Valuing Protocols and Tokens

Market Cap, FDV, or Somewhere in Between...

In my former life as an M&A banker one basic piece of analysis we would often do for our clients was called an AVP (“Analysis at Various Prices”). We would look at a range of potential transaction prices per share for a given company and imply aggregate deal values by multiplying these share prices into the outstanding shares. This was usually a very simple exercise but having deal values (i.e., the aggregate value of all of a company’s shares) and transaction multiples laid out at different prices was often useful to get a directional sense of what price a deal may or may not be attractive at (on either side of the transaction).

I’m not a super active public equities investor, but I can imagine when making buy/sell decisions on individual stocks some version of this same analysis might be useful as well. One could apply a few different revenue or cash flow multiple (or run a DCF under different assumptions) to determine some potential company values and then divide by the number of outstanding shares figure to spit out what those values imply about the price of a share in that company under these various scenarios.

This is probably all very obvious and straightforward to those of you who have spent any time at all in banking, public equities, or finance in general… The point to understand here is that the taking the proper number of outstanding shares as given is a key part of the equation that ultimately gives you what you are looking for, whether it be an ultimate M&A price tag or a target share price based on different valuation assumptions. Correctly identifying/calculating this number can make a pretty material difference to the analysis in either instance. This is even more true in DeFi, where the proper number of “outstanding” tokens in a given protocol is not always apparent.

In traditional finance there are two basic ways to think about the aggregate value of the equity interests in a public company, they are both fairly simple. 

1. Basic Market Capitalization = Outstanding Basic Shares x Share Price

   written another way…

   Share Price = Basic Market Capitalization / Outstanding Basic Shares

When Google or Yahoo Finance lists the “Market Capitalization” of a company, they are literally taking the basic outstanding shares from the latest public filing that requires share disclosure (for US companies this is usually a 10-Q or a 10-K, sometimes a proxy or prospectus) and multiplying that number by the share price. This is not very different from market caps in crypto, which is simply the circulating supply of a given token multiplied by its price. It is the quickest and dirtiest way to think about the “value” of a company.

This number isn’t wrong, per se, but the reality is it is usually incomplete. Market capitalization gives you the value of the outstanding shares of a company or the floating tokens of a protocol, that’s it. Most companies have other equity interests that aren’t captured in the basic outstanding figure reflected in the filings described above, which is why oftentimes folks choose instead to focus on the second, more “complete” method.

1. Diluted Market Capitalization = (Outstanding Basic Shares + Other Outstanding Equity Interests

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   ) x Share Price

   written another way…

   Share Price = Diluted Market Capitalization / (Outstanding Basic Shares + Other Outstanding Equity Interests)

I suppose it depends on the context but in most cases this is the “right” way to think about market capitalization or “Equity Value” given it captures the value baked into the other equity interests in the company. This includes stock options, RSUs, convertible bonds; basically anything that isn’t technically equity today but has the possibility of becoming equity in the future and has already been granted. Smart money trading public equities absolutely price in this type of future dilution when buying or selling, any analysis you do on the company should as well.

In some cases the difference isn’t really important (if a company doesn’t issue equity awards or hold any convertible debt then these numbers should be the same) but it often matters tremendously. High growth technology companies, for example, tend to rely on stock-based compensation and/or convertible debt financing more often than their more mature, low-growth counterparts. In these cases using the basic equity value calculation would completely miss a large chunk of aggregate company value implied by their share price. If you’re an investor evaluating the price of a stock, it would cause you to overstate your target price. If you’re another company looking to make an acquisition, it would cause you to understate the ultimate price tag. Dilution matters, even if it technically hasn’t occurred yet.

In DeFi, this distinction is oftentimes an even larger deal than in traditional company analysis. Not only do core team members usually have vesting terms applied to their token issuance but investors usually do as well, creating a large balance of issued but unvested tokens with known vesting dates. Beyond that, while reward emissions aren’t technically “outstanding” their issuance schedule is generally known and that dilution (at least the near term amounts) is likely baked into the trading price of the token as large liquid token investors account for it.

