Private Rounds or Public Auctions? Fundraising in the Age of the DAO

Written by Jordan Stastny (@jstastny101) and Sam Bronstein (@Sam_Bronstein).

A lot has been written about the importance of diversifying DAO treasuries in the name of liquidity/capitalization. Today, let’s talk about some of the methods DAOs with publicly traded governance tokens might utilize to raise capital. Specifically, we’re going to focus on the pros and cons of private versus public capital and three specific structures for public capital auctions [1].

Something to note: these are all ways to diversify at scale (i.e., in ways other than simply selling small chunks of tokens on an exchange). Any DAO with a floating token can obviously sell on the open market, but they usually can’t make a dent in their capitalization needs without putting material selling pressure on their governance token given the relative lack of liquidity. These are all methodologies that allow DAOs to alleviate that concern while still raising the funds it needs to operate.

Private Capital

While many compare diversification/capital from a VC fund to a traditional, off-chain private capital raise, the proper TradFi analog is probably a PIPE (Private Investment in Public Equity). Regardless of your choice of analog, tapping institutional investment funds is a simple and common way for protocols to raise money in DeFi.

The common practice thus far has been fairly simple: the DAO’s governance token is exchanged for stables or Ethereum at some discount to its current market price. Discounts have varied but in general the common practice currently appears to be in the ballpark of 30-50%. If that sounds hefty, that’s because it certainly is, but it does usually come with a vesting period in the range of 2-4 years and often includes a one-year cliff, so it isn’t necessarily a steal for the investors. On the one-hand, all the VCs who took part in Lido’s ~$70M raise at a steep discount last May probably feel pretty good about that decision. The investors who funded POOL’s stablecoin diversification around the same time? Probably not so much. Whatever the “right” discount vs. lock-up tradeoff is will likely take some time to sort itself out, but this is more or less what would be considered standard today.

The Positives of Private Capital

This heavily depends on the specific investors involved and what each DAO values as a community. There is certainly merit in the “stamp of approval” marketing you get from being able to boast brand name investors. The price of LUNA ran over ~100% in the week after Galaxy Digital’s $25M investment was announced. Correlation is not necessarily causation, but it’s probably fair to say that this particular private investment discount more than paid for itself immediately.

In addition to the marketing value, you also (theoretically) get a long-term partner that can bring relationships, know-how, and additional governance wisdom to the table. Included in that is a large shareholder who isn’t likely to just dump your tokens as quickly as individual token holders might [2].

As with anything, both of these positive side-effects will vary from investor to investor. Not all VC firms hold the same cachet and marketing value and not all will be incredibly helpful, hands-on partners. This probably goes without saying but in venture not all capital is created equally.

The Downsides of Private Capital

The big downside here is obvious: token holder dilution at a significant discount to market price. This can be especially painful in DeFi where you may feel like you have a bunch of other options to raise capital. To be perfectly blunt about it, there simply is not an analog in the traditional investing world (private or public) where this size of discount to the “market value” of equity is swallowed when fundraising [3]. That doesn’t necessarily make it an unfair trade, but it does make it understandable that protocols and communities would have reticence to diversify this way.

Going down this route is, quite simply, a trade-off between capital at a discount to market and the partnership, stability, and marketing value that specific capital brings. That’s the trade.

Public Auctions

Another way to raise capital without hitting exchanges or negotiating with VCs is simply auctioning off some of your treasury to the public in what effectively amounts to a retail crypto version of a diluted follow-on public offering [4]. Auctions can be limited to existing token holders, an invite-only group of potential new token holders, or not limited at all; part of the beauty of public auctions is that both the audience and mechanism for price discovery are, at least to a certain extent, up to the DAO.

The Positives of Public Auctions

There are a few different things to like here. DAOs get a chunk of capital without being required to slowly diversify in the open market or rely on an institution to play ball at a price they are comfortable with. Auctions will always be at a discount to market price (this is the case by necessity) but the size of that discount will likely be nowhere near the terms you would have to give a venture capitalist. The auction itself can also serve as a marketing event to drive protocol awareness and usage, this value can be compounded if DAOs choose to align the timing of the auction with a product release or something similar. On their face, most free market auctions also stick very cleanly to the ethos of DeFi and crypto more broadly, to the extent you and/or your community are particularly passionate about that.

The Downsides of Public Auctions

Whereas a private capital raise has one massive negative to consider (dilution at a highly discounted price), public auctions have a bunch of smaller issues to think about.

