Issue #35: Barbarians at the Gate

One of the greatest M&A stories of all time happened in 1988. RJR Nabisco, the resulting company after the merger of Nabisco brands and R.J. Reynolds Tobacco Company, was purchased in a leveraged buyout by famed private equity firm KKR (Kohlberg Kravis Roberts).

A leveraged buyout (LBO) is one company’s acquisition of another company using borrowed money (typically a loan from a bank), and collateralizing the loan with the assets of the company being acquired.

Takeovers like this happen when a private equity firm or existing shareholder believe they can create more value than the current management team. They make a tender offer directly to the company’s shareholders and purchase a majority of outstanding shares.

Pretty vanilla up to this point, but…

RJR Nabisco was a public company at the time. The CEO, F. Ross Johnson, had his own plans to take the company private at $70/share. KKR got wind of the deal, found financing, and ultimately took control of the company by convincing the Board and shareholders to accept an offer of $109/share.

How the deal came together and the personalities that were involved was made for Hollywood. A year later, it was chronicled in the New York Times’ Bestseller Barbarians at the Gate, and turned into a movie with the same title in 1992.

I love deals and wrote about decentralized M&A a few weeks ago because I anticipated things heating up in the next bear market. What I didn’t anticipate was a hostile takeover attempt so soon. DeFi had a Barbarians at the Gate moment this week.

Let’s zoom in…

Venus

Venus is a money market and stablecoin protocol on Binance Smart Chain with over $2B of assets under its control. Users can borrow, lend, and mint synthetic stablecoins called VAI. If MakerDAO and Compound had a baby, it would be Venus. That analogy is truer than a I realized when I started writing this issue because it turns out Venus just forked the code of both protocols when it started.

Earlier this year Venus, like many other DeFi protocols, transitioned control of the protocol to a DAO. Since then, the protocol has been managed by XVS token holders. Proposals are submitted to the governance process as Venus Improvement Proposals (VIPs). Addresses with more than 300,000 XVS can propose a change, and other tokenholders can vote to approve or reject proposals. Often, changes are related to supporting a new asset, interest rate models or core upgrades to the protocol.

Team Bravo at the Gate

Venus and its core team has been under a fair bit of scrutiny this year, in particular after a May 2021 price manipulation event found the protocol in $100M of debt. Immediately before the May event, XVS was trading near $140. For the last four months, the token hasn’t been able to stay above $40.

Now remember, anyone with 300,000 XVS tokens can submit a proposal through Venus governance. On Tuesday, an anonymous group of XVS token holders submitted VIP42, briefly outlining a plan to take control of the Venus protocol and treasury. The goal of the self-proclaimed Team Bravo was simple - “increase and sustain a high XVS price for investors”.

To execute on their plan, Team Bravo asked for roughly 3.7M XVS ($100M), the majority of which would vest over a five-year period.

Probably the most interesting aspect of the proposal though is Team Bravo’s promise to distribute 900,000 XVS ($30M) to wallet addresses that voted YES for VIP42. Yes you read that right - this promise is an attempt at bribing XVS token holders to approve the new team and plan. Now technically this isn’t illegal, because XVS token holders aren’t public officials or operating in an industry that explicitly forbids this activity, but I think we can all agree it doesn’t set a good precedent. You want changes of control to be based on the merits of the new team’s plan, not the fact that they are willing to pay you off.

Here’s where the story picks up steam...

Because the token threshold for a proposal was met, the proposal was active for over two days and actually passed with 1.3M XVS votes. It passed!

For a split second the barbarians had broken through the gates.

Immediately after though, the core team at Venus cancelled the proposal by executing a “guardian” function in the governance smart contract. Had the proposal not been cancelled at the 11th hour, the hostile takeover attempt would have been successful.

Decentralization Theater

The first thing that jumped out at me is how the story ends. The core team at Venus have an big CANCEL button built into the system they can press if they don’t like the direction governance is going.

I don’t know if it was a good thing or a bad thing that the Venus core team had the ability to cancel VIP42. It’s a matter of opinion. What I do know is the decision wasn’t left to token holders.

The purist would say that if your token holders are willing to support a Team Bravo-like proposal, then you clearly aren’t doing a good job and someone else should be allowed to take control. This is the way it works in corporate America. If you are doing a great job building a community and increasing protocol revenue, then you have nothing to worry about because the token price will reflect that.

As much as our industry loves to fly the decentralization flag, I suspect a lot of teams would have a hard time actually doing this. It’s easy to say you are decentralized when it is convenient from a regulatory standpoint. It’s much harder to say when a group of rogue token holders are trying to kick you out of your own project.

On the other hand, being able to prevent fraud and malicious actors is desirable. If Team Bravo’s motivations were to get control of the protocol for personal gain, then in this instance maybe the right outcome was reached. Ideally, token holders are smart enough to sniff this out on their own and make a decision in the best interest of the community.

The lesson I take from this is that protocols need to be at one end of the decentralization spectrum or the other. Long term, if you live in the middle, you’re dead. If the Venus team was operating out of the US, the fact that they have a guardian function in their governance contract controlled by the core team is all the evidence a regulator needs to prove centralized control.

Cautionary Tale

I suspect most projects in the ecosystem have already gamed out hostile takeover scenarios. If not, they are doing it now.

One common way to prevent just any proposal from making it through is to implement thresholds. In this regard, many protocols have adopted measures you see in public companies today. For example, you need a certain percentage of the token supply (i.e. 1%) to submit a proposal. For more mature protocols with bigger market capitalizations, meeting that threshold can be quite expensive. While it didn’t prevent Team Bravo, Venus requires 300,000 XVS to submit a proposal. That is over $9M at current prices. Uniswap requires 2.5M UNI (0.25% of the token supply) to be delegated to your address to submit a proposal.

Healthy token distribution and governance participation are also critical. The other thing that jumped out at me about the VIP42 vote was how few addresses participated. 16 addresses voted Yes, and 39 addresses voted No. According to BSC Scan, there are over 43,000 wallets holding XVS. Now some of those could be exchange and custodian wallets, but either way, less than 1% of XVS token holders voted for or against VIP42. With these participation numbers, it easier to game the process.

Parting Thoughts

The threat of a takeover is a powerful motivator for protocol core teams to start running their protocol and communities like companies in hyper competitive markets. As more institutional investors acquire stakes in these systems, I expect token holder activism to increase. There is just too much money at stake now.

One obvious area for improvement is treasury management. Projects are still not wielding their purse like they could and should.

As I’ve said before, the next bear market will be revealing.

Thanks for reading,

Andy

Not a subscriber? Sign up below to receive a new issue every Sunday.