Using DeFi to open up Venture Capital to Non-Accredited Investors

Today, it is common to believe that Decentralized Finance (DeFi) is just a playground for developers, and it isn’t actually solving any real world problems. However, this is not entirely true. There are some ways that it can already 10x traditional finance today.

Capitalism in the West is in a self-reinforcing feedback loop where money is continually funneled to the top 1%, and is not being fairly distributed to the bottom 80%. This is not to say that capitalism is bad, it just highlights the fact that at the extremes in any system, weaknesses become more pronounced. DeFi can help to combat this problem.

This blog will examine some research done by AngelList that reveals how early stage investment rounds being made available to non-accredited investors allows for a more balanced system. Thus, allowing new money to enter the hands of these less privileged investors. Then it’ll reveal how DeFi can allow us to do this today.

Capitalism’s Self-reinforcing Feedback Loop

Today (March 2020) the world is experiencing a potential worldwide economic recession. The catalyst to start the chaos was the COVID-19 Coronavirus, but many people were already predicting a recession before the virus caught us all by surprise. An excellent example is Why and How Capitalism Needs to Be Reformed, written by Ray Dalio, one of the top Hedge Fund managers in the world. This paragraph sums up the article’s central point [1]:

I believe that all good things taken to an extreme become self-destructive and everything must evolve or die, and that these principles now apply to capitalism. While the pursuit of profit is usually an effective motivator and resource allocator for creating productivity and for providing those who are productive with buying power, it is now producing a self-reinforcing feedback loop that widens the income/wealth/opportunity gap to the point that capitalism and the American Dream are in jeopardy. That is because capitalism is now working in a way in which people and companies find it profitable to have policies and make technologies that lessen their people costs, which lessens a large percentage of the population’s share of society’s resources.

An image from the article worth sharing here is how bad the wealth gap has grown in the United States:

Today the wealth of the top 1% of the population is more than that of the bottom 90% of the population combined. [1] If nothing is done, these problems will continue in their feedback loop and heighten the damage an economic collapse would cause.

AngelLists Research on Early Stage Investing

The report Startup Growth and Venture Returns produced by AngelList gives interesting insights into early stage capital returns for investors. The key finding of the article is summarized in this single sentence:

If you miss the best performing seed investment, you will eventually be outperformed by someone who blindly invests in every credible deal. [2]

This is shown in the chart below:

Also, mentioned in the report is the fact that startups are staying private longer. The average time from company founding to IPO for a U.S. technology company has gone from 4 years in 1999 to 11 years in 2015. [2] This extremely powerful wealth-creation engine exists entirely in the private market, thus limiting exposure to non-accredited investors.

The problem here is that these seed investing opportunities are only available to a select group of insiders who have worked their way into the Venture Capital world. On top of that, you must also be an ‘Accredited Investor’ — someone who has $1,000,000, or makes at least $200,000 a year.

The AngelList report argues that these opportunities need to be made available to non-accredited investors. Their conclusion can be summed up in the excerpt below from their report [2]:

We argue from equity and fairness that if a sizable fraction of the wealth created by an economy will be generated from early-stage investing, then a correspondingly large fraction of society should have the ability to participate in that wealth creation. That is why we call on policymakers to take steps that would enable retail investors to broadly gain access to early-stage venture capital as an asset class within their portfolios, consistent with the appropriate investor protections. That is why we call on policymakers to take steps that would enable retail investors to broadly gain access to early-stage venture capital as an asset class within their portfolios, consistent with the appropriate investor protections. [2]

Case Study — Uber

Let’s do some quick math to show how much money could get into the general public’s hands when investing in seed rounds. Ubers seed round valued the company at around $5.4 million [3], and today it is worth about $35 billion. That is 6,500x the original valuation — meaning an individual who invested $1000 would now have $6,500,000!

Wealth creation opportunities like investing in Uber’s seed round would clearly benefit the non-accredited investor. Now let’s dive into some solutions that could get us there.

AngelLists’ Solutions

Changing regulations

AngelList proposed steps to open broad-based, early stage venture capital indexing to the 90% of retail investors who are unaccredited, while still maintaining appropriate investor protections. [2] Their main requests are summarized below:

  • Policy makers to enable less friction for early stage accredited investors to cash out profits. [2]
  • Regulatory updates that promote transparent and efficient liquidity for early-stage accredited investors would drive startup growth by enabling the following [5] :
  • Promoting startup capital formation by the improved ability to sell private shares quickly, at reasonable prices, with low transaction costs.
  • A transparent, open and efficient secondary market to benefit early selling of securities, reducing fraud, and increasing liquidity.
  • Loosening up the returns from unicorn tech companies stuck in private markets for years (i.e. Uber, which did not IPO for 10 years, and had billions of dollars locked up that could have been re-invested).

