The Future of M&A on the Blockchain
There are only a few examples of on-chain (i.e., token to token) M&A to-date. Yearn and Pickle kicked things off in 2020, choosing to join forces and merge their vaults rather than continuing to co-exist as competing forks. Since then we’ve seen only a few others: Polygon purchased Hermez, merging their teams by swapping MATIC for HEZ; Gnosis bought xDAI, paying a small premium to cement an existing partnership and minority stake and bring everything in-house (despite some xDAI community misgivings); most recently, Fei acquired Rari, a combination that we’ve already written about at length.
And… that’s about it. There may be some other small M&A-like activity in the space that we’ve left out, but in terms of transactions of scale or significance there has been very little activity, despite acquisitions of off-chain Web3 counterparts exploding. As the space continues to grow and market conditions shift we believe that is likely to change, and we’re not alone. With that backdrop, we wanted to spend some time on the key pieces of M&A in a traditional context and how they may begin to take shape on-chain.
We’ll be taking a high-level pass through today, and will dig deeper into each of these topics separately in subsequent pieces.
On-Chain vs. Off-Chain
For starters let's spend a bit of time defining exactly what we’re talking about. There are a number of different permutations of what crypto deals might look like, but for simplicity's sake we’re going to contrast two types of deals on either side of the spectrum: traditional M&A between two centralized companies that are organized offline and are governed by a board of directors with ownership represented in shares (“Off-Chain” - e.g., Google buying FitBit or Intuit buying MailChimp) and M&A between two decentralized entities that are organized on-chain and are governed by a community with ownership and governance represented in tokens (“On-Chain” - e.g., any of the deals mentioned above).
It’s important to note that the majority of crypto deals done so far still technically fall under the “off-chain” umbrella. OpenSea buying Gem and Nansen buying ApeBoard are interesting deals with real DeFi ramifications… but, because of the nature of their organization they were likely structured similarly to a typical off-chain deal.
On-chain deals are different beasts entirely.
#1 Motivations: The Forking Issue + Near Term Advantages
It’s probably fair to say that, in general, a lot of deals will get done on-chain for traditional reasons - the ROI of buying vs. building, competitor consolidation, vertical integration, etc. That said, the open source nature of on-chain code creates new questions acquirers will need to ask themselves about potential targets: how easy is it to fork and/or replicate what a project is doing and how much value does the team, community, and user base bring beyond simply IP. This includes (but is not limited to): brand value, existing product network effects, and especially the talent and institutional knowledge that the core team brings, to the extent you can keep them around (more on this later).
I would also not be shocked to see a flurry of on-chain deals in the short term simply by virtue of the fact that it is an abnormally good time for potential acquirers to consider M&A. The bear market aside (relatively depressed token prices = cheap price tags), the currently lax regulatory environment and inefficient governance token markets present an interesting near term opportunity. Acquirers may also see projects with useful technology and strong developers with depressed prices due simply to poor tokenomic structuring or inefficient decentralized management. Finding market inefficiencies and getting a good deal is something buyers are always on the hunt for off-chain, however the relative illiquidity in the token market and the nascent nature of DeFi broadly makes this quest more likely to yield fruit on-chain. This is more true today than it will ever be in the future.
#2 Advisors: Deal Facilitators + Meditation
In the off-chain world “deal teams” usually include M&A advisors (bankers) to negotiate the large deal terms and render deal fairness and outside counsel (lawyers) to paper the contracts and negotiate some of the smaller and/or corner-case deal terms. Another advisory group that will likely emerge on-chain are deal facilitators (coders) to write the smart contracts that ultimately govern the deal. This is pure conjecture but pre-regulation I would not be surprised to see smart contract coders effectively fill a lot (the majority?) of the role on-chain that outside counsel fills off-chain. That said, as much as we may like to think crypto exists in its own bubble online and outside of the real world, the reality is this is real value exchanging hands with real world considerations and consequences… lawyers should be involved.