First is the need to market your event. Auctions only work if people show up; pricing terms are heavily dependent on demand. The larger the amount of funds you wish to raise, the more true this fact is. Second is the negative signaling that comes along with selling treasury tokens at scale – this is true of basically any diversification strategy (i.e., “if you’re so confident in your token then why are you selling it?”) but is compounded in this instance by the fact that the sale itself hinges on the aforementioned marketing. That said, negative connotations can be mitigated by being clear about your intentions and rationale for the capital raise (i.e., “we’re raising money specifically to fund initiatives X, Y, and Z which we’re super stoked about and you should be too because…”).

Lastly, off-exchange auctions require a discount to be effective (otherwise participants would just buy on exchanges) and thus require at least some degree of vesting terms to avoid price arbitrage. Given this fact, it’s important to consider the negative effects of a mass vesting event and the downward sale pressure that could be caused by your auction structure and terms. This can be mitigated by including vesting terms as an auction variable or by using a granular linear vest for all participants following an initial cliff. The reality is that individual “retail” investors are never going to be as stable of token holders as institutions will be; your auction terms will need to account for that.

There are obviously a number of different ways to structure a public token auction, today we’re going to consider three. To illustrate the differences, let’s look at a made up set of bidders in a fictional auction. Additionally, let’s assume that a protocol is looking to raise ~$250k in stables with a current market price of $50.

To create a hypothetical “demand” curve, I went ahead and created 100 made-up auction participants with randomly generated buy prices, using $35 as my minimum and $45 – a 10% discount to market – as my maximum. I also randomly generated hypothetical desired token quantities using a minimum of 50 tokens and maximum of 250. Lastly, I took the desired fundraise size of $250k and divided each potential bid price by it to create a theoretical “supply” curve for our auction as well. The results are below:

Note that this isn’t a normal supply curve (hence the quotations above) given we are focusing on a single event and a fixed fundraise figure rather than supply and demand on an exchange. Normal supply would obviously increase with price rather than decrease.

Now that our bounds are set, let’s talk about three different auction types and apply each of them to our set of bidders. One very important point to stress here: as with any economic model this exercise is both oversimplified and assumes bidders are rational actors and behave efficiently with regard to price discovery. There are likely a bunch of behavioral (i.e., FOMO) and technical (i.e., gas prices) realities that lead to imperfections in some of our conclusions here but I think the exercise is both interesting and directionally instructive when thinking about what roles various auction structures play in determining price. This is particularly true moving forward as the crypto community scales and crypto markets ultimately become more efficient.

Methodology #1: Batch Auction

In a Batch Auction [5], a dollar value of capital (or a fixed number of tokens) and a minimum price is set by the DAO beforehand, and a bidding period for the auction is scheduled. Bidders place their bids (both quantity and their own personal maximum limit price) throughout the bidding period. Taking all the bids into account, a clearing price at which the tokens will ultimately be sold is calculated as the lowest price at which the dollar value of capital can be filled while including the quantity of all the higher bids (pro-rating the lowest price bid with the lowest price to fill the remaining tokens/dollar value).

Using the supply and demand curves we created earlier, you can see how an auction structured this way would have theoretically ended up shaking out:

As mentioned before, the particularly nice thing about batch auctions is that DAOs are able to control some of the variables that might matter to them - you can flexibly focus on fixing the dollar value raised (or a fixed number of tokens distributed if you’d rather think about it that way) and you can easily set a minimum price. Assuming enough demand to simultaneously satisfy those two variables, a Batch Auction is able to accomplish price discovery at an individual level, group pricing preferences together, and calculate an efficient, “fair” price and distribute a DAO’s tokens accordingly based on where the supply and demand curves meet.

Methodology #2: Streaming Auction

In a streaming auction [6], a fixed number of tokens is set and a bidding period for the auction is scheduled. Throughout the bidding period participants are able to freely deposit and withdraw funds into a staking pool that represent their “bids.” The catch is that these deposits don’t individually come with a desired price, instead the price is implied based on the number of deposits in the pool, with the size of the pool and current implied price freely available for participants to see, allowing for bidders to hop in and out of the pool if the price is below or above the price they are individually willing to pay. The auctioned tokens are distributed linearly and continuously across the deposited funds in the pool. If you are confused it’s because this isn’t a straightforward concept on its face – Locke (a facilitator of such auctions) produced a simple, helpful video to explain more or less how it works.