These proposed regulation changes are well thought out, and regulators would do well to heed this advice. However, DeFi can’t directly help in this regard.

Diversified Index Fund for Early Stage Startup Investing

The AngelList report points out that it is unrealistic to participate in every single seed round presented to you, since many startups are rejected from Day 1. Their data only includes startups that received an initial round of funding to begin with. [2]

However, a solution that provides ample opportunity for investors would be a Diversified Index Fund for early stage startup investing. It is difficult for investors to assess, evaluate, and execute investments in numerous startups in the private markets to obtain the same benefits as a well-diversified pooled investment vehicle. [5] Such a fund would provide non-accredited investors access to a pool of wealth creation that was not available to them before, creating a more balanced and fair access to capital for all investors.

I hope that regulators take the suggestions that AngelList has made seriously, and implement them soon. But as that is happening, blockchains and DeFi are already creating opportunities that work today.

How DeFi is creating opportunities for Non-Accredited Investors

People forget that Ethereum is DeFi

DeFi is usually used to reference any protocols built on top of Ethereum, or other smart contract protocols. But Ethereum itself is core to the DeFi movement, and it is common for people to separate Layer 1 blockchain protocols from DeFi. But it can all be put under the same umbrella.

By looking at some of Ethereum’s biggest achievements, it becomes clear that it solved a lot of the problems that AngelList references in their report:

  • Promoting startup capital formation — Etheruem did an ICO in 2014 that allowed anyone around the world to cheaply send bitcoin, and receive Ether when the Ethereum network launched. This created low transaction costs, and a large pool of global investors that made the opportunity possible for Ethereum to be developed in the first place.
  • An open secondary market — You could sell Ethereum in the secondary market when the network went public in 2015, as there were already centralized crypto exchanges that could list Ethereum.
  • Loosening up returns in the private market — The ICO worked out to roughly $0.30 per Ether. This was a public sale that was available to anyone around the world who was willing to send Bitcoin. At today’s price of ~ $137, that is a 45,670% return on investment — meaning an investment of $2200 would be worth $1,000,000. These profits from Etheruem were quickly invested in new startups in the crypto space.

The Ethereum ICO should be hailed as an example of capitalism working at its finest. It created millionaires out of a large group of non-accredited investors, while doing so legally and with an open opportunity for all to invest.

Respectfully circumventing regulation

Another key point with Ethereum’s ICO was that in 2018 the U.S. Securities and Exchange Commission (SEC) determined it was decentralized enough to not be considered a security. [7]

ICOs like Ethereum, have allowed early stage seed investment opportunities to non-accredited investors, giving them access to massive wealth creation opportunities. It has gone even further by making it available to any investor around the world that has access to the internet. This is DeFi working today.

Ethereum’s ICO respectfully circumvented regulations by starting a foundation in Switzerland. Today a team of decentralized employees around the world are paid to keep Ethereum functioning. This setup works so well because it is almost impossible for a single country to ban a decentralized protocol with a decentralized workforce. They are better off allowing the innovation to happen in their country, and tax the wealth that is created by the foundation.

Silicon Valley used to have a stranglehold on VC investment opportunities in the U.S. And the U.S. had a stranglehold on the whole world. Decentralized protocols have opened up early stage investment opportunities to any investor, making it a more democratic and fair opportunity. This is the most important movement blockchain has made for decentralized finance so far.

Driving regulation forward

Regulators are notoriously slow at changing laws. But if there is external pressure, regulations can be passed at an accelerated rate.

Being able to invest in decentralized protocols will put pressure on Regulators to update investing laws for non-accredited investors. There is no use in banning these investment opportunities, because it will only prevent access to wealth creation for their citizens.

Let’s now discuss some of the protocols and technologies being built on top of Layer 1 blockchains that can help provide the opportunity for non-accredited investors to earn early stage profits.

Security Token Offerings (STOs)

Security Tokens Offerings (STOs) are securities (i.e. stocks, bonds) that are on a blockchain. Although it is not fully decentralized (securities inherently must follow regulations), they actually meet a lot of the requirements that AngelList suggests:

  • Promoting startup capital formation — The transaction costs for creating the STO and post market trading would be much more affordable and streamlined.
  • An open secondary market — They are easy to sell quickly and transparently in the secondary market. The secondary market would benefit from both centralized and decentralized exchanges.
  • Loosening up returns in the private market — STOs are easy to transparently trade in the secondary market. However, STOs need to have a whitelist of accounts that can own the token. Because of this the liquidity of STOs is low today. It is expected that more investors will start investing in STOs in the coming years as it becomes more mainstream.

