The DAO Treasury Issue
Let’s talk about DAO treasuries for a moment.
A brief layman’s description of treasuries for the uninitiated: a DAO’s treasury is its capital – said another way, it is all of the resources (in the form of both fungible and non-fungible tokens) that a DAO has at its disposal to be used to both pay for and do stuff. When a DAO wants to pay contributors or issue grants to advisors or cement partnerships via a token swap, they dip into this treasury to do so. Because treasury balances are often used as currency for transactions, people discuss them as if they are simply cash-like assets. They usually aren’t. The purpose of this piece is to talk about why that is and, more importantly, why it matters.
On one hand, you can sort of forgive people for the aforementioned misconception. At first glance a DAO treasury really does resemble a balance sheet of cash-like assets. There are a bunch of tokens in the treasury, and you can, quite easily, go to any crypto exchange to ascertain the value of these tokens. On the other hand, a large chunk (often the majority) of almost any DAO treasury is made up of that particular DAO’s governance tokens. This creates a bit of a paradox and thus the confusion. How should we actually think about the size of DAO treasuries? How do treasuries play into the the aggregate value of a DAO’s equity? More specifically: how does the makeup and utilization of a DAO’s treasury impact the ultimate trading value of its governance token?
Let’s dig in.
Defining “Value”
To properly have this conversation we first need to talk about value. In traditional markets there are two basic ways to think about the value of equity (i.e., ownership) in a company. One is the Book Value of Equity. This is, quite simply, the assets that a company controls less the liabilities that it holds. If Evan Spiegel decided to tear Snap up today, pay off all its debts and other liabilities, and then sell all the remaining assets (Snap spectacles in inventory, computers, desks, coffee machines, whatever) and split up the proceeds between all the shareholders of the company, the Book Value of Equity is – theoretically at least – the aggregate value that they would get as a result of him doing this. The second is the Market Value of Equity. This is, quite literally, how the market values the aggregate equity of a company: the outstanding shares of a company multiplied by its share price [1].
These two values of equity are rarely equal to one another, but given they are different calculations of the same thing they are obviously quite related. The Market Value of Equity bakes in the belief that the company is greater than the sum of its assets – put more simply, the market value is a reflection of future expected company performance as opposed to simply present asset value net of liabilities. Put even more simply: if there is broad consensus that a company is good and will utilize the assets it currently has to generate more assets in the future (specifically cash or cash-like things), the market value will be greater than the book value. If there is broad consensus that the company is bad and is more likely to waste the assets that it has today than it is to generate cash, the market value will be less than the book value [2]. The most simplistic way of thinking about the Market Value of Equity would to be: Net Asset Value Today (aka Book Value) + the Probability of Future Asset Generation in the Future [3].
The purpose of this finance lecture is to highlight a few really important points that we should consider when trying to understand a DAO’s value and what role the treasury plays in that value:
- The base level of the value of any organization’s equity is its asset value today net any liabilities, AKA its book value.
- The aggregate market value of equity is determined by how today’s asset base is expected to be utilized to generate cash in the future (i.e., a larger asset base than it has today).
- The operations that a company undertakes to generate cash are costly. Market value being greater than book value comes with an implicit assumption that shareholders must necessarily hold that the company will choose to spend their assets efficiently today and earn more assets tomorrow.
Let’s apply these points to DAOs one at a time. Note that the below assumes a DAO’s governance token has claim to its treasury and any future asset flow net of fees, rewards, and other expenses. (If you can’t say that about your DAO’s governance token I would… reconsider your position. Personally.)
Item #1: The Value of Assets Today
The value of the equity of any protocol is first determined by a DAO’s asset net value. The actual price of its token is simply this number plus presumed future asset generation divided by the supply of the tokens in the market. Both of these items are important pieces, but this calculation always begins with today’s book value [4].
The catch with DAO treasuries is that a DAO’s book value cannot include its own governance token because the price of those tokens is determined, at least in part, by its current assets. Statement of the obvious: a token itself cannot be used in an equation to determine its own value. Not only that, if a DAO were to liquidate then these tokens would be dissolved, and the DAO assets would be spread amongst the outstanding token holders given they each have equal claim to the treasury. You wouldn’t take the treasury tokens into account, how could you even if you wanted to? Treasury assets cannot have claim on themselves, the claims and rights these tokens hold are effectively redispersed pro-rata to non-treasury token holders.
Beyond value there’s also the practicality of uber-liquid assets to consider – if a large liability comes due or a DAO simply wants to invest a chunk of capital into a new growth initiative, how liquid are a DAO’s governance tokens to pay for any of this? Ethereum and stables can be utilized at a moment’s notice to pay for the cost of, let’s say, restitution for a hack. A DAO’s governance token could theoretically be liquidated at scale to pay for this but it is obviously not nearly as liquid as fiat crypto, to say nothing of the cost of dilution to token holders, particularly when you don’t always get to choose the token price at which you are transacting (more on this in a moment). Lastly, any token liquidation at scale would obviously come at the cost of token sell pressure, driving down the aggregate market value of equity in addition to the aforementioned dilution.
