Debt vs. Equity
A quick TradFi primer (be patient!) and then how this applies to DAOs
Individuals, businesses, and DAO’s alike - all need capital to meet day-to-day needs or make investments for the future. Capital consists of both Equity and Debt. Earlier in the doc, we covered debt capital in the form of a loan. Unlike lenders seeking repayment, equity capital is acquired from investors that wish to own a part of a business in hope that it is able to generate profits above operating expenses and make strategic investments that increase future profitability, while simultaneously servicing outstanding debt obligations. In return, equity investors are entitled to the earnings a business generates after meeting all other expense items.
Shareholders are in line behind creditors when it’s time to distribute profits. Simply put, creditors are first in line to receive payment while shareholders get paid last with any remaining earnings. The benefit of providing equity capital is corporate-governance voting rights and the potential for unlimited upside because remaining earnings can far exceed business-related expenses and fixed-interest payments. The downside occurs when there are no leftovers or the leftovers are shrinking over time. In the event of business closure, remediations are far more forgiving for debt holders as loan agreements contain things like collateral repayment.
As a result, equity capital is considered ‘more expensive’ to a business compared to debt capital because shareholders require higher returns on investment for bearing greater risk.
Equity capital for DAO’s are represented by tokens. The value of a token greatly depends on the underlying project’s ability to create and capture value within an ecosystem or network. Like common stock, many tokens entitle the holder an ability to share in the governance of the issuing entity.
Recall that equity is a more expensive form of capital. In a capital market system lacking debt product offerings, DAO’s looking to raise capital are constrained to equity and this has led to an all familiar cycle:
- 1.DAO raise capital by issuing additional tokens which dilutes existing token holders.
- 2.Token gets dumped – in turn, higher price volatility amid the depreciation of the token’s value results in even higher capital costs as potential investors require an even higher return for greater risk.
- 3.DAO has a greater need for capital, repeat.
Debt is a critical component of sustaining the growth of a business and larger marketplace. By tapping into cheaper sources of non-dilutive capital, both DAOs and their Token holders are afforded the assurance of continued incentive alignment with greater capital efficiency.