Governance Is The Killer App of the VC Platform
The great unbundling of VC has been discussed before. Naval Ravikant captured it perfectly here in 2010 and more recently Fred Wilson discussed possible ways VC could be reconfigured here. Token sales have added a new dimension that is best explored through the lens of Ben Thompson’s work on aggregation theory.
Fred Wilson has previously suggested that his portfolio companies are his customers. It’s a nice idea and I really do get where he is coming. But it’s clear that limited partners keep the lights on so surely LPs are the customers and startups are the suppliers*. VCs provide a lot of value to their “suppliers” in terms of advice, operational help, a ready-made network of contacts and, of course, financing. When we map this out in the context of aggregation theory, a VC is a distributor and limited partners are the customers. LPs are buying a service that bundles market intelligence, capital allocation, governance, “supplier” services (as per above) and (on the occasions where it is required) operational intervention. In aggregation theory terms, startups, as the suppliers, are commoditised and modularized**.
One common mistake is to assume that venture capital is all about capital allocation decisions, and from that mistaken perspective it might look like token sales are disintermediating VC. If VCs are to be disrupted, aggregation theory suggests we look at what is bundled before the disruption, what becomes unbundled and finally what is reconfigured into a new bundle. It turns out that we end up with two unstable (i.e. not viable long-term) re-configurations (a) token economies and (b) VC self-disruption.
In the (somewhat idealised) token economy model, the community analyse a wide selection of white papers to decide which are worthy projects, and self-select into the token economies they like, providing finance to these projects. The token economy now has an army of dedicated contributors: they build clean APIs, they document the platform, they build (and help others build) apps on the platform with world class UX and they promote the service to small and large firms who integrate it into their own platforms. The ecosystem grows, a platform evolves, competition dissolves away and the flywheel spins its way to profit for all.
The first hidden assumption in all of this is that the project leaders are entrepreneurial deal-makers who can navigate the project to success. In 2017, platform success means a large ecosystem of customers, partners, integrators, service providers, developers etc. The second assumption is that when the first assumption fails to hold, then the community will re-align around new leaders who can deliver success. We’ll come back to this later.
First let’s go back to aggregation theory and the Clay Christensen-influenced analysis of reconfigured value chains. Here we have the smart contract platform as a multi-sided network. It aggregates the crowd the same way Airbnb and Uber did with tourists and commuters, where deal flow and market intelligence are crowd-sourced through (off-chain) online communities. This approach modularizes and commoditizes finance. The new value capture is through the integration of the token-backed network itself, it’s governance mechanism and (assuming the project put some thought into their token distribution at crowd sale time) the ability to tap into a large number of advisers with the operational know-how required to help the project succeed. And this new bundle of value all feels like Naval’s 2010 vision taken to it logical conclusion.
So what about the alternative model where VCs are disrupting themselves? The best example of this is USV / Andreessen Horowitz investing in Polychain Capital. In some sense, this is just two levels of indirection to the previous model. Polychain is part of the crowd. They have enhanced influence over the crowd-sourcing of wisdom and therefore on the capital allocation decisions the rest of the crowd make. As long as Olaf an co. are doing their homework (and it’s clear that they are) then the crowd can gain from this highly relevant market signal. The potential downside will come as their fund grows and as they need to put more money to work and therefore take an increasing share of the token allocations, thus diluting the incentives of the community to actively participate. But they have some very smart backers who can advise on how to navigate this risk and anyway the operational know-how that their LPs bring to the table should outweigh this risk. But what is important is that, even though USV and A16Z join the crowd in this model, their ability to promote effective governance is significantly weaker than in the old VC value chain. A point which USV are already well aware of.
So when I say that the above solutions are unstable, what I mean is that without a reliable governance mechanism it’s hard to see how cryptoassets can evolve beyond their position today as highly speculative assets. In a very real sense, governance is the killer app of today’s VC platform. Without it the ecosystem is likely to break down. Proposed (non-centralised) solutions to governance issues fall into two categories: community self-determination and market-based.
The community self-determination model is probably clear to most people in the space. Tokens come with voting rights and over time the community will agree to changes in how the network is run by some democratic, futarchic or other similar mechanism. It’s a little difficult to say at this stage how well these will work but it’s clear that there are some promising approaches being attempted.
As the infrastructure of crypto matures, it feels like market-based solutions will take a leading role in efforts to enforce governance, or more specifically some form of proactive metagovernance, by which I mean mechanisms to guide the ecosystem as a whole rather than specific projects. Ari Paul in discussion with CoinFund here refers to one particular strategy, where an activist investor would buy up tokens to reinvigorate a struggling token-backed network. This is a form of metagovernance, as once other networks see this approach play out they will need to adjust their own strategy to avoid a similar fate. There are multiple possible variations of this model, some more aggressive in approach than others, from network forks retaining existing allocations to re-initiating networks with new token allocations and / or new governance rules (see Fred Ehrsam discussions on funding and forking networks here and here). Ari Paul’s activist investor buying in at a collapsed market valuation would mitigate the tragedy of the commons / free loader issue that Fred refers to, as the activist investor (and their developer partners) would capture most of the upside of their efforts. It’s worth pointing out that, as long as token-backed protocols deliver genuine network effects then they will be protected from some of the the more aggressive forms of forking.
What’s also interesting is that the activist investor-lead hostile takeover concept outlined above, somewhat resembles the operational invention by a VC to replace a non-performing CEO. In fact, what is interesting is that the key points in the lifecycle of a company where the VC adds most value in terms of proactive governance, may all have parallels in cryptomarket governance. We could, for example, see activist investor-lead strategy pivots, M&A (i.e. funding one project to take control of or fork another project) or governance interventions, e.g. to attempt to block inflationary token issuance.
In conclusion, while cryptomarkets learn more about which governance models are most effective, the current venture capital model will continue to dominate, at least when measured in terms of Assets Under Management. This dominance is mostly down to their proven and effective governance approach. However, when a new approach to governance finally does take hold, do not expect the new model to resemble the old one. New and powerful models may combine the strengths of decentralised self-determination by communities with market-based metagovernance approaches.
*Actually, if we want to be needlessly cruel in our supply chain analogy, startups could be seen to be the raw materials (but I’m an entrepreneur too, so I won’t go that far).
**Like I said I’m an entrepreneur so do bear with me. But we could (arguably) say that ideas are ten a penny, strategy can be taught and 99% of startup life is pure perspiration. I’m not saying anyone can do it. But I am saying it’s possible to swap out a founding team and still deliver success, so it is modularized in this sense (and we’ll come back to operational intervention).