The characteristics of the equity interests in DeFi protocols and traditional companies obviously differ but this principle remains: any organization, decentralized or otherwise, has an intrinsic value attached to it and that value is dispersed among both vested floating interests and unvested, future interests. When thinking about the correct value of a protocol, the right answer is almost never the market cap or fully-diluted value of its governance token, but rather somewhere in the middle.

With that backdrop - here is how I am currently thinking about and accounting for various equity value adjustments when looking at DeFi protocols, both in the context of trading value as well as in a hypothetical M&A scenario.

#1 Unvested Investor / Core Team Tokens

This is not terribly distinct from traditional companies, the difference between TradFi and DeFi though is simply the scale of unvested rewards you are often dealing with. 

In M&A you are likely going to need to think of these unvested tokens as effectively the same as any other vested, circulating token from a price tag perspective. You could theoretically negotiate the cancellation of some of these unvested tokens held by core team members who may not be continuing on with you after the acquisition, but in the majority of cases I would imagine the acquiring protocol is going to end up paying these out (likely on the same vesting schedule)

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As a liquid token investor how you might look at these awards likely depends on your anticipated hold period. They might not be vested and out in the market today, but if I’m anticipating holding for 2-3 years and substantially all of these tokens will be vested by that point then, for all intents and purposes, they may as well be vested today. It must be said: I am not currently much of a liquid token investor, my guess is there are other, more precise ways to think about this.

#2 Treasury Tokens

From an M&A price tag perspective any treasury tokens should be effectively ignored in the majority of cases. They aren’t held by anyone you need to pay out in conjunction with an acquisition. They are held by an entity, an entity that you would be acquiring. They can be swapped out or burned or left in the old entity’s wallet forever, it makes no difference.

From a trading perspective how you look at it likely depends on the protocol. On the one hand, the value of all tokens held in treasury today should, theoretically, accrete to each governance token holder

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. On the other hand, many protocols use their treasury quite regularly to pay for things. I would personally look at past treasury issuance and extrapolate out that assumed issuance across my assumed holding period and call it a day. Again, I would not be shocked if there are more precise ways to think about this.

In either event - the key point here (that many people either miss or don’t understand when thinking about the value of a protocol) is that governance tokens held in treasury today do not count towards the aggregate equity value of that protocol today. They mathematically cannot.

#3 Reward Emissions

I would assume most traders look at these in a similar manner to unvested tokens - the only difference being perhaps a slight discount given the potential for reward emissions to be changed. Regardless, it’s all about the emissions rate and your hold period and what that implies about the degree to which you expect to be diluted while holding onto a token. That’s it.

In M&A… the short answer is “it depends.” For an acquiring entity you should likely think about it as a matter of negotiation. Most rewards are mutable, meaning if both entities agree you can go ahead and cancel future emissions and call it a day

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(my understanding is this was the case in the Fei/Rari transaction, for example). If they are immutable… welp, you’re effectively going to be funding that and will need to tack it onto your assumed price.

Conclusion

As a general rule of thumb, folks in DeFi simply do not think enough about equity dilution. This is true when pricing a protocol in aggregate, a token individually, or even just a DAO thinking through the consequences of token-funded expenses. Accounting for it in each instance does matter and has tremendous impact on value-driven problem solving and decision making.

1. Note that where applicable these equity interests would need to be represented net of exercise price. This includes options, convertible bonds, etc, etc.

2. This is true for a lot of reasons… not the least of which being unvested token holders usually hold large portions of voting power and won’t vote for something that cancels the unvested portion of their holdings. Also, on a macro level, I personally don’t recommend canceling or refunding already-paid-for tokens held by investors who are funding the development of your space and setting the industry back decades.

3. I understand that this being explicitly the case can run you into Howey Test issues, but if this isn’t implicitly the case… then what the hell does anyone think all of these investors are doing here?

4. Maybe not always a good idea, depending on the type of rewards. Liquidity rewards will almost certainly go away but protocol usage/infrastructure rewards might be pretty important to keep the protocol you’re buying running properly. This will likely become a key part of any pre-acquisition analysis.