Are DAOs more efficient SPACs? A deep dive.
A discussion framework of two financial instruments specific to their market.
Hello guys!
First time writing this type of article or whatever you want to call it, so please be lenient, the market is already hurting me.
What a year 2021 was. We have witnessed a parabolic growth on every project in the top 1000 GC, people realizing 10k% returns and tons of capital flooding into the market to support the so-called innovation. 2021 was also the year of the emergence of many buzzwords, here to make newbies have a feeling of understanding of this market. “DAO”, “Web3” are the leaders of this whole group of words used without really knowing what it means, but relax, our TradFi friends also have their own. Indeed, the most notable is “SPAC” which stands for “special purpose acquisition company”, which we could easily translate to “a lot of capital in an empty shell”.
To be honest, @0xSisyphus gave me the idea to write this when I saw him comparing DAOs to SPACs, but Daniele preceded me when he decided to turn TIME into a SPAC. So let’s try to understand what these folks were thinking when comparing both buzzwords.
At a glance, a SPAC is a “blank check company” i.e. a company with no commercial operation and purpose. A SPAC is formed solely to raise capital through an IPO (or some sort of rigged IPO, but we’ll cover that later) to acquire or merge with an existing company. This type of structure is no new, but SPACs popularity has soared over the last two years, stuffed by a huge amount of dry powder (i.e. unused cash kept on hand by VC, Private Equity funds, etc.) and some market discounts pushed by the crisis. Also, traditional investment funds have struggled in raising debt for risky assets over the first months of covid, forcing them to put more equity at work and lowering their Internal Rate of Return (which is positively correlated to the debt raised on an acquisition). This phenomenon has kept the doors wide open for SPACs to outperform them with fresh capital. But actually, SPACs hardly outperformed S&P500.
Now that you have the basics on SPAC trend, I’ll try to discuss how and if well-capitalized DAO could be considered as more efficient SPAC. To structure my thinking, I’ll try to answer this problem following a framework based on:
- Funding method and “quality” of funds raised (participants, funding type, etc.)
- Management i.e how the structure is organized towards efficiency
- Investment strategy (asset diversification, types, etc.)
- Capital rollover i.e is fresh capital flooding into the structure
- Internal Rate of Return or some sort of ROI
Funding method and funds raised
SPAC funding is somehow a complicated process, but the only thing you have to remember here is that funding is heavily dominated by big sponsors and hedge funds.
Basically, IPO investors get a share of stock (usually priced at $10) as in any traditional IPO, but SPAC investors are also entitled to partial warrants to buy additional shares at an exercise price just over the IPO price (11.5$ is considered a standard). To further reward the investors who put money into this empty shell, the SPAC model also gives the right to investors to get their initial investment back while keeping the warrants. And that’s how you build risk-free gains by investing in, well, nothing.
These economic incentives are gold for large capital holders, and who is a better capital holder than a hedge fund? A bigger hedge fund. That is why today, SPAC IPOs are heavily dominated by a group of hedge funds, known as the “SPAC Mafia” because this model gives them a source of free warrants and rights. According to research by Stanford professor Michael Ohlrogge, these funds redeem or sell their IPO stocks before target mergers 97% of the time but retain and trade the warrants leading to risk-free like returns. This model is not incentivizing for a long-term hold but rather a sell in a short time frame, while people (3,3)ing i.e long-term holders are often at loss (and are often retail investors). Even Gary Gensler, Chair of the SEC, and not known for its work ethic, stated that “SPAC mergers are structured to ensure Wall Street insiders receive huge profits” while “the retail public is bearing much of these costs”.
Now, you may wonder how DAO are executing this fund-raising process in a better way, so let’s try to look at it.
First, DAOs fundraising is pretty much straightforward.
This breakdown from Bankless: The Ultimate DAO Report is not clear I have to concede, but it gives a general overview of the funding process. Moreover, this graphic may not be very relevant regarding the disparity of what is considered a DAO (protocol DAO, purpose DAO, social DAO, etc.), but it seems clear that the retail (assuming the token sale is well-executed, and investors capital doesn’t take the lion share) have their place in such a funding process. Also, DAO structures are way more flexible than SPAC ones. It is then important to identify several factors before launch (large/small, exclusive/open) especially because a DAO may have a purpose before funding, allowing investors to not invest in a sort of empty company. For example, if you want to create a sort of private social club, you may choose to make the funding process exclusive. If your goal now is to onboard millions of people onto your purpose, you’ll make the funding more open. The point here is clear; unlike SPAC, a DAO fundraise is more transparent and gives a chance to everyone if it’s aligned with its purpose. That’s why to identify the way you are going to bootstrap your treasury must be correlated with the purpose of your DAO.