One last point here: I expect to see situations where advisors are engaged on behalf of both communities to price the deal, render fairness, design the contracts, and give legal advice in a mediation role rather than that of a one-sided advocate. This will obviously depend on the nature of the relationship between the teams, the timing advisors are brought in, any pre-deal advisor relationships/conflicts, etc. but the often collaborative nature of Web3, the ability to split advisors costs, and the current scarcity of third party advisors in the space may make this an attractive option.
#3 Diligence: Code Audits + Background Checks
The biggest difference in on-chain versus off-chain diligence that I expect us to see is the monumental importance of the code audit. Off-chain deals always include code scans and basic auditing but hacks in DeFi have potentially massive consequences for acquirers, putting a massive premium on this portion of diligence relative to traditional deals. Off-chain hacks of something you acquired lose you data, reputational credibility, and maybe a civil suit; on-chain hacks may lose your users millions of dollars with the restitution crippling your treasury.
Another key difference to consider is the doxing of anonymous core team members and key token holders. Whether this happens openly in the public forum or behind closed doors will likely be a point of negotiation, but acquiring protocols would be wise to do some individual due diligence prior to forking over large amounts of capital to any anonymous folks on the other side of the deal. I would also not be shocked if it became standard for core team members to go through background checks and/or wallet tracing.
#4 Valuation: Fundamentals vs. Potential + The Nature of Tokens
I would expect on-chain M&A fairness valuations to take on a mix of public and private off-chain characteristics. Off-chain public deals are fairly formulaic. You usually have real cash flow to consider, trading data from an efficient and well-informed trading constituency, and publicly-traded comps to lean on. Private deals can be a bit squishier. Targets rarely have cash flow and your best “trading history” is the valuation from the most recent fundraise - these values are less about formulaic “fairness” and more about gut feel on potential, precedent, and the value expectations of founders and investors.
I would expect on-chain deals to be a mix of both of these concepts. Many token-governed protocols have public trading data but in a relatively uninformed (at least in terms of financial disclosure) and inefficient market. Some protocols are cash flow positive but that is certainly the exception rather than the rule today. Attempting to use science of fundamental valuation principles while balancing the art of projecting potential will be extremely challenging for advisors, but it will be key.
Lastly, tokens and shares have many similarities but they are not the same and cannot be valued the same. I’ll write more deeply about this another time, but suffice to say that rights and value accrual will differ from token to token, tokenomic structure will impact valuation tremendously, future emission negotiations will matter a lot in some cases, etc.
#5 Non-Price Deal Terms: Potpourri
This could be a massive list, this is my attempt to distill the biggest ticket items.
Unaffected Price Calculation: insider trading is a reality in crypto that (theoretically) doesn’t need to be accounted for off-chain. Any exchange ratio calc will need to be based off of a truly unaffected price that may need to be negotiated. See the “Unaffected Date” portion of our Fei/Rari piece for my more detailed views on this.
Reps & Warranties: This has been effectively ignored to date on-chain (as far as I can tell) but shouldn’t be. Basic reps and warranties should be agreed upon with regard to financial accuracy and code integrity with an on-chain arbiter engaged to mediate in the event of a claim.
Indemnification: In connection with the above, rep and warranty insurance (to the extent that it is ever developed and offered on-chain) or partial deal consideration holdback should be negotiated and agreed upon to indemnify the buyer of any breached reps. On-chain this would likely look like an escrow vault or perhaps wrapped, claimable tokens exchangeable for unwrapped tokens upon term expiration. There are a few ways to get creative here to make this work on-chain but this will be absolutely key to mitigating the risks (particularly hack risks) that come with protocol acquisition.
Talent Lock-Up: This matters off-chain but this really matters on-chain given the aforementioned open-source nature of on-chain protocols and premium on talent acquisition. This is another area for creativity but I would not be shocked to see large chunks of deal consideration be broken out into a retention pool for core team members, performance earnouts, or revesting agreements with a larger premium applied.
While it’s likely impossible to predict how M&A will ultimately evolve on-chain. The deals that get done over the next few years will be responsible for a lot of precedent setting and playbook writing. All that said, an understanding of how and why off-chain deal processes look the way they do in conjunction with an understanding of tokens and the on-chain world help us understand what they probably should begin to look like as the space moves forward.