Tokenizing Venture Capital

The future of venture capital is tokenized securities transacted on blockchain. What are tokenized securities? They are digital tokens representing fractional equity ownership in a business often referred to as crypto assets, which is an asset class backed by real assets and cryptography. The benefits of tokens far outweigh the current way of investing in and managing assets in terms of enhanced liquidity, ease of transaction, terms and conditions built into transactions and more. 

Currently, the age-old method of startup investing involves a business raising funding from family and friends, angel investors, and venture capitalists. The problem with this is that the process is inefficient, time consuming, and expensive. Most equity-based venture investments involve a series of legal documents including term sheets, shareholder agreements, and operating agreement revisions to incorporate updated terms. These documents can take weeks to months to negotiate depending on the size of the company and the complexity of the investment. A more streamlined way of financing a startup is through convertible notes, Simple Agreements for Future Equity (SAFE), and Keep It Simple Securities (KISS). These investment structures allow for a more streamlined negotiation process due to the smaller amount of terms being agreed upon; usually a valuation cap, discount rate and financing amount for conversion. These are debt instruments that are set up to convert to equity at a later date upon specific triggering events. Although these transaction documents allow for a more streamlined process, they have risks to both investors and startups that can end up burning shareholders in the future if the notes aren’t structured in a sophisticated manner planning for potential unforeseen circumstances. Another more new-age method of raising capital is through equity crowdfunding that has opened up the door for startups to publicly raise capital through various accredited platforms. This was a big step in opening the door for unaccredited investors to get in on venture deals and allowing startups a new mechanism for raising funding through smaller increments with a much larger investor base. As with any investment structure, equity crowdfunding also has it downsides.

The big issue with the various investment options laid out above is that the opportunity for liquidity for both the startup and investor is often difficult and takes years. When an investor provides capital to the startup, a series of documents are executed and the securities being purchased in the business are stored on digital paper contracts and cap tables. The ownership interest is constantly changing as businesses raise additional capital in the future and both the investor and the startup must manage the fluctuations in dilution of the specific ownership stake for each investor. If an investor wants to liquidate their position in a startup investment, they either wait years until the company gets acquired (~5-8 years), goes public (~6-10 years) or they get their shares bought out at a future financing round (timeline can vary, but usually years). Another option is to list their shares on a secondary market exchange in an attempt to get their return. All of these options usually require an investor to wait quite some time to see a return and limits the opportunities for liquidity.

Over the last few years, with the adoption of blockchain, a new mechanism for funding startups was invented called Initial Coin Offerings (ICO). This innovation allowed startups to create digital crypto coins on a blockchain, usually the ethereum blockchain, that issue investors digital ownership in a business. The investor sends cryptocurrency to a specific crypto address for their investment and a smart contract executes issuing a digital coin to the investor. The investor maintains custody of the coins in their own exchange account or private digital wallet allowing them to freely liquidate their position and transact on global exchanges whenever they want. This new model was all the hype and companies raised billions of dollars in a matter of months. The problem is that a lot of companies that raised funding didn’t have a product built or any actual traction in a market. Most companies were able to raise a ton of money off of a white paper and investors flooded the market in an attempt to get rich quick. Most of the ICOs that occurred were scams and investors lost all their money. Before long, the financial enforcement agencies around the world began cracking down on startups launching ICOs in an attempt to eliminate the fraud in the market. Some regulatory agencies like the SEC in the United States began classifying some of these offerings as security sales and going after startups that were mislabeling their offerings with hefty fines and legal action. Although the ICO boom created an incredibly innovative way to raise capital, it was the beta version of this new funding opportunity for both investors and startups. There was a lot of capital lost and a lot of education opportunities for all parties involved. Although most startups that raised millions of dollars through ICOs on nothing more than a white paper have failed, a small percentage of companies with seasoned teams put that capital work in intelligent ways and built amazing products.

As the hype wave of ICOs has crashed, the next generation of funding is quickly developing and seems to be creating an innovative new way to digitize all assets in the future. This new mechanism is Security Token Offerings (STO). This model allows for a company to create a digitized security crypto token that provides fractional ownership in an asset class. In terms of the U.S. financial agencies, the SEC classifies STOs as security interests in a business for which a company needs to file all the necessary securities paperwork to list their securities on a market for accredited investors. Obviously, this is going to be far to cost intensive for a startup company, so there will likely be new laws and regulations defined for each stage of company that is looking to raise capital through an STO. For now, a good way to think about an STO is a more mature company could take their company public on a blockchain listing their tokenized assets on global cryptocurrency exchanges. The unique thing about STOs is that companies looking to leverage this funding opportunity will likely need to work with firms that have licensed broker dealers to handle the security aspects of the listing and experienced technologists to handle the build out of tokenizing the assets on a distributed ledger. Some of the benefits of a tokenized security are:

·      Digital fractional ownership

·      24/7 global marketplace for liquidity

·      Smart contract-based investment execution

·      Self-enacting smart contracts handling terms and conditions such a liquidation preferences, distributions, and rights of first refusal

·      Investor can choose to have custody of its tokens or leverage custody providers

·      State of the art security

·      Streamlined and recorded transactions on blockchain

·      Low legal costs for transactions

The STO world is quickly evolving and new models are under development creating opportunities for digital convertible debt tokens, traditional debt financing tokens and more. As this technological financing innovation matures, it is likely that it will be applied to early-stage businesses with new regulations and exemptions that apply to the venture space that aren’t present in the public securities markets. For example, it is likely that startups won’t need to list their securities with the SEC if they are private companies and venture investors will be able to invest in startup tokens with the same regulatory standards that traditional venture funds have. Venture funds will also need to structure themselves in new ways and have custody accounts at digital token exchanges or wallets that protect their investments, while allowing them to easily transact. They will also have to carry new forms of insurance covering crypto assets and startups will have to get their own insurance for the tokenized assets they are providing to investors to ensure their smart contracts operate in the way advertised. This will open brand new lines of business for insurance providers.

It’s clear that the traditional venture investment and startup markets are being disrupted in terms of financing options. This is great because for an industry that is focused on investing in disruption, the venture space in and of itself has experienced barely any innovation from an investment perspective since it was invented. ICOs and STOs open the opportunity for the next generation of financing startups and will create brand new product and service opportunities for businesses to supplement this new wave of asset investing and management. If your business is interested in learning more about how advanced technology can create new solutions to drive growth, reach out to our experts at Capital Innovators to learn more.

Disclaimer: This article is not intended to provide financial or legal advice. The information is based on the opinions of the author based on their view of global trends in the blockchain-based financial markets. Manifest Ventures recommends that any companies or investors interested in the legal, regulatory, and accounting ramifications of the topics discussed consult with licensed professionals to fully understand the requirements of any of the information outlined.