Ever heard of the Modigliani-Miller Theorem (M&M)? As I was walking to grab dinner today, M&M suddenly popped into my head. A theory that every Finance major has heard of, but one probably not really remembered (given its lack of real life applicability), the M&M theory broadly states that “the market value of a company is correctly calculated as the present value of its future earnings and its underlying assets, and is independent of its capital structure”. Why do companies take on debt then? Well, this theory is only applicable under four key assumptions: there are no taxes, no bankruptcy nor transaction costs, no information asymmetry, and investors have the same cost of borrowing as companies. Realistic? No… BUT, the theory does have value as one can build propositions off of it by changing an assumption at a time. Add in taxes, and borrowing becomes very valuable as it lowers the cost of capital and enhances firm value. Add in transaction and bankruptcy costs, and now the level of leverage becomes a tradeoff between the tax benefits and the potential bankruptcy and transaction costs. You get the point.

Anyways, thinking about this theory, and how theoretically one can calculate the optimal leverage ratio for a company under certain conditions, I realized that nearly all DAOs lack debt. Quite weird, right? We have a set of financial theories, as well as a lot of practical research, which argue for the levering of firms. At least a little leverage can be value enhancing. So, why don’t DAOs have debt? Well, I think there is some rationale supporting the fact that all DAOs are too young in their lifecycle to lever up. For example, check out this graphic (taken from one of Aswath Damodaran’s presentations):

If we were to reasonably assume that all DAOs fit under Stages 1–3 (and 3 is pushing it), then debt is not practical. Why? Because high growth is high risk, and the cost of debt for DAOs would be too high as to not be value enhancing for a DAO. This is fair and I concede it; however, I have two scenarios in which it does make sense to think deeper about a DAO’s capital structure and its use of debt.

Firstly, the space might not be there yet, but it will get there sooner than later, especially for some of the bluechip DAOs (i.e. MakerDAO). Starting to think and speak (as a community) about DAO leverage makes sense. Even if we could begin to take small, baby steps with regards to levering DAOs, we would benefit from it. Secondly, why should that graphic apply to DAOs? It is a tough question, but in some sense a fair one. DAOs are in many ways different structures and treating them as full fledged companies could be dangerous. By dangerous, I mean both for saying that they are too early for debt as well as that they should be taking on debt. Frank conversations and experiments is what we need to be focused on. Maybe it is the case that DAOs shouldn’t take on much debt for a number of reasons that we develop. But maybe, and I think theoretically, they should. And that is what we need to start figuring out.

What are the pros and cons of debt, at least in the way that we understand it to be for companies?

Pros

• Tax benefits. The tax code (in general) is tilted in favor of debt, with interest payments being tax deductible in most parts of the world. Yes, DAOs do have to and should have to pay taxes

• Discipline. Debt creates a disciplinary force for managers (in the case of DAOs, core contributors and community). Borrowing money makes capital allocation more thoughtful and adds another set of parties who are involved in the success of the business

Cons

• Bankruptcy costs. Borrowing money increases the probability and possibility of bankruptcy. It increases insurance premiums, affects valuation, presents increased costs to certain services, etc.

• Agency costs. What is good for lenders might not always be good for the equity holders. This is a bit trickier for DAOs given the automation and anon P2P nature of DeFi lending (but this will most likely begin to change and, even without change, lenders do have expectations and there are implicit restrictions on actions)

• Loss of future flexibility. This is a big one and a notable concern in the crypto space. If a DAO levers up, it is losing flexibility to react to certain events and is absorbing debt capacity now at the cost of not doing it in the future

While these were rationalized for the corporate / equity world, they all apply to DAOs and would form considerations that each DAO would have to digest as they think about leverage.

This will be by far the trickiest subject of thought. Even in the TradFi world, all one really has at their disposal is some tools and theories; however, in reality none of that can truly spit out what is the right leverage ratio. These theories and assessments change with time, and perhaps we need a new way to do so in crypto. That being said, just understanding the relationships between debt and no debt can point to general directions for a DAO to go with regards to levering. I learned of five ways to determine the optimal capital structure:

1. Lifecycle approach (refers to the graphic discussed above)

2. Cost of capital approach — the optimal debt ratio is the one that minimizes the firm’s cost of capital

3. Enhanced cost of capital approach — the optimal debt  ratio is the one that generates the best combination of low  cost of capital and high operating income

4. The APV (adjusted present value) approach — the optimal debt  ratio is the one that maximizes the overall value of the firm

5. Sector approach — the optimal debt ratio is the one that  brings the firm closes to its peer group in terms of financing  mix (less applicable until DAO debt is much more established)

Using components of these tools / theories, DAOs could get a sense of what direction to go in with regards to leverage. Each one has its pros and cons, and thus a wholistic approach would be advised. Perhaps, with a steadier revenue and some profitable capital allocation opportunities, knowing to lever up a bit calls for the use of these tools to understand around what leverage range to aim for.