This isn’t to say that governance tokens held in treasury are valueless, that obviously isn’t the case. It simply redefines how DAO communities and leadership should think about them both in terms of the capital that a DAO holds and in terms of how that capital interplays with the value of already-distributed tokens. Cash-like assets make up a baseline of value that token holders have claim to today, have a fixed and known cost when they are spent, and provide guaranteed liquidity when needed to transact – DAO governance tokens held in treasury do none of these things.
Takeaway #1: Governance tokens held in DAO treasuries do not contribute to the underlying value of said governance token
Takeaway #2: Governance tokens held in DAO treasuries should not be considered liquid capital and the actual cost of spending them is not immediately known
Item #2: The Value of Future Asset Flow
A DAO’s governance token price (e.g., its market value of equity divided by the number of outstanding tokens) begins with present net asset value but ultimately hinges on future asset flow [5]. You would hope this wouldn’t be a controversial statement but candidly I sometimes wonder if even traditional tech investors fully grasp this (particularly those who have only ever been investors during the longest bull market of anyone’s lifetime). The purpose of any organization that distributes equity is to produce more capital for that equity to govern and have claim to. Period. Growing user base and TVL is cute, but if you can’t turn a profit off of it or that profit does not match the emitted rewards dilution used to drive said users/TVL then over time the aggregate value of your treasury will shrink, your token price will fall, and your DAO will die.
This doesn’t mean you need to be generating a bunch of assets today – many successful traditional companies don’t end up being cash flow positive for a very long time, and I assume many DAOs won’t either. However, this should be because there is a conscious decision being made to either spend on growing the protocol user base (i.e., additional S&M or R&D), distribute treasury earnings to token holders via treasury distribution (i.e., dividends), or make governance token purchases (i.e., buybacks). If your treasury isn’t growing and you aren’t doing any of those things? Well, that’s a problem and probably a decent explanation as to why you may end up trading below your PCV (i.e., your DAO has been deemed “bad” and you don’t make any money. NGMI.).
Takeaway #3: The key to token holder value creation is positive asset flow or at the very least the proven ability for positive asset flow combined with top line growth
Takeaway #4: Relatedly, the underlying health of any protocol should be determined if it is asset flow positive when you strip out: growth-related expenses, token holder dividends, and token repurchases
Item #3: The Cost of Capital
Cost is necessary to generate value, but how much are your expenses actually “costing” you?
If I use cash to buy a computer – what did that cost me? The value of the cash? I mean yes, sort of – but I now have a computer with value more-or-less equal to the cash I spent in the transaction. What it actually “cost” me is the return I could have gotten on that cash (in the traditional finance world folks usually think of this in terms of treasury bond rates given that’s the best guaranteed return you could have gotten). This is my Cost of Cash. People rarely talk about it this way but, at its heart, cost of capital is all about opportunity cost. Instead of parking my cash in US treasury bonds and getting a 2-3% guaranteed annual yield, I parked it in a computer, and I get no guaranteed yield. If you don’t consider costs this way, then how the hell could you ever think about the ROI of any business decision?
What if instead of using cash I finance my computer acquisition using debt? The answer to this cost question is even more simple: what kind of annual interest rate can I get on that debt? 5%, 10%? Whatever it is, that figure is my Cost of Debt. It’s almost certainly higher than my Cost of Cash, because if it wasn’t then why the hell would anyone be lending money to me instead of to the US Government via the aforementioned treasury bonds? Especially given I’m taking out a loan to buy a computer lol.
My last option: what if I trade some of my company’s stock for the computer? Best Buy probably doesn’t take my stock so I would likely need to sell it to someone else first then use that cash to buy the computer… but from a “cost” perspective the actions are synonymous. Calculating what this actually cost me is a lot harder to determine though, and this is especially true in DeFi. The way to think about this is the expected (or required) rate of annual return of that equity. The Cost of Equity for traditional public companies often hovers between 8% and 12%, depending on the maturity of the company and the assumptions that you’re using [6]. Given the immaturity, volatility, relative illiquidity, and expected/required returns of institutional investors in crypto that figure should be a hell of a lot higher for any DAO.
All this is to say that how you pay for stuff has a monumental impact on the ROI of your expenses and ultimately your DAO’s value. If you have any belief in the direction of your protocol and the value of your tokens (i.e., the future value and thus cost of your equity) – you shouldn’t be using them as everyday currency or employing tokenomic structures that give them away cheaply. To be honest, anyone who owns your token implicitly has that belief simply by virtue of that fact that they are holding it at all. Spending/emitting governance tokens in a careless manner dilutes your token holders, gives away your control over the true cost of your expenses, and signals (intentionally or unintentionally) that you don’t value ownership of your own token.