Let’s assume for our hypothetical auction that we set aside 6,500 tokens to be continuously auctioned off over the course of our bidding/staking period. Again, we are assuming all bidders behave efficiently and rationally (a big assumption in general and a massive assumption in crypto, particularly today). Regardless, we ran the auction amongst our fake set of bidders and this is how it played out:

From a price discovery perspective the outcome is very similar to that of a Batch Auction. At least in theory, when auction price discovery occurs at a group level, irrespective of the precise auction mechanism, you are going to get a crowdsourced price outcome where supply meets demand. One positive to this particular structure is it is simply more transparent than the Batch Auction (i.e., participants are able to see current pricing terms and get in and out based on their own preferences). Bidders obviously enjoy that level of transparency/empowerment and it also could theoretically serve to generate perceived demand (read: FOMO) if it looks like more and more bidders are entering the auction pool. That said, transparency can just as easily cut the other way if you aren’t ready and willing to act as a stabilizing agent and do a bunch of staking in your own auction to keep the price afloat should things go poorly.

The primary negative with regard to the Streaming Auction is control. Unlike other auction choices, DAOs must by necessity set auction supply based on a fixed number of tokens (hence the straight red line in the graph above) rather than having the ability to set a fixed dollar value. This is compounded by the fact that if a DAO wishes to set a minimum price the primary way to do this is to simply stake in your own auction which may lead to your DAO acquiring large chunks of its own governance token back into treasury. DAOs can obviously account for this by planning to auction off more tokens but the variance between what your own staking position might net you is fully dependent on the demand your auction generates and thus more or less out of your control.

Methodology #3: Dutch Auction

In a Dutch Auction, a fixed number of tokens or dollar value of capital is set by the community beforehand, and a bidding period for the auction is scheduled. Over the course of the auction, the terms slowly change and become more favorable for bidders the longer the auction goes on – but with the catch that once the allotment is filled, the auction is over. DAOs can set-up a “fixed-vest” or “fixed-price” auction or some combination, depending on preference. In a fixed-vest scenario the bidding would begin at the current market price and scale down linearly over time to some set discount (5%, 10%, whatever you like). Bidders can buy at whatever price they please, subject to a set vesting period to avoid immediate price arbitrage. Conversely, in a “fixed-price” scenario the discount to market is set beforehand and the vesting period floats (starting larger and gradually getting smaller) over the course of the auction.

Assuming a “fixed-vest” Duction Auction with a floating price applied to our supply and demand curves illustrates the material difference relative to the other auctions structures:

Note that this outcome obviously assumes a few different things (the auction is truly done “blindly,” there is enough participation to avoid collusion, etc.) but because Dutch Auction price discovery is done and transactions are cemented individually rather than on the group level, it theoretically allows protocols to capture the most possible value throughout the auction.

That all being said, there is certainly a negative connotation with this type of structure given you are obviously selling the same token to different people at different prices (the specific economic term for this type of pricing is quite literally “price discrimination” and it’s most closely associated with airlines, so that should tell you something). An emotionless economist would tell you that this sort of negative connotation is nonsense - everyone is transacting at prices that they are clearly willing to pay. And at a discount! That said, I don’t know a ton of emotionless economists in crypto - my guess is that while more efficient and better for your current token holders, this wouldn’t necessarily be a super popular route if you are particularly concerned about PR.

In Conclusion

When DAOs make the decision to diversify their treasury and raise funds there are a number of different variables to consider with regard to source of capital and pricing structure. This is nowhere near an exhaustive list but hopefully can be utilized by protocols and communities in the future when approaching this decision and thinking about the pros and cons of various strategies.

[1] This is not an exhaustive list. There are many types of auctions.

[2]  DeFi is probably way too nascent for publicly traded protocols to be thinking about shareholder optimization yet, but this stuff does matter.

[3] The only real comparison I can think of is underpriced IPOs but at least in that case you can half-heartedly argue there was no set market price to begin with.

[4] Note that an at-the-market offering is a version of a follow-on that would be more analogous to algorithmically diversifying over time via an AMM. We’re basically just focusing on a single event, at scale version of this.

[5]  Would refer to Gnosis Batch Auctions as an example of this.

[6]  Would refer to Locke Protocol’s Streaming Auction as an example.

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Artwork credit: 0xEFRA.

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