After understanding what move to make (i.e. lever up a turn or two), the choice of debt instruments is another big consideration. Should it be fixed or variable? In USDC, DAI, or even Euro stables? 5 year or 30 day maturity? These considerations are important, and factors like the intended use of capital, profit stability, strength of DAO treasury, macro outlook, etc. all play into this. The one known as it pertains to DAOs here is that DAOs are currently limited in their choices. DeFi innovation has been tremendous, but we still have a long way to go. With protocols like Element Finance and Notional Finance leading the way with fixed rate lending, there are some inroads forming on the fixed vs. variable front. However, when it comes to denominations and tenures for debt, the choices are limited. It will take time for debt markets to professionalize, yet, if DAOs start engaging with the debt protocols, then progress on both fronts would be reinforcing and symbiotic.

This post is just the tip of the iceberg for corporate debt; however, these are some high level buckets that should at least kick off a conversation or two. The real elephant in the room is whether DAOs are even ready for this or not… and that is tough to answer. Also, what opportunities are out there for deploying capital that require a big chunk of debt? Perhaps mergers will be the first one. Yes, protocols like Tribe have big treasuries and can spend tokens, but why not add in some leverage into the mix, assuming taking a loan from Notional or Maple would be possible? All just considerations to think about.

Debt is very valuable in the corporate world. Used correctly, it can enhance firm value, be used in strategic situations, and facilitate operations. Used incorrectly… it is BAD. I have faith in correct use, but we need to figure a lot out first. I look forward to talking about this subject more with fellow DAOs and peers in the space.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

Ever heard of the Modigliani-Miller Theorem (M&M)? As I was walking to grab dinner today, M&M suddenly popped into my head. A theory that every Finance major has heard of, but one probably not really remembered (given its lack of real life applicability), the M&M theory broadly states that “the market value of a company is correctly calculated as the present value of its future earnings and its underlying assets, and is independent of its capital structure”. Why do companies take on debt then? Well, this theory is only applicable under four key assumptions: there are no taxes, no bankruptcy nor transaction costs, no information asymmetry, and investors have the same cost of borrowing as companies. Realistic? No… BUT, the theory does have value as one can build propositions off of it by changing an assumption at a time. Add in taxes, and borrowing becomes very valuable as it lowers the cost of capital and enhances firm value. Add in transaction and bankruptcy costs, and now the level of leverage becomes a tradeoff between the tax benefits and the potential bankruptcy and transaction costs. You get the point.

Anyways, thinking about this theory, and how theoretically one can calculate the optimal leverage ratio for a company under certain conditions, I realized that nearly all DAOs lack debt. Quite weird, right? We have a set of financial theories, as well as a lot of practical research, which argue for the levering of firms. At least a little leverage can be value enhancing. So, why don’t DAOs have debt? Well, I think there is some rationale supporting the fact that all DAOs are too young in their lifecycle to lever up. For example, check out this graphic (taken from one of Aswath Damodaran’s presentations):

If we were to reasonably assume that all DAOs fit under Stages 1–3 (and 3 is pushing it), then debt is not practical. Why? Because high growth is high risk, and the cost of debt for DAOs would be too high as to not be value enhancing for a DAO. This is fair and I concede it; however, I have two scenarios in which it does make sense to think deeper about a DAO’s capital structure and its use of debt.

Firstly, the space might not be there yet, but it will get there sooner than later, especially for some of the bluechip DAOs (i.e. MakerDAO). Starting to think and speak (as a community) about DAO leverage makes sense. Even if we could begin to take small, baby steps with regards to levering DAOs, we would benefit from it. Secondly, why should that graphic apply to DAOs? It is a tough question, but in some sense a fair one. DAOs are in many ways different structures and treating them as full fledged companies could be dangerous. By dangerous, I mean both for saying that they are too early for debt as well as that they should be taking on debt. Frank conversations and experiments is what we need to be focused on. Maybe it is the case that DAOs shouldn’t take on much debt for a number of reasons that we develop. But maybe, and I think theoretically, they should. And that is what we need to start figuring out.

