October 16, 2017

Crypto Acquisitions: All Theory, No Practice

by Kyle Samani

Many have asked “how would a merger or acquisition work in crypto?”

Although a merger could work in theory, in practice it’s not possible. The economics, individual sovereignty, and lack of drag along rights on both sides will prevent any sort of meaningful and cleanly executable acquisition.

Drag along rights are paramount to understanding this post. Per Investopedia, a drag along right is defined as a “right that enables a majority shareholder to force a minority shareholder to join in the sale of a company. The majority owner doing the dragging must give the minority shareholder the same price, terms and conditions as any other seller.”

Traditional Acquisitions

When one company buys all of the equity of another firm, it acquires a few things:

  • Employees – the people who have the know how to build and deliver the product/service to customers.
  • Customers – a proven customer base that values and pays for a product/service.
  • Processes – a series of proven processes of people, property, and technology that create value for customers.
  • Balance sheet – the actual hard assets and liabilities of the firm: cash, debt, equipment, debt, etc.
  • Intellectual property – patents, trademarks, copyright, etc.

Crypto Acquisitions

Let’s say that a company or a crypto foundation wanted to buy all of the tokens of some cryptoasset. What exactly would be purchased?

  • Employees – N/A: protocol developers and business people do not work for token holders.
  • Customers – N/A
  • Processes –N/A
  • Balance sheet – N/A
  • Intellectual property – N/A: all of code that powers that the token – the blockchain and/or smart contract – is open source. In this regard, there’s nothing to purchase. It’s possible that the dev team would turn over closed-source portions of what they’ve built that live outside of the blockchain or smart contract itself; however, this software is not “owned” by the token holders.

So there’s nothing to acquire?

Not quite. The value of a token accrues to token holders. The value of the token is imbued by the network of token holders and users. There is no way to acquire the network of autonomous users. If an organization somehow managed to acquire all of a given token, then by definition there wouldn’t be a network. You can’t have a network of one.

Merging Networks Using Inflation And Hard Forks

By leveraging currency inflation and hard forks, it’s theoretically possible to construct scenarios in which networks could merge.

Let’s use Monero ($XMR) and Zcash ($ZEC) as an example. Both protocols aim to to provide users complete privacy, such that no person or organization can a given user’s money. The protocols leverage different technical approaches.

Let’s say that after a prolonged battle and years of community mudslinging, the devs of Monero and Zcash come to believe that they’d be better off combining forces. Let’s also say that the Monero dev team capitulates and acknowledges that Zcash offers a better technology solution.

What now?

The Zcash devs could propose a hard fork to Zcash chain in which that the inflation schedule for ZEC is modified to issue ZEC tokens to XMR holders on the ZEC blockchain (this is non-trivial; many technical details would need to be addressed for this to work). The ratio of ZEC issued per XMR would be based on some negotiated price between the leadership of both networks, similarly to a stock swap. In order to ensure XMR holders don’t keep their XMR tokens after the transaction, the Monero developers would need to establish some sort of proof-of-burn system. Only XMR holders who provably burn their tokens would be eligible to receive ZEC.

On a marginal basis, this transaction could be structured such that it’s not value destructive to existing ZEC holders. Even though each user’s individual economic value would be preserved, all existing ZEC holders would be diluted as the total value of ZEC grows in an inverse proportion to dilution. Some may find this acceptable. Others – those who are focused on owning a fixed % of total supply – would not, even if the addition of new users to the network is value accretive in a 1+1=3 scenario given the characteristics of network effects.

This would likely lead to a contentious hard fork among ZEC holders. One group would welcome the new users, believing that growing the network is good for existing ZEC holders and the future growth potential of the network. Others would oppose it, arguing that they’re being unfairly diluted.

XMR holders would engage in an inverted version of the same debate. Some would want to move their economic value to Zcash. Others would want to stay on the original XMR chain. The XMR chain would likely survive even if the core dev team honored the agreement and joined the Zcash team. The value of XMR would likely plummet, but it would probably stay above $0 and the chain would continue to grow, albeit with some short term turbulence.

Both ZEC and XMR holders have valid claims on each side of the debates within their respective communities. Because crypto is fundamentally about empowering individuals, drag along rights do not exist. This virtually guarantees that that divisive decisions such as “let’s all move to the other side” or “let’s welcome the other side” cannot occur. The minorities on each side of these major decisions is always likely to be large enough to sustain itself after a contentious hard fork.

Crypto networks have tremendous inertia.

Good Artists Copy; Great Artists Steal

The vast majority of code that powers these protocols is open source. Although smart contracts on Ethereum are not open source, most major contracts as published as open source. The ethos of the crypto community is that projects must be open source. This creates interesting new dynamics and incentive models to copy from other projects.

The first high profile example of this is playing out now. Ethereum, through its recent non-contentious hard fork called Metropolis, will support zk-SNARKs. zk-SNARKs are the mechanism that Zcash uses to achieve confidential transactions. Although Ethereum’s implementation is not as advanced as that of Zcash, it’s clear that, in time, the Ethereum Foundation aims to enable users to easily transact confidentially.

Perhaps most interestingly, the Zcash team helped with the Ethereum foundation with this.

As the crypto ecosystem evolves, I expect the rate of feature-copying to accelerate. This will create interesting new dilemmas for users. What happens when your favorite coin – which used to be the only coin with feature X – is suddenly one of 8 coins with X? Do you move your wealth over, or do you stay zealous and support your original coin?

Wealth Transitions

There is no practical way to conduct a cryptocurrency merger or acquisition. No protocol dev will voluntarily push their community through an unprompted contentious hard fork. This process is too value destructive.

There’s only one way for value to move across chains: for users to individually make the decision to move their money. As one chain begins a process of decline – a process that will likely take years given the dogmatism in the space – it’s price will fall and liquidity will dry up, making it harder for users to exit. Ultimately, only the most adamant believers will be left standing.

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