision being made affects the entire future of the DAO. However, a closer look at the breakdown of the votes can shed some light on just how fair this deal was perceived to be. With over 93% of the Rari community voting in favor of the merger, and 90% of Tribe voters, it seems as though the move was well-received by both organizations.

Perhaps the most overlooked component of this deal is the functionality of the application. Rari’s permissionless lending pools, also known as Fuse Pools, require liquidity to be effective. The biggest bottleneck to their growth thus far has been the lack of initial liquidity needed to provide manipulation-resistant oracles for long-tail assets. Fei, which has provided the liquidity for 8 of the top 10 performing Fuse pools, is the ideal partner to help ensure that lending can continue down the line.

Combining Fei’s liquidity with Rari’s lending strategy lends itself to the creation of an incredibly strong platform that can serve as a launchpad for the protocols of tomorrow. As the Ethereum L1 and L2 money markets continue to grow and prosper, demand for secure permissionless lending will increase alongside it. Pricing aside, this move sets up both Rari and Fei to capture significantly more value together, than either would have on its own.

Alternative Structure: Leveraged Buyout

The merger could have had a completely different outcome had a different methodology been used. Considering debt was involved in the merger, it left open the possibility of using a leveraged buyout instead. However, if this was the case, there would have been implications that could have made the whole deal less attractive than it was at the time of finalization. Even though this move is being labeled as a merger, the structure of the deal suggests that Fei has acquired Rari capital. However, in a decentralized world where the community behind the organization takes center stage, it makes sense that messaging around the deal focuses on partnership and coalition rather than takeover.

When considering the other ways this deal could have played out, a leveraged buyout was definitely not off the table. Naturally, with $10M in liabilities being assumed by Fei, one could definitely make the argument that a full-debt deal might have made more sense. However, we would contend that a deal of that nature would leave Fei extremely vulnerable, given the already high amounts of uncertainty in this nascent space. From Fei’s perspective, the interest rates on the debt they are taking on could end up being too high, and could result in a lower credit rating. If they are unable to service the debt, the result is bankruptcy, making an LBO especially risky for companies in highly competitive or volatile markets like crypto.

It’s also worth considering how the merger would play out practically if it were done through an LBO. Given that most companies will focus on cutting costs post-buyout to pay back debt more quickly, LBOs sometimes result in downsizing and layoffs. For an organization like Fei, which needs consistent growth to sustain the competitiveness of the industry, having a credible and reliable partner in Rari sends a strong market signal.

In the end, the decision to pursue a deal financed primarily through debt ultimately comes down to the risk tolerance of the acquiring party. With expected revenue set at over $100M by 2024, Fei is well-positioned to accrue some short-term debt, especially as demand for permissionless lending grows. However, given the uncertainty and volatility of the crypto space in addition to the existing liabilities on the balance sheet, it is also possible that Fei might have been dissuaded by additional debt.

GFX Labs was brought in as an independent third party to act as a neutral facilitator that would help both parties achieve their goals. However, they declined to address sensitive questions regarding pricing and protocol valuations. This made the process more complex, and created complications during merger discussions. While this hesitancy to weigh in may be understandable as it was the first major DAO x DAO merger, there is plenty of room for improvement. This was a dilemma that the founder of Rari abstained from as well.

This is where we see Bankless Consulting, or other web3-native M&A advisory services, participating in fairness evaluations. Considering our capabilities and our ability to view these questions impartially and from a wide variety of perspectives, there would be benefits to each side of the deal. Taking the communities into account while still providing a professional point of view is fundamental to making sure all parties involved leave the table happy.

Tax implications

In general, from the tradFi point of view, there is no federal income tax in the US on transactions where only stock, securities, or both are exchanged for property of an acquired organization. Though there is no tax regulation specifically defining DAO mergers, it is reasonable to assume that there should be no tax implications for neither Rari nor Fei during the merger transaction. However, the parties would have needed to exercise caution if there had been a stablecoin payout in the transaction, which could be recognized as cash or cash equivalent under certain circumstances.

Merge vs Fork

A large question that looms over large deals of this nature centers around the composability of DeFi. Open source smart contracts make it easy for protocols to fork parts of other protocols unless they have a moat that is difficult to replicate. Considering this possibility, forking ends up being a much cheaper solution for many protocols versus going through a complicated merger process.

Importantly, there are some things that cannot be forked. One of those is community. If a desired target protocol has a strong community and a strong team, a fork is less beneficial since the acquiring protocol might not have the capability internally to ensure that it is executed smoothly and integrated into both the community and protocol. Also, considering how fast the industry moves, strong teams that consistently deliver to their community are extremely valuable. A merger is a way to make sure you acquire the best talent.

Another point worth mentioning is that it is difficult to fork a treasury. As protocols gain value over time, they typically build up large war chests that put them in a strong strategic position if deployed correctly. If a protocol identifies smaller players in the market that do not utilize their treasury efficiently, they might go through the process of staging a merger or a hostile takeover with the goal of gaining access to the treasury to better allocate that capital.

This is something that we might see in the coming years, as capital flows to protocols that consistently deliver. The industry is still nascent and a large amount of underutilized capital is sitting idle in the market. There is no doubt that actions will be taken to rectify this over time as the market matures.

Finally, if the community decides to go through with a merger and some do not agree, it has the potential to split communities from within. We have seen this take place with Yearn Finance, where people against the merger decided to go in another direction and forked the protocol. This was prevalent in the Rari-Fei merger as well, and members of the community were given an option to “Rage Quit” if they didn’t want to take part in the merger, which meant that they could exchange their TRIBE tokens for the FEI stablecoin at a premium.

Final Thoughts

Mergers are a complicated topic that becomes even more complex when they take place in the world of web3, DAOs, and DeFi Protocols. However, M&A is healthy for the market and a welcome development in an exponential industry that is filled with innovation. There are some tough questions that we are ready to deal with as the industry grows over time.

Bankless Consulting is looking forward to contributing to a future where stronger communities join forces and capital can be put to better use.

If you are interested in discussing or hearing more about DeFi M&A Advisory, please get in touch with our team at Bankless Consulting (info@banklessconsulting.com)

Bankless Consulting contributors ETS, Cryptodad and ETH_ contributed to this article.

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