Management i.e organization towards efficiency
It is no secret that every structure, either a SPAC or a DAO, has to be well managed to perform in the long term.
For SPACs, the Klausner/Ohlrogge study shows that high-quality managers are positively correlated to results, which seems logical. Nevertheless, high-quality managers are not common in such a structure. Indeed, raising funds is easier than ever, but is managing a company in a market you barely know the same challenge? Definitely not.
As an ex-PE Analyst, I know how things are happening when buying out a company via a sponsor, with incentives for the top management along with huge management packages and performance-based obligations. Doing it through a SPAC is way different as it is often making a private company public, adding a huge layer of complexity to the operations. The company will have to report its financials to the SEC as well as establish more structured governance with boards and committees, all of this in an accelerated time frame because of the SPAC structure (18 to 24 months to realize the merger). It’s then clear that getting a great deal is good, but if a SPAC wants to boost its share price, having a great deal is not even a thing. Sponsors behind SPACs will then have to capitalize on long term incentives (very paradoxical as investors have short-term incentives) for the top management, hiring people in sectors where value creation is possible and building a real equity story that is truly achievable and resonates in the public market (in contrary to the bs equity story that you could find in every sell-side M&A pitch deck).
The same challenge is present in DAO structures, mainly because this type of organization is still in its infancy. That’s why DAOs may struggle in coordinating their teams. But, contrary to traditional organizations and companies, DAO participants may have some feelings of fulfillment, meaning, and purpose, making them sometimes more long-term incentivized than the company’s management ruled by SPAC’s shareholders. You just have to look at how some DAOs are developing a well-engaged community just by coordinating financial and human capital towards a common purpose. Peoples want to feel useful, not as a simple wheel in the gear, but as a true decision holder (forum proposals to get soft consensus, token vote to get hard consensus, etc.)
In my opinion, DAO management's future is bright because of the developed tooling, from Snapshot to Gnosis safe, Coordinape, etc. Nevertheless, organization and management are still a huge challenge to overcome, especially because of the non-linearity of such organizations.
Investment strategy
SPACs’ investment strategies are very basic, as in any M&A buy-side process, but with a limited time frame. They have to find a target, get shareholders’ approval, and then merge, following a (very) quick due diligence process. Historically focused on positive EBITDA companies, the crisis made SPACs shift their strategy towards riskier. Indeed, the covid mania has created a huge market momentum in the first months of 2020, with companies struggling to sustain their debt, funds being left with non-profitable companies, and banks being tough in giving credit lines. All these macro trends have pushed higher acquisition multiples in some sectors (tech, healthcare mainly) even if companies were not generating any profit. An efficient market they said, but ok. We will see later that this phenomenon is a key factor of the SPACs’ lag.
There is honestly not much to say for SPACs’ investment strategies as the diversification is 0, leaving aside voluntarily some SPACs that aimed at some bolt-on strategies with their cash on hand. That’s a minority and is not relevant here.
On their side, DAOs’ investment strategies are, well, hard to describe. There are a ton of DAOs, all with different purposes and structures, but the flexibility of such organizations allows for more diversified and efficient investment allocations.
As you see, DAOs’ purposes are flexible and their investments could point towards everything (PleasrDAO that collects cultural artifacts, ConstitutionDAO that bought a copy of the U.S Constitution). To be honest, it’s hard to really compare DAOs and SPACs on such factor because they are not playing on the same ground, one having flexibility and time, the other being hurried in a very competitive market post crisis.
I think that through investment strategy aspect, a DAO could be better assimilated to a VC than a SPAC, but who knows, maybe a DAO will take over a protocol sooner than we think.
Capital rollover
I’ll just make a quick point here, especially to enlighten a very specific aspect to SPACs. As you may remember, SPACs’ IPO investors can redeem their capital at par any time before the merger. This poses not only a problem of available cash predictability for the acquisition, but it is also forcing SPACs to raise new funds post-IPO. Indeed, redemptions commonly leave the SPAC with only 25%–50% of the capital it initially raised. To fill in the gap and build enough additional capital for a larger acquisition, SPAC sponsors usually turn to PIPE (Private Investment in Public Equity) financing, further diluting ownership. This creates not only an inefficient capital rollover but also a dissemination of shares, rights and warrants along the road. Is this capital efficiency? I’ll let you decide.
Nothing here to say for DAO, as capital may go in and out of the structure in a more efficient way than in a traditional structure.
Return on Investment
Ah, this is maybe the most interesting part. You may think that such a closed flywheel between institutional investors must be very lucrative to invest such money in SPACs. Well, no. On a sample of 121 SPACs studied by Bain, more than 60% have lagged the S&P 500 since their merger dates, with 50% trading down post-merger.