Takeaway #5: In general – a DAO’s cost of using equity is much higher than its cost of using stables or debt to fund incentives/expenses and can dramatically lower the ROI of those incentives/expenses
Takeaway #6: The cost of carelessly giving away tokens has multiple compounding negative effects to token holder value – ownership dilution, market sell pressure, lack of cost control, and negative market signaling
The Bottom Line
Whether you want to talk about DAO treasury management in terms of risk diversification or simply capitalization it ultimately doesn’t make a difference – how you strategically deal with it matters. During the bulge bracket iteration of my banking career we used to spend hours simply talking with CFOs of publicly traded companies about nothing but the company’s capitalization/cost of capital and what they could do to optimize. I know that sounds awful and boring (it usually was) but it flatly matters and, generally speaking, most DAOs don’t appear to be thinking about it much at all.
Spend even a little time on DeepDao or OpenOrgs and you’ll see what I mean. The issues are on both sides of the spectrum. Some DAOs are horrendously undercapitalized and not at all equipped to pay for day-to-day expenses (let alone handle black swan events) and their ultimate costs to and token holder dilution is based entirely on the whims of the market (i.e., you better pray to god that when your liabilities and expenses come due that your token is trading well). Others are massively “over-capitalized”[7] and have millions (in some cases hundreds of millions) in stablecoin and other tokens sitting in treasury rather than spending on growth or distributing this value back to token holders via dividend or token buyback*[8]*. In either case, I can promise you millions of dollars of value is being left on the table due simply to unnecessary dilution, improper capitalization practices, and treasury mismanagement.
Bottom Line: DAOs should begin today thinking about and managing their cost runway and optimizing their capital expenditures and treasury diversity. It is well worth it to spend real time (or better yet, to hire someone to spend real time) thoughtfully analyzing and projecting the direction of your protocol and focusing specifically on:
- Tokenomics and token holder dilution
- Capitalization planning and needs
- Treasury strategy and optimization
All of this will have a tremendous impact on value, both today and in the future. This is the way.
About the Authors
Jordan Stastny and Sam Bronstein were previously M&A advisors at Qatalyst Partners. While at Qatalyst, they advised on over $150Bn of M&A volume across some of the most significant deals in the technology industry, including the sales of Slack, LinkedIn, Mailchimp, Qualtrics, Glassdoor, and others. Jordan and Sam co-founded MSPC Partners at the beginning of 2022 to advise early-stage technology companies on M&A.
[1] Note that the outstanding shares of a company must, by necessity, include outstanding but unvested shares like employee RSUs, employee options, and convertible debt (the DeFi analog being unvested tokens to investors/core team) if you want to think about the market value of equity properly. The market (read: the share price) certainly factors in this type of expected dilution and so should we when thinking about the true aggregate value of equity. It can be argued that the market also bakes in some expected dilution from authorized, but not-yet-issued shares held by an entity as well, which creates an interesting nuance when thinking about DeFi valuations given their propensity to dilute themselves via reward emissions and/or treasury mismanagement (both treasury and un-emitted tokens can simplistically be considered authorized, unissued stock for most purposes). This footnote is already way too long – let’s set this aside and I’ll write another piece on the effects of tokenomic structure and treasury management dilution on equity valuation some other day.
[2] You don’t see this very often for the same reason you never see a two-star restaurant on Yelp. Things like this don’t have a very long shelf-life. Nature tends to take care of these things.
[3] There is some nuance here regarding operational versus non-operational assets when determining market equity value but for simplicity we can ignore that for now… also not to further overcomplicate things but any future asset value would obviously need to be discounted to its present value.
[4] One way to illustrate this relationship is by considering how the market reacts to dividends in TradFi: the stock goes down by the cash paid out. This is because A. the prior stock price baked in this future cash payment and B. the dividend cash has left the entity and thus the net asset value (aka Book Value of Equity) has decreased by that amount (i.e., shareholders are no longer entitled to it).
[5] “Asset flow” and “cash flow” are basically interchangeable in this context – asset flow likely makes more sense in DeFi given “cash” connotes fiat. Maybe we’ll ultimately come up with a more crypto-y name for this, idk.
[6] This range is ballparked based on what I usually saw during my investment banking days and what we often calculated as the “cost of equity” when discounting cash flow but is backed up by the fact that the S&P has returned ~10.5% annually since inception in 1957.
[7] I put this in quotations because “overcapitalization” in the real finance world means something other than what it sounds like and isn’t the exact opposite of undercapitalization. The reasons for this remain unclear to me.
[8] Hopefully they are at least putting these balances to work on some level and properly optimizing risk versus yield but my guess is that is rarely the case.