Today it might be hard to launch an STO in a country like the U.S. But STOs are slowly gaining momentum, and they are available to a global pool of investors. Once the momentum picks up, regulators will start passing laws to allow favorable laws for STOs in their own countries.

Decentralized Autonomous Organizations (DAOS) and Non-Accredited Venture Capital Funds

Decentralized Autonomous Organizations (DAOS) have gained a lot of popularity in the last year. They currently are used for a variety of things related to open source software, but they have the potential to help investors as well.

One of AngelList’s suggestions is to create an Index Fund that invests in early stage startups. I wouldn’t be surprised if AngelList is planning on doing this themselves in the near future — they are in a great position to do so. But it is a complex endeavour that needs regulators to pass new laws and it will take some time.

In the meantime, a DAO could be used to create something similar. A Venture Capital Fund where a pool of non-accredited investors could send a small amount of money to create a large pool of capital. Consider the following:

  • You want to raise a small VC fund with $5 million.
  • With blockchain technology, you could approach many non-accredited investors to invest in your VC fund, limiting their investments to $10,000.
  • This would require 500 investors.

This is an attractive investment opportunity. But it should be noted that full decentralization is not needed here. A small VC fund only needs a handful of people to run it. So what is the advantage of being completely decentralized? It isn’t like the fund would ask all of their investors for advice — the whole point is to leave the decision making to the fund managers.

Instead let’s create the following arrangement:

  • Find the country that will legally allow you to start a VC fund that takes money from non-accredited investors worldwide, at $10,000, and create a $5,000,000 fund.
  • Vet the 500 investors you have sending money your way.
  • Now the fund can legally invest in ICOs. But you can also invest in traditional companies, because to the outside world your fund will look like any typical foreign VC fund.

This fund could directly compete with VC funds in the US, and Silicon Valley, where most of the opportunities are today. Essentially using blockchain technology to enable the possibility for a Non-Accredited Venture Capital Fund to exist. It is similar to how STOs are a bridge between ICOs and traditional securities. The Non-Accredited Venture Capital Fund exists to bridge the gap between Venture Capital today, and a fully decentralized Investment fund.

Turning Investors into Users

Creating a Non-Accredited Venture Capital fund by using blockchain technology to raise money is a new idea, and I don’t believe it has been put into practice anywhere. It would be worthwhile to think how this type of fund could have an advantage over traditional VC firms.

If you raise $5,000,000, you would have 500 members in the fund, rather than maybe 10–20 high networth individuals that a traditional VC firm would have. These 500 members are likely to be scrappy and highly invested in the $10,000 they handed over to you. You can use these 500 members to become the first 500 users of any startup you choose to invest in. These users will be:

  • Excited to use the product or service.
  • Give detailed feedback on beta versions of any product the fund has invested in.
  • They can brag to their friends about the product and how they are a part owner.
  • By the time a product launches their beta, the 500 investors might have brought in 1000’s of users through word of mouth.

Taking advantage of this opportunity would be a great bootstrapping mechanism for any of the start ups the Non-Accredited VC Fund chooses to invest in.

Conclusion

It is obvious that non-accredited investors are at a disadvantage when it comes to having early stage opportunities to invest in startups, and the AngelList report shows the data on this.

The AngelList suggestions are great, but regulators will be slow to pass these laws. Because of this, Ethereum and DeFi can be relied upon to create new opportunities, and be a driving force to convince regulators to move more quickly.

This can be done because decentralized companies can register in a regulatory-friendly jurisdiction, and can openly sell work tokens or security tokens to investors around the world. It takes away the centralization of technology innovation from the U.S. and Silicon Valley, and opens it up to everyone. Innovation in DeFi is currently pushing this forward.

A solution that can help drive this forward is a Non-Accredited Venture Capital Fund that is created in a regulatory friendly jurisdiction, and uses blockchain technology to do the raising and distributing of funds more smoothly. This could be a great opportunity for non-accredited investors to invest in some of the best crypto projects, along with traditional technology startups.

Sources

[1] Why and How Capitalism Needs to Be ReformedRay Dalio

[2] Startup Growth and Venture ReturnsAngelList

[3] Uber FundingCraft.co

[4] Google FinanceGoogle

[5] Concept Release on Harmonization of Securities Offering, File No. S7–08–19AngelList letter to SEC

[6] Ethereum ChartOnChainFX

[7] SEC says Ether is not a securityReuters

Written by

Blockchain developer & researcher. Thoughts on blockchains can be found here. I do work at https://thegraph.com/

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