The 63 SPACs studied in 2020 seem to be better performing than the 2016-2019 cohort, but it’s still early. Most of the SPACs have realized their merger in 2020 Q4, making figures hard to interpret. Moreover, it’s clear that most of the upside is done when trading is dominated by hedge funds, where they can buy at the IPO and earn risk-free gains by selling winners and redeeming the rest for cash. Then hold onto warrants to capture additional risk-free gains from the few—but extreme—post-merger winners. Not very different to CT guys nuking charts on their followers.
To give an example, S&P500 CAGR (annualized return) over the 2016-2021 period was around 17%, which is good for traditional market. Private Equity funds on their side are approximately targeting 15-20% of IRR (annualized return per target). You may understand, such returns are pretty achievable for DAOs evolving in the crypto space, considering of course that your DAO don’t end up in the rekt.news front page.
DAOs’ returns, are hard to extract because of the structure heterogeneity, some have tokens, some don’t, some are towards an investment goal, some are just protocols etc. Nevertheless, I’ve tried through this bref analysis to give a better understanding of some DAOs’ returns based on KPIs I found.
Taking as an example the single purpose ConstitutionDAO. They have raised around $44m with c.17500 participants. As they lost the Sotheby’s auction, I carried the return analysis over the price of its token, $PEOPLE, a bit as SPACs’ returns are calculated. Initially, $PEOPLE inception value was 1,000,000 $PEOPLE per ETH. As of 2022/01/26, it’s nearly 0.0026 per token. Current token price is 0.0044 at time of writing, inducing a 69% return since the raise (Nov.2021). It’s indeed not so relevant to state that the DAO has outperformed SPACs regarding its lifespan and the current market price action, but there are a lot of other DAOs’ tokens trading way higher than their inception price.
Taking Wonderland as an example of a protocol DAO, knowing moreover that Daniele stated that Wonderland has become a SPAC, the analysis would be totally different. Indeed, carrying the analysis through the token price would lead to a negative return of c.(13%), but carrying it through the market cap would give a positive return of c.25k%. Yes, that’s HUGE. But it’s easy to make the numbers say what we want, especially in the case of a rebasing token. In order to be fair, I think that such protocol’s returns should be calculated on the productivity of assets (Wonderland has a $1bn treasury generating c.$1m/day) and annualized it with a sort of P/E ratio. With this method, and with the hypotheses that cash flows from assets is constant over a year as well as the market cap (yes, that’s a lot of fuzzy hypotheses, I have to admit), we would have a P/E of 49x. To your knowledge, Compound is trading at 44x and Curve at 97x.
Conclusion
At this point, could we really answer to the problematic posed by this reading? I don’t think so.
I have tried through this article to build a comparison model over these two financial instruments specific to their market, but saying that DAO is a more efficient SPAC is maybe too early. Indeed, both evolve in different markets, are constrained (or not) by regulations and are funded by totally different capital holders. One seems to be transparent and fair, the other rigged and dominated by hedge funds. Nevertheless, I think that this breakdown gives a good mental model of how the two instruments have evolved so far and who they are serving. So yes, it’s easy to say that SPAC is trash by their very nature, but DAOs are not that old, as well as the market they evolve in, and some had also proved that they were not so different to their TradFi pair, or even worse. As an example, you may want to look at AnubisDAO, and how they rugged millions to participants.
If I had to give a true comparison, I would say that DAOs are gradually transforming into community owned boosted-VCs/PE funds rather than SPACs, but on chain and much more transparent, with higher flexibility and not ruled by risk averse LPs. Maybe a DAO could do far more than the traditional VC model, which is primarily advisory and funding, or maybe this model is what the market needs right now.
I would like to conclude this reading with an open thinking on an essential instrument of traditional finance aka debt. Indeed, debt allows TradFi funds to reduce the equity put on an acquisition, pushing down the cost of capital. Debt also allows them to diversify more with less capital. In crypto, debt is not even a thing because capital seems infinite, with protocols raising millions in 5min with no shipped product. But think a bit. Is debt a way for DAOs to counter the downward price pressure of their native token as well as the dissemination of their governance rights by raising equity? But, wait, isn’t the dissemination of governance rights the way to decentralize your DAO? To be honest, I don’t know, so maybe future will tell. Nevertheless, I already see great initiatives in the space to bring debt to DAOs, like @debitors, giving further tools to develop this type of organization and making this space even more exciting. Perhaps we could even see a DAO becoming a true SPAC, or a SPAC becoming a DAO (very unlikely tbh). In any case, in the long term, I think we may see a better parallelization of the two economies, for the better or the worse.
If you’d made it this far, thank you. I’ve put some time researching and writing this article, and I really hope you were not too bored reading it. Please feel free to share it if insightful and give any thought on it, as well as following me on twitter @0xAkimbo, would be happy to discuss.
Take care!