While venture capital’s interest in crypto continues despite the bear market, it might well be undergoing a critical test. Episodes such as the sanctioning of Tornado Cash throw light on the friction between the law of the land and the law of decentralization. While this has caused great debate in the crypto community, it has steadily created deeper concerns among venture investors, albeit quietly. A watershed event occurred (and passed without much fanfare) amidst the contagion, which exemplified these cracks.
Tanvi Ratna is the CEO of Policy 4.0, a research and advisory body working on policy approaches for digital assets.
On June 9 of this year, the community of Merit Circle DAO voted out Yield Guild Games (YGG) as their seed investor. By doing so, the community canceled the SAFT agreement binding Merit Circle Ltd., its parent entity, and its investor, YGG. This vote was the first incident where decentralized autonomous organization (DAO) governance overturned a legal agreement, and in its aftermath sent shockwaves across the investor ranks.
YGG gets booted out of Merit Circle
The simple agreement for future tokens (SAFT) is the de facto legal agreement used in financial deals for early stage crypto projects. Interestingly, this practice has its roots in the initial coin offering boom of 2017 as a way to avoid security regulations. When a project raises funds through a SAFT, it is accepting money from that investor without selling, offering or exchanging a coin or token. However, SAFTs are non-debt financial instruments and investors who purchase a SAFT may lose their money and have no recourse if the venture fails.
YGG entered into a SAFT agreement with Merit Circle Limited in September 2021 for a 175,000 USDC seed investment into Merit Circle DAO. Ahead of the vesting schedule, in April 2022, Merit Circle posted a new initiative on their forum asking seed investors to highlight their contributions to the Merit Circle DAO.
Many members of the community believed that YGG did not add value to the DAO. A member of the DAO created a proposal for canceling YGG’s SAFT by refunding their initial investment and buying back the tokens. This proposal received a majority vote and support from the DAO community.
This was an extremely worrying development for the founding team, which had to move into damage control mode. They highlighted the contributions of YGG to the community, even warned the community about the moral and legal ramifications of canceling the agreement. More importantly, they requested the owner of the proposal to put forward an alternate proposal to find middle ground with YGG. A counterproposal was finally passed wherein the DAO bought out YGG’s 5 million MC tokens at 32 cents each for a total of $1,750,000. While this gave YGG a substantial 10x return on its investment, it was left with no governance rights or any future involvement in the growth of the project.
The law of the land vs. the law of the DAO
Publicly, both YGG and Merit Circle DAO issued statements signaling an amicable settlement. But, speaking to CoinDesk on the condition of anonymity, several investors expressed deep concern over the incident.
The inability to publicly express concern over such an incident is already an odd compulsion for investors in the space. From a legal perspective, YGG did have grounds to enforce the terms of the SAFT and win back its governance rights and capital gains as accrued over the five-year period in the agreement. But most VCs admitted that they would not have taken such action either and would have reached a settlement like YGG did. Reputation is the most sacrosanct currency for investors in the space and any indication of them being unfriendly towards community decisions could severely impact their deal flow. As one investor put it, “In this space everything is dictated by narratives, whether or not the facts support it. We cannot risk a narrative building against our fund.”
Even if legal recourse existed, the incident showed how starkly underdeveloped legal protections are for investors in the space. Despite a SAFT being in place, it provided no protection when pitted against a community vote. Legal action was also overruled by investors due to the absence of legal precedent for situations like this, which could result in long drawn and fruitless legal battles for them.
As VC attitudes towards DAO investments get more cautious, this will “definitely shift the structuring of SAFTs going forward,” says Romit Mehta of Lightspeed Capital India. SAFT agreements may become more watertight with respect to the vesting schedule, obligations of the investor and the internal power structure of the DAO. The metrics for the value add of an investor may also be properly defined in future SAFT agreements. Investors might also confer additional requirements in terms of business structure such as for registering the DAO as a Wyoming DAO LLC, a brand new legal designation.
Can communities judge fairly?
On the one hand, this case shows the power of communities in holding freeloading investors accountable. On the other hand, given the often-intangible benefits of investors, it also raises real questions about whether communities can accurately gauge the value addition provided by investors. The perception of value provided by the investor can be different for founders, the core team and the community. The credibility brought by an investor to the project through early-stage funding is difficult to attribute quantitatively.
Additionally, in the early stages, investors and founders often have private discussions that might be very valuable for the project. Above all, there can be information asymmetry between the founders and the community once the project is sufficiently decentralized. Even in the case of Merit Circle, we saw that the founding team were in support of YGG and had a different opinion about their value add as compared to the community.
Nitin Sharma, General Partner and Global Web 3 lead of VC firm Antler Global, believes that value-add to crypto projects can either come from global institutional investors or investors with specialized knowledge in crypto. While crypto specialists bring in domain expertise for product development, global investors bring in new relationships, advisors, and employees from all over the world. Their experience in investing serves as a network effect and can be valuable for the early growth of the project. However, this is a value that is difficult for a community to evaluate.
In the case of YGG and Merit Circle DAO, YGG clarified in its official statement that the SAFT did not confer any obligation to provide any “value-add” services to the DAO. This raises the question of the criteria using which the community could dishonor a legal agreement and expel an investor.
Going forward, we will see more deliberations on whether the DAO community should have its say on all the matters of the DAO. The open system of governance might empower any community member to have their influence on all important matters concerning the DAO. But they could disregard legal commitments to investors.
At the same time, communities are the cornerstone for the success of a DAO. Founders have to strike a difficult balance between decentralization and having their voice and may decide to not pass on all the governance decisions to the community. Investors are themselves likely to engage in secondary due diligence and will look more deeply into the voting structure and expectations of the community.
This incident has set a landmark precedent in the investment boom into DAOs. Given the overall increase in regulation of crypto, and the bear market, we will see shifts in the way VCs legally structure their investments in future DAOs