What are the pros and cons of debt, at least in the way that we understand it to be for companies?

Pros

• Tax benefits. The tax code (in general) is tilted in favor of debt, with interest payments being tax deductible in most parts of the world. Yes, DAOs do have to and should have to pay taxes

• Discipline. Debt creates a disciplinary force for managers (in the case of DAOs, core contributors and community). Borrowing money makes capital allocation more thoughtful and adds another set of parties who are involved in the success of the business

Cons

• Bankruptcy costs. Borrowing money increases the probability and possibility of bankruptcy. It increases insurance premiums, affects valuation, presents increased costs to certain services, etc.

• Agency costs. What is good for lenders might not always be good for the equity holders. This is a bit trickier for DAOs given the automation and anon P2P nature of DeFi lending (but this will most likely begin to change and, even without change, lenders do have expectations and there are implicit restrictions on actions)

• Loss of future flexibility. This is a big one and a notable concern in the crypto space. If a DAO levers up, it is losing flexibility to react to certain events and is absorbing debt capacity now at the cost of not doing it in the future

While these were rationalized for the corporate / equity world, they all apply to DAOs and would form considerations that each DAO would have to digest as they think about leverage.

This will be by far the trickiest subject of thought. Even in the TradFi world, all one really has at their disposal is some tools and theories; however, in reality none of that can truly spit out what is the right leverage ratio. These theories and assessments change with time, and perhaps we need a new way to do so in crypto. That being said, just understanding the relationships between debt and no debt can point to general directions for a DAO to go with regards to levering. I learned of five ways to determine the optimal capital structure:

1. Lifecycle approach (refers to the graphic discussed above)

2. Cost of capital approach — the optimal debt ratio is the one that minimizes the firm’s cost of capital

3. Enhanced cost of capital approach — the optimal debt  ratio is the one that generates the best combination of low  cost of capital and high operating income

4. The APV (adjusted present value) approach — the optimal debt  ratio is the one that maximizes the overall value of the firm

5. Sector approach — the optimal debt ratio is the one that  brings the firm closes to its peer group in terms of financing  mix (less applicable until DAO debt is much more established)

Using components of these tools / theories, DAOs could get a sense of what direction to go in with regards to leverage. Each one has its pros and cons, and thus a wholistic approach would be advised. Perhaps, with a steadier revenue and some profitable capital allocation opportunities, knowing to lever up a bit calls for the use of these tools to understand around what leverage range to aim for.

After understanding what move to make (i.e. lever up a turn or two), the choice of debt instruments is another big consideration. Should it be fixed or variable? In USDC, DAI, or even Euro stables? 5 year or 30 day maturity? These considerations are important, and factors like the intended use of capital, profit stability, strength of DAO treasury, macro outlook, etc. all play into this. The one known as it pertains to DAOs here is that DAOs are currently limited in their choices. DeFi innovation has been tremendous, but we still have a long way to go. With protocols like Element Finance and Notional Finance leading the way with fixed rate lending, there are some inroads forming on the fixed vs. variable front. However, when it comes to denominations and tenures for debt, the choices are limited. It will take time for debt markets to professionalize, yet, if DAOs start engaging with the debt protocols, then progress on both fronts would be reinforcing and symbiotic.

This post is just the tip of the iceberg for corporate debt; however, these are some high level buckets that should at least kick off a conversation or two. The real elephant in the room is whether DAOs are even ready for this or not… and that is tough to answer. Also, what opportunities are out there for deploying capital that require a big chunk of debt? Perhaps mergers will be the first one. Yes, protocols like Tribe have big treasuries and can spend tokens, but why not add in some leverage into the mix, assuming taking a loan from Notional or Maple would be possible? All just considerations to think about.

Debt is very valuable in the corporate world. Used correctly, it can enhance firm value, be used in strategic situations, and facilitate operations. Used incorrectly… it is BAD. I have faith in correct use, but we need to figure a lot out first. I look forward to talking about this subject more with fellow DAOs and peers in